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    Choice Theory: A Simple Introduction
    Choice Theory: A Simple Introduction
    Choice Theory: A Simple Introduction
    Ebook93 pages1 hour

    Choice Theory: A Simple Introduction

    By K.H. Erickson

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    About this ebook

    Choice Theory: A Simple Introduction offers an accessible guide to the central theories and methods of choice theory, with examples and calculations, empirical evidence, and over 20 diagrams to support the analysis.

    Examine expected value theory, with the two envelopes problem and St. Petersburg paradox which challenge it. Understand expected utility theory and learn how to create a utility function, and assess the Ellsberg paradox, Allais paradox, and preference reversal phenomenon.

    Look at risk neutral, risk seeking and risk averse attitudes, explore original, cumulative and third generation prospect theory, and the role of risk sensitivity and loss aversion.

    Evaluate zero-sum games, minimax and maximin strategies, and see how a mixed minimax strategy can overcome game outcome cycles.

    Understand auction theory, with the revenue equivalence theorem for English, Dutch, and sealed bid private value auctions, and how bidders may avoid the winner’s curse in common value auctions.

    Examine voting theory, with voter preferences, the median voter theorem, Condorcet winner, and Condorcet voting cycles. See how voters or government can manipulate the voting system.

    LanguageEnglish
    PublisherK.H. Erickson
    Release dateOct 3, 2013
    ISBN9781301878536
    Choice Theory: A Simple Introduction

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      Book preview

      Choice Theory - K.H. Erickson

      Choice Theory: A Simple Introduction

      By K.H. Erickson

      Copyright © 2013 K.H. Erickson

      All rights reserved.

      No part of this publication may be reproduced, stored in or introduced into a retrieval system, or transmitted in any form or by any means, including electronic, mechanical, photocopying, recording or otherwise, without the prior permission of the author.

      Also by K.H. Erickson

      Simple Introductions

      Choice Theory

      Financial Economics

      Game Theory

      Game Theory for Business

      Investment Appraisal

      Microeconomics

      Table of Contents

      1 Introduction

      2 Expected Value Theory

      2.1 Expected Value

      2.2 Two Envelopes Problem

      2.3 St. Petersburg Paradox

      3 Expected Utility Theory

      3.1 Expected Utility

      3.2 Ellsberg Paradox

      3.3 Allais Paradox

      3.4 Preference Reversal Phenomenon

      4 Prospect Theory

      4.1 Original Prospect Theory

      4.2 Cumulative Prospect Theory

      4.3 Third Generation Prospect Theory

      5 Risky Games

      5.1 Certain and Uncertain Games

      5.2 Minimax Strategies

      6 Auction Theory

      6.1 Types of Auction

      6.2 Private Value Auctions and Revenue Equivalence

      6.3 Common Value Auctions and the Winner’s Curse

      7 Voting

      7.1 Voter Preferences and the Condorcet Winner

      7.2 Condorcet Voting Cycles

      7.3 Playing the System

      Bibliography

      1 Introduction

      Choice Theory examines the processes people engage in during decision-making, and specifically what they do when faced with conditions of risk or uncertainty. In conditions of certain outcomes the choice is easy and they’ll always select the highest payoff. But when faced with a range of possible outcomes a number of factors come into play, including the possible odds and value of each outcome, and this book examines how individuals try to navigate this uncertainty in search of better results.

      The subject of choice theory is divided into two parts; choice under risk, and choice under uncertainty. Choice under uncertainty looks into situations with unknown probabilities of events occurring, and may represent a world where an individual has limited power among a larger group. Choice under risk assumes only unknown outcomes due to a range of possible results, and outcome probabilities are fully known and can be acted upon as desired by an individual.

      This book focuses first on choice under risk, and looks at the factors influencing human decision-making when probabilities are fixed but outcomes are varied. Common sense may suggest that individuals would go for the outcome they expect will offer the highest value, and Expected Value Theory is explained in depth with examples used to calculate the value of an uncertain outcome. Well known criticisms of the model are then examined, with the Two Envelopes Problem and St. Petersburg Paradox challenging the idea that choice is based on expected value.

      Focus then turns to Expected Utility Theory and the idea that an individual’s own risk attitude can affect their valuation of outcomes, as risk aversion and risk seeking behaviour are explained, along with the steps used to find an individual’s utility function. But there is evidence of violations of the model’s core assumptions and three examples are put forward here, with the Ellsberg Paradox, Allais Paradox, and Preference Reversal Phenomenon suggesting that individual choice under uncertainty is not as predictable as may be expected.

      An alternative model is put forward with Prospect Theory, which looks at gains and losses differently and centres on the idea of a reference point from which prospects are evaluated. The prospect model has evolved over time, and the three different versions are all presented with graphical representations of their key features, and some conclusions drawn as to their use in predicting human behaviour when facing risky choices.

      The second part of the book turns to choice under conditions of uncertainty, with three separate areas addressed where the probability of outcomes is not necessarily known, as other people enter the equation and individual choice is affected by group choice. Risk attitudes are applied to the competitive game theory model of human interaction, as people turn to minimax or maximin strategies to manage the uncertainty brought by co-dependent interactions with others, and secure a better payoff.

      Auction Theory examines the situation where a choice must be made to outmanoeuvre competing bidders without paying over the odds. The revenue equivalence theorem shows how a bidder can ensure the auction type doesn’t affect his winning bid, and a strategy to avoid the Winner’s Curse of overpaying for an object is also discussed.

      Voting strategies in a world where an individual is outnumbered is the focus in the final part of the book. The idea of a Condorcet Winner that can’t lose the vote against any alternative is examined, along with voting cycles where voters don’t have a clear collective preference. Small changes to the choice of alternatives put before voters can make all of the difference to the result, and a situation where the government manipulates the outcome is put forward, along with the reaction of the voters who may choose to play the system in response.

      2 Expected Value Theory

      2.1 Expected Value

      Imagine a generous friend coming to you with an appealing proposition. He’s willing to give you free money, and all you have to do is choose which of the two amounts on offer you’d prefer; £10 or £20. This decision

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