Decision under risk

Definition

Decision under risk refers to the process of making choices when the outcomes are uncertain but can be associated with known probabilities. This concept is essential in understanding how individuals evaluate potential risks and rewards, particularly in situations where they must weigh their options based on uncertain outcomes. It connects closely with theories of human behavior, as well as various strategies in decision-making that influence choices in competitive environments.

5 Must Know Facts For Your Next Test

1. In decision under risk, individuals often use probabilities to assess potential outcomes, which allows for a more informed choice despite uncertainty.
2. People exhibit different levels of risk aversion, which affects their decision-making; those who are more risk-averse will likely choose safer options.
3. Framing effects play a significant role in decision-making under risk, as the way a choice is presented can influence perceptions of risk and value.
4. Prospect theory illustrates that individuals value potential losses more than equivalent gains, leading to risk-seeking behavior in loss scenarios.
5. Decision-making under risk is crucial in games and economic behavior as it impacts strategies and outcomes, shaping competitive dynamics.

Review Questions

• How does prospect theory enhance our understanding of decision under risk?
  • Prospect theory enhances our understanding of decision under risk by explaining how people perceive and evaluate potential gains and losses differently. It posits that individuals tend to weigh losses more heavily than gains, leading them to make choices that may seem irrational if viewed through traditional expected utility theory. This difference in perception helps explain why people might take risks to avoid losses while being conservative when considering potential gains.
• Discuss the impact of framing effects on decision making under risk and provide examples.
  • Framing effects significantly impact decision making under risk by altering how choices are perceived based on presentation. For example, presenting a medical treatment as having a 90% survival rate may lead individuals to view it more favorably compared to describing it as having a 10% mortality rate, even though both statements convey the same information. This manipulation can lead to different decisions based solely on how the information is framed, demonstrating the importance of context in risky choices.
• Evaluate the implications of risk aversion in competitive situations where players face decisions under risk.
  • In competitive situations where players face decisions under risk, risk aversion can significantly influence strategies and outcomes. Players who are more risk-averse may opt for safer strategies that yield guaranteed but potentially lower payoffs, while less risk-averse players might pursue higher-risk strategies for greater rewards. This divergence in approaches can create asymmetries in competition, impacting overall game dynamics and leading to varied outcomes based on individual risk preferences.

Related terms

Expected Utility Theory: A theory that suggests individuals choose between risky or uncertain options by comparing the expected utility of each option, calculated by multiplying the utility of each outcome by its probability.

Risk Aversion: A behavioral trait where individuals prefer to avoid risk and choose options with lower uncertainty, even if it means potentially lower returns.

Prospect Theory: A behavioral economic theory that describes how people make decisions based on potential gains and losses, highlighting that losses often weigh heavier than equivalent gains.