Choice Involving Risk and Uncertainty

Decision or Choice Theory in economics is concerned with identifying the values, uncertainties and other issues relevant to a given decision, its rationality, and the resulting optimal decision. It is closely related to the field of game theory. Decision theory is concerned with the choices of individual agents, whereas game theory is concerned with interactions of agents whose decisions affect each other. This area represents the heart of decision theory.

The procedure, now referred to as expected value, was known from the 17th century. Blaise Pascal invoked it in his wager, which is contained in his Pensées, published in 1670. The idea of expected value is that, when faced with a number of actions, each of which could give rise to more than one possible outcome with different probabilities, the rational procedure is to identify all possible outcomes, determine their values (positive or negative) and the probabilities that will result from each course of action, and multiply the two to give an expected value. The action to be chosen should be the one that gives rise to the highest total expected value.

In 1738, Daniel Bernoulli published an influential paper entitled Exposition of a New Theory on the Measurement of Risk, in which he used the St. Petersburg paradox to show that expected value theory must be normatively wrong. He also gives an example in which a Dutch merchant is trying to decide whether to insure a cargo being sent from Amsterdam to St Petersburg in winter when it is known that there is a 5% chance that the ship and cargo will be lost. In his solution, he defines a utility function and computes expected utility rather than expected financial value.

In the 20th century, interest was reignited by Abraham Wald’s 1939 paper pointing out that the two central procedures of sampling–distribution–based statistical-theory, namely hypothesis testing and parameter estimation, are special cases of the general decision problem. Wald’s paper renewed and synthesized many concepts of statistical theory, including loss functions, risk functions, admissible decision rules, antecedent distributions, Bayesian procedures, and minimax procedures.

The phrase “decision theory” itself was used in 1950 by E. L. Lehmann. The revival of subjective probability theory, from the work of Frank Ramsey, Bruno de Finetti, Leonard Savage and others, extended the scope of expected utility theory to situations where subjective probabilities can be used. At this time, von Neumann’s theory of expected utility proved that expected utility maximization followed basic postulates about rational behaviour.

The work of Maurice Allais and Daniel Ellsberg showed that human behaviour has systematic and sometimes important departures from expected-utility maximization. The prospect theory of Daniel Kahneman and Amos Tversky renewed the empirical study of economic behaviour with less emphasis on rationality presuppositions.

Kahneman and Tversky found three regularities – in actual human decision-making, “losses loom larger than gains”; persons focus more on changes in their utility–states than they focus on absolute utilities; and the estimation of subjective probabilities is severely biased by anchoring.

Castagnoli & LiCalzi (1996) and Bordley & LiCalzi (2000) recently showed that maximizing expected utility is mathematically equivalent to maximizing the probability that the uncertain consequences of a decision are preferable to an uncertain benchmark. This reinterpretation relates to psychological work suggesting that individuals have fuzzy aspiration levels (Lopes & Oden), which may vary from choice context to choice context.

Hence it shifts the focus from utility to the individual’s uncertain reference point. Pascal’s Wager is a classic example of a choice under uncertainty.

Read More- Microeconomics

1. Microeconomics: Definition, Meaning and Scope
2. Methods of Analysis in Economics
3. Problem of Choice & Production Possibility Curve
4. Concept of Market & Market Mechanism in Economics
5. Concept of Demand and Supply in Economics
6. Concept of Equilibrium & Dis-equilibrium in Economics
7. Cardinal Utility Theory: Concept, Assumptions, Equilibrium & Drawbacks
8. Ordinal Utility Theory: Meaning & Assumptions
9. Indifference Curve: Concept, Properties & Shapes
10. Budget Line: Concept & Explanation
11. Consumer Equilibrium: Ordinal Approach, Income & Price Consumption Curve
12. Applications of Indifference Curve
13. Measuring Effects of Income & Excise Taxes and Income & Excise Subsidies
14. Normal Goods: Income & Substitution Effects
15. Inferior Goods: Income & Substitution Effects
16. Giffen Paradox or Giffen Goods: Income & Substitution Effects
17. Concept of Elasticity: Demand & Supply
18. Demand Elasticity: Price Elasticity, Income Elasticity & Cross Elasticity
19. Determinants of Price Elasticity of Demand
20. Measuring Price Elasticity of Demand
21. Price Elasticity of Supply and Its Determinants
22. Revealed Preference Theory of Samuelson: Concept, Assumptions & Explanation
23. Hicks’s Revision of Demand Theory
24. Choice Involving Risk and Uncertainty
25. Inter Temporal Choice: Budget Constraint & Consumer Preferences
26. Theories in Demand Analysis
27. Elementary Theory of Price Determination: Demand, Supply & Equilibrium Price
28. Cobweb Model: Concept, Theorem and Lagged Adjustments in Interrelated Markets
29. Production Function: Concept, Assumptions & Law of Diminishing Return
30. Isoquant: Assumptions and Properties
31. Isoquant Map and Economic Region of Production
32. Elasticity of Technical Substitution
33. Law of Returns to Scale
34. Production Function and Returns to Scale
35. Euler’s Theorem and Product Exhaustion Theorem
36. Technical Progress (Production Function)
37. Multi-Product Firm and Production Possibility Curve
38. Concept of Production Function
39. Cobb Douglas Production Function
40. CES Production Function
41. VES Production Function
42. Translog Production Function
43. Concepts of Costs: Private, Social, Explicit, Implicit and Opportunity
44. Traditional Theory of Costs: Short Run
45. Traditional Theory of Costs: Long Run
46. Modern Theory Of Cost: Short-run and Long-run
47. Modern Theory Of Cost: Short Run
48. Modern Theory Of Cost: Long Run
49. Empirical Evidences on the Shape of Cost Curves
50. Derivation of Short-Run Average and Marginal Cost Curves From Total Cost Curves
51. Cost Curves In The Long-Run: LRAC and LRMC
52. Economies of Scope
53. The Learning Curve
54. Perfect Competition: Meaning and Assumptions
55. Perfect Competition: Pricing and Output Decisions
56. Perfect Competition: Demand Curve
57. Perfect Competition Equilibrium: Short Run and Long Run
58. Monopoly: Meaning, Characteristics and Equilibrium (Short-run & Long-run)
59. Multi-Plant Monopoly
60. Deadweight Loss in Monopoly
61. Welfare Aspects of Monopoly
62. Price Discrimination under Monopoly: Types, Degree and Equilibrium
63. Monopolistic Competition: Concept, Characteristics and Criticism
64. Excess Capacity: Concept and Explanation
65. Difference Between Perfect Competition and Monopolistic Competition
66. Oligopoly Market: Concept, Types and Characteristics
67. Difference Between Oligopoly Market and Monopolistic Market
68. Oligopoly: Collusive Models- Cartel & Price Leadership
69. Oligopoly: Non-Collusive Models- Cournot, Stackelberg, Bertrand, Sweezy or Kinked Demand Curve
70. Monopsony Market Structure
71. Bilateral Monopoly Market Structure
72. Workable Competition in Market: Meaning and Explanation
73. Baumol’s Sales Revenue Maximization Model
74. Williamson’s Model of Managerial Discretion
75. Robin Marris Model of Managerial Enterprise
76. Hall and Hitch Full Cost Pricing Theory
77. Andrew’s Full Cost Pricing Theory
78. Bain’s Model of Limit Pricing
79. Sylos Labini’s Model of Limit Pricing
80. Behavioural Theory of Cyert and March
81. Game Theory: Concept, Application, and Example
82. Prisoner’s Dilemma: Concept and Example