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In expected utility theory, a lottery is a discrete distribution of probability on a set of states of nature.The elements of a lottery correspond to the probabilities that each of the states of nature will occur, (e.g. Rain: 0.70, No Rain: 0.30). [1]
In decision theory, the von Neumann–Morgenstern (VNM) utility theorem demonstrates that rational choice under uncertainty involves making decisions that take the form of maximizing the expected value of some cardinal utility function. This function is known as the von Neumann–Morgenstern utility function.
This is demonstrated in the contrast of individual preferences under the insurance and lottery context, which shows the degree of indeterminacy of the expected utility theory. Additionally, experiments have shown systematic violations and generalizations based on the results of Savage and von Neumann–Morgenstern.
The rank-dependent expected utility model (originally called anticipated utility) is a generalized expected utility model of choice under uncertainty, designed to explain the behaviour observed in the Allais paradox, as well as for the observation that many people both purchase lottery tickets (implying risk-loving preferences) and insure against losses (implying risk aversion).
To this aim, we just need to change the game so that it gives even more rapidly increasing payoffs. For any unbounded utility function, one can find a lottery that allows for a variant of the St. Petersburg paradox, as was first pointed out by Menger. [8] Recently, expected utility theory has been extended to arrive at more behavioral decision ...
The Allais paradox is a choice problem designed by Maurice Allais () to show an inconsistency of actual observed choices with the predictions of expected utility theory. . The Allais paradox demonstrates that individuals rarely make rational decisions consistently when required to do so immediat
He advises taxpayers to educate themselves on smarter financial strategies to cope with things like a higher-than-expected tax bill. Above all, consider talking to a professional for ongoing tax ...
When prospect theory was added to a previously existing model that was attempting to explain consumer behavior during auctions, out-of-sample predictions were shown to be more accurate than a corresponding expected utility model. Specifically, prospect theory was boiled down to certain elements: preference, loss aversion and probability weighting.