Risk and Decision Making

In this chapter, we consider decisions in risky situations.  Each decision has a set of money consequences or “prizes” and the associated probabilities.  In such cases, it is straightforward to calculate the expected money value of each decision. For example, a filp of a fair coin that yields $10 with probability 1/2, $0 otherwise, has an expected value of (0.5)($10) + (0.5)($0) = $5.  A person who is neutral to risk will select the decision with the highest expected payoff.  A risk-averse person is willing to accept a lower expected payoff in order to reduce risk.  A simple lottery choice experiment is used to illustrate the concepts of expected value maximization and risk aversion.   Variations on the experiment can be conducted prior to class discussions, either with the instructions included in the appendix or with the Veconlab software (select the Lottery Choice Menu experiment from the Decisions menu of   http://veconlab.econ.virginia.edu/admin.htm 
 

Published in: Markets, Games, and Strategic Behavior
2006