Monday, December 30, 2013

Uncertainty (TFS, Part 11)

I am reading Thinking, Fast and Slow, by Daniel Kahneman. In this series I will summarize key parts of the book and supply some comments and reflections on the material.

Part IV: Choices
Chapters 25-34

Summary:

Expected Utility Theory, Prospect Theory (gains/losses matter more than wealth; there is diminishing sensitivity to changes from the reference point; loss aversion; extremely low probability events are overweighted and extremely high probability events are underweighted relative to expected utility theory), The Endowment Effect.

If people have NO experience with something, then low-probability events are UNDER-weighted, not overweighted (e.g. perceived probability of an earthquake in CA by those living in CA who have not yet experienced an earthquake is too low).

Valuations of gambles are less sensitive to probability changes when the outcomes are vividly described. Framing matters. People can exhibit preference reversals, which violates standard economic assumptions.

Rules (Kahneman calls them "risk policies" in this part of the book), even ones that you impose on yourself, can mitigate some of these biases.

My Thoughts:

We have now reached the point in the book where things are becoming very dense. Much more dense than a normal "popular economics" book. If you are interested in reading more about the results and material in the book, I encourage you to pick it up.

Rather than spell out some of my "deeper" thoughts on this section, I want to present some of the paradoxes he uses in his (and others use in related) research. If you've never thought about the questions at the heart of these research paradoxes before (especially #3-5), they are worth thinking about.

Food for Thought:

1) "As a rule, I never buy extended warranties."

2) "Always take the highest possible deductible when purchasing insurance."

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For the following questions, read them carefully, but decide on a preliminary answer in 10 seconds or less. Then, spend as much time as you need on them to reason out what you would do if it really mattered. (Hint: What would an expected value maximizer do? What would a utility maximizer who is risk averse do? Then ask again, what would you do?)

3) Decision i) Choose between:
    A) sure gain of $240
    B) 25% chance to gain $1,000 and 75% chance to gain nothing.

    Decision ii) Choose between:
    C) sure loss of $750
    D) 75% chance to lose $1,000 and 25% chance to lose nothing.

    Decision iii) Choose between:
    AD) 25% chance to win $240 and 75% chance to lose $760.
    BC) 25% chance to win $250 and 75% chance to lose $750.

If you chose A, D, then BC, think VERY HARD about what you just did.

4) Imagine the US is preparing for the outbreak of an unusual Asian disease, which is expected to kill 600 people. Two alternative programs to combat the disease have been proposed. Assume that the exact scientific estimates of the consequences of the programs are as follows:
    If Program A is adopted, 200 people will be saved.
    If Program B is adopted, there is a one-third probability that 600 people will be saved and a two-thirds probability that no people will be saved.

Do you choose A or B? Now suppose instead your options were as follows:

    If Program C is adopted, 400 people will die.
    If Program D is adopted, there is a one-third probability that no one will die and a two-thirds probability that 600 people will die.

Do you choose C or D?

Think VERY HARD if you choose A and D. Think VERY HARD if you choose B and C. 

5) Suppose for a family, a standard tax exemption is allowed for each child the family has. The amount of the exemption does not depend on the income of the family. Should the per child tax exemption be larger for the rich than for the poor?

Suppose instead for a family, a tax surcharge is levied for each child fewer than three the family has. The amount of the surcharge does not depend on the income of the family. Should the childless poor pay as large a surcharge as the childless rich?

If you answered NO to both of these questions, THINK VERY HARD about your answers. You cannot logically reject both proposals. Was your reaction based on the moral framing of the questions or the substance of the policy?

6) Read about the Allais Paradox. Now that you know about it, would you make the same selection if offered the same gamble again? What if you could take the gamble 100 times and real money was on the line? What would you choose? Now that you've learned something, would any of your answers to 3), 4), or 5) change?





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