What would you do?

"For example, consider a case where a person is presented with the following three options

"(a) Receive $500,000 with certainty.
(b) A 95 percent probability of receiving $1 million dollars and a 5 per cent probability of receiving just $100.
(c) A 50 per cent probability of receiving $900,000 and a 50 per cent probability of receiving $100,000

"For both shackles model and Prospect Theory, option (a) becomes the referenced point and the rival strategies have to be reframed as follows for Prospect Theory:

"(b) A 95 per cent probability of gaining $500,000 and a 5 per cent chance of losing $499,900
(c) A 50 per cent probability of gaining $400,000 and a 50 per cent probability of losing $400,000

"In terms of prospect theory, loss aversion guarantees that (a) will be preferred over (c); option (b) may also be rejected in favour of (a) due to the downside risk being assigned a much bigger weight than 5 per cent, whereas in terms of traditional subjective expected utility theory (b) would normally be expected to be favoured." -- G. L. S. Shackle, pp. 173-174

The authors go on to note that Shackle could explain the possible choice of (a) over (b) better than Prospect Theory. For Shackle, a likely reason one might favor (a) over (b) is that (a) might be seen as a "life-changing event": "At last! Now I can open that Italian restaurant I've dreamed of running. The additional $500,000 upside is unnecessary to the dream, while the $499,900 downside is absolutely destructive of it.

Indeed, offered the choice of (a), (b) or (c) right now, I probably would take (a). How about you?

4 comments:

  1. I'm going to answer without calculating expected values.These questions never specify how much you have in the bank, which is actually always relevant . If the amount at stake is relatively trivial, it makes sense to go wìth the highest expected value.

    If I have some pressing need or use for the low payoff of the sure thing, then go with that.

    If I don't have a pressing need or use for the lower payout but the big money small odds would make life significantly better, I would go for the big money.

    Really, to answer a question like this you need to understand both the sums and your current position in terms of maslow's heirarchy of needs or something like it.

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    Replies
    1. Yes, this was Shackle point about a "life-changing event." For someone who has $10 in the bank, go for the sure $500,000. Bill Gates probably goes for the million.

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  2. I forgot to add that, I would currently go for choice C. 500,000 would mean a lot to me now. A million would be twice as good, but 100 would be essentially zero. 100,000 would still be very good and 900,000 would be just as good as a million to me.

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