Lecture : Risky choice

1. Overview
today’s learning objectives. By the end of the lecture you should:

– Understand how to design an experiment to calibrate an expected

utility function
– have an understanding of tests of expected utility theory.

2. Motivation
1. Most choices involve some risk: e.g.
1. Farmers’ decisions on what crops/varieties to grow
2. Students’ decisions to go to university
3. Investors decisions on share purchases
2. So we want to know
1. What are people’s attitudes to risk?
2. Whether behaviour conforms to simple theories, such as
expected utility theory.
 2. Background: Lotteries.
States of the world are possibilities, described so that they are mutually
exclusive and exhaustive. There are S states.
A lottery associates an outcome for each state of the world.
Example 1. buy a dollar to sell in one year. It may rise in value to ¥150 or
fall to ¥80 or stay at ¥100:
150
0.3
0.5 100 outcomes
0.2
probabilities 80

This is a simple lottery.

We summarise it as, L = (x1,p1; x2,p2;x3,p3) = (80,0.2; 100,0.5; 150,0.3),
By convention, the worst outcome is 1 and the best is S.

Lottery outcomes don’t have to be money. They could be exam grades,

farm yields, etc.
3. Expected utility (EU): the basic theory of choice under risk used
in economics.
Theories of risky choice are theories about how we choose between
different lotteries, L1, L2 etc.
Expected utility predicts that individuals assess lotteries as if by taking the
sum of the utility of the outcomes weighted by the probabilities.

Example. L = (x1,p1; x2,p2;x3,p3) so,

EU = p1U(x1) +p2U(x2) + p3U(x3)

• U(x) is the utility function

• EU is expected utility.
• More generally, L = (x1,p1; …;xn,pn)
i n
EU   pi u ( xi )
i 1
 Axioms

1. Notation:
L denotes lottery, x denotes an outcome, p and q are probabilities,
, , ~ have their usual meaning.
Axiom 1. Preferences over lotteries are Complete and Transitive
Axiom 2. Continuity. Suppose x1  x2  x3 then there exists P such that

P X1
L
~- X2
1-P X3
A3. Independence. If x1  x2 and L1 and L2 are such that
P X1 P
X2
L1
L2
1-P
1-P X3 X3

Then L1  L2 for any p.

A4. Reduction axiom. A compound lottery is indifferent to its simple

equivalent. e.g.

Q X1 X1
PQ
P
L1 1-Q X2 -L2 P(1-Q) X2
1-P
X3 1-P X3
Theorem. If 1-4 hold, there exists a utility index U(x) such that ranking
according to expected utility accords with actual preference over lotteries.

The tests of EUT reported in the lecture imply that either Independence or
Reduction fail.
 Implications of the Axioms
a. U(.) is unique up to a positive, linear transformation

i.e. If we replace U(y) with a + bU(y), b > 0, then we have the same
preferences between lotteries.

b. EU is linear in probabilities, meaning: indifference curves are straight

lines in probability. space.
e.g. Let EU  p1U ( x1 )  p2U ( x2 )  p3U ( x3 )

Or (i.e. eliminating p2)

EU  p1U ( x1 )  (1  p1  p3 )U ( x2 )  p3U ( x3 )
then dEU/dp1 = U(x1)-U(x2)
And dEU/dp3 = U(x3)-U(x2), so

dEU  dp1 U ( x1 )  U ( x2 )   dp3 U ( x3 )  U ( x2 ) 

 Implications of the Axioms

Along an indifference curve dEU = 0 or,

dp3 u ( x1 )  u ( x2 )

dp1 u ( x3 )  u ( x2 )
Note that this slope does not depend on p.
Indifference lines are also parallel in probability space: rewrite the equation
for EU as,
 u ( x1 )  u ( x2 )   EU 

p3   
 
p1   

 u ( x3 )  u ( x2 )   u ( x3 )  u ( x2 ) 
A rise in EU simply shifts this line up (providing u(x3)>u(x2)).
 The Marschak-Machina Triangle.
For: representing preferences between lotteries.
Lotteries of the form p = (p1,p2, p3); x = (x1,x2, x3);
Typically x1< x2 < x3; In the diagram the x values are fixed. Only p varies between
lotteries.
1

p3
e

a
0 c p1 1
P1 (probability of the worst outcome) is measured along the bottom axis
P3 (probability of the best outcome) is measured along the vertical axis.
P2 = 1-P1-P3 so it’s just the horizontal distance to the hypotenuse

Indifference curves are parallel lines. Note that steeper indifference curves means
greater risk aversion.
 4. Plan
Historically there are two main strands to experiments on risky choice:

Themes in
experiments on
risky choice

Calibrating Testing
expected utility assumptions of the
theory, assuming it theory
to be true

Useful when we Led to development

need parameters of newer theories
for other purposes (next lecture)

Calibration of newer
theories
(next lecture)
 5. Calibrating EUT.
• Useful when we want to build a model of consumer choice.
• E.g.
– Savings decisions
– Portfolio decision
– Demand for insurance
– Tax evasion etc.
• Calibration in this case means determining a shape for the utility
function, U(.).

Risk averse
Risk neutral
Risk loving

x
• We learn the Holt-Laury method – the most popular approach.
• Holt, CA and SK Laury, 2002, Risk aversion and incentive effects -
American Economic Review
 5. Calibrating EUT.
• Reminder: a person is risk neutral if they are indifferent between the
lottery and the expected value of the lottery.
 i n  i n
u  pi xi    pi u ( xi )
 i 1  i 1
• risk averse if they prefer the expected value of the lottery to the lottery.
 i n  i n
u  pi xi    pi u ( xi )
 i 1  i 1
• risk loving if they prefer the lottery to the expected value of the lottery.
• Note that the definition of risk averse implies that u is concave in x.

Risk averse

 i n

 i i 
• Reminder: the expected value of the lottery is p x
 i 1 
 5. Understanding check.
• There’s a lottery with a 50% chance of winning 10,000 yen and a 50%
chance of winning 0.
• There’s an alternative with a sure prize of 4,000 yen.

1. Akiko prefers the lottery. Is she risk averse, neutral, loving or cannot
say?

2. Suppose Taro is risk neutral and is indifferent between the sure 4,000
yen and a lottery with a 40% chance of -2000 yen and a 60% chance of
x. What is x?
 Holt-Laury (example)
• Each subject must choose
one option A or B for each
of the questions.
• (Question 4 already has a
choice)

Outcomes (¥)
 Holt-Laury (example)
• How is this incentivized?
• 1 question is picked at
random
• There are 4 numbered
‘chips’ in a bag.
• One chip is pulled from the
bag. This, in combination
with the subject’s choice,
determines the payoff.
• Example: in question 4, B B
is preferred.
• Suppose this question is
selected and ball number 3
is pulled from the bag.
• Then the subject wins
¥2,000

Outcomes (¥)
 Holt Laury

1. We record the question number at

which the subject switches from A to
B.
2. Here the subject switches at Question
4. A
3. This provides a measure of risk
aversion A
4. A risk neutral person will switch at 3
or 4.
A
5. A very risk averse person will switch B
only at question 8
6. So the switching question number B
provides one measure of risk aversion
– higher numbers = higher risk
B
aversion.
B

B
 Methodology point: random lotteries.
• For individual choice experiments it is common to use a random lottery
device.
1. Subjects make choices between options
2. Usually they make several choices in a sequence but
3. Only one is for real.
4. At the end of the experiment, the subject’s choose a lottery number
from a bag or throw a dice to decide which of their questions was ‘for
real’
5. They then receive whatever they chose earlier in the experiment (i.e.
they cannot choose again)
6. Note that if the choice is itself a lottery they play the lottery.

This provides more data than just asking one question per person.

What are the incentives for this design?

Only one question is real, so if a person chooses according to EUT, then
she or he should treat each question independently.
 Practical notes I

1. Here B gets steadily better compared

to A. Usually we have a second
version with the same questions, but
where B gets steadily worse. Subjects
are randomly assigned.
2. Usual to have practices first
3. And tests of understanding
4. Here, in question 1 B is dominated by
A; in question 8, B dominates A. So
these provide 2 tests of
understanding
5. Fresh random draws are done for
each individual
6. In some cultures, ‘gambling’ language
is not appropriate
7. Pilot for: appropriate language, tests
of understanding, parameter values.
 Practical notes II

1. B gets steadily better compared to A.

2. So if B is chosen in one question we
expect it to be chosen in all
subsequent questions.
3. Sometimes subjects choose A
otherwise.
4. What should you do? B
1. Intervene and overrule? A
2. Provide guidance but allow?
3. Say nothing? B
4. Drop from sample?
 6. Using the results.
• We can use the switching question number as a measure of risk
aversion
• Sometimes we want more. x1 r
• Suppose utility functions have the form: U 
1 r
• This is called a constant relative risk aversion (CRRA) function
• (for r = 1 the function is ln(x))
• r is a measure of risk aversion U
• r = 0: risk neutral
• r < 0, risk loving
• r > 0, risk averse
x
 6. Understanding check. 1 r
• Differentiate this function. What do you get? U  x
1 r
• Differentiate again. How does the sign relate to r?

• Calculate the index of relative risk aversion (RRA)

x
 6. Using the results.
• We can use the switching question number as a measure of risk
aversion
• Sometimes we want more. x1 r
• Suppose utility functions have the form: U 
1 r

• This function has the property that choice does not depend on the scale
of the lotteries.
• E.g. if 100 Yen preferred to a (0,0.5;230,0.5) then 1000 Yen preferred to
(0,0.5;2300,0.5)
• Question: how would you test to see if a person has a CRRA utility
function?
 6. Using the results.
• We can just use the switching question number as a measure of risk aversion to
find a possible range for r.
A
B
B
• Example:
• This person switches from A to B as we move from question 3 to 4. We do not
know the exact value of r.
• In one extreme case they are indifferent between A and B in question 3. Then
they strictly prefer B in question 4. This gives us one extreme value for r.
• In the other extreme, then are indifferent between A and B at question 4. They
strictly prefer A to B at question 3. This gives us the other extreme value.
 6. Using the results.
• We can just use the switching question number as a measure of risk aversion to
find a possible range for r.
A
B
B
• Example:
• Lowest possible value for r:

U (4000)  0.5U (2000)  0.5U (6000)

• Or
40001 r  20001 r   60001 r 
 0.5   0.5 
• Or r = 0.
1 r  1 r   1 r 
• Highest possible value for r:

40001 r  0.520001 r  0.570001 r 

• Or r =0.656

• *Use goalseek in excel (unreliable) or matlab etc. to solve for r.

 6. Using the results.

A
B
B
• For people who switch at the ends, the range is bounded only one side:
at r = -0.617.

40001 r  0.520001 r  0.555001 r 

• The range is therefore (-∞,-0.617]

• Then we use the range, to estimate demand for insurance, say

• Or use interval regression to relate risk aversion to occupation, income,
sex etc.
 6. Using the results. Example
• Long run effects of conflict.
• Korean war example
• Figure shows casualty rates in SK
• For civilians

• A Holt-Laury task (unincentivized)

• Added to national survey.
 The second theme: tests of EUT.
• EUT is the basic model of risky choice used by economists.
• EUT has particularly strong predictions..
• Are they true?
 A specific example
A: 0.9 chance of ¥1000 B 0.4 chance of ¥5,000
0.1 chance of 0 0.6 chance of 0

C: 0.09 chance of ¥1000 D: 0.04 chance of ¥5,000

0.91 chance of 0 0.96 chance of 0

1. Out of A and B which would you choose

2. Out of C and D which would you choose?
 7. Tests of EUT.
• Consider two lotteries, A and B.
• Write EU(A) to mean the expected utility of A etc.
• For any individual, either EU(A) > EU(B) or EU(A) < EU(B) or EU(A) =
EU(B).

Equivalent statement Equivalent statement

A preferred to B EU(A) > EU(B) (EU(A) - EU(B)) > 0

B preferred to A EU(A) < EU(B) (EU(A) - EU(B)) < 0

A indifferent to B EU(A) = EU(B). (EU(A) - EU(B)) = 0

 A specific example.
• Consider a 3rd and a 4th lottery, C and D.
• C is constructed from A and looks like this:

p A
C:
1-p 0
• In other words, there is a probability p of winning the lottery A and a
probability 1-p of winning 0.
• D is constructed from B
• D looks like this:

p B
D:
1-p 0
 7. Tests of EUT.
• EU(C) = pEU(A) + (1-p)EU(0)
• EU(D) = pEU(B) + (1-p)EU(0)

• Therefore EU(C)-EU(D) = pEU(A) – pEU(B) = p(EU(A)-EU(B))

• So if A is preferred to B then C is preferred to D and so on.
• As long as p>0, the value of p is irrelevant.

• To sum up we can test Expected utility as follows:

1. Offer subjects a choice of lotteries A and B.
2. Offer subjects a choice of lotteries C and D (constructed as above)
3. If it’s a within subjects test, then individuals should choose consistently
4. If it’s a between subjects test, then the proportion choosing A should
equal the proportion choosing C.
Choose C Choose D

Choose A Consistent

Choose B Consistent
 Using The Marschak-Machina Triangle.
We can use the triangle to design tests of EUT. 1

p3
e

d
b
a
0 c p1 1
The lines ae and cd are parallel. p3 is the same for b and d.
So if a is preferred to b we know:
• a is preferred to e
• c is preferred to d.
Conversely if b is preferred to a we know:
• e is preferred to a
• d is preferred to c.
Tests where some subjects choose out of {a, e} and others choose out of {c,d} are
known as common ratio tests.
Tests where some choose out of {a,b} and others choose out of {c,d} are known as
common consequence tests.
 The original questions using the Marschak-Machina Triangle.
We can use the triangle. 1
The best outcome is 5000
This becomes outcome 3. p3
The worst outcome here is 0,
This becomes outcome 1. b

a
0 c p 1
A: 0.9 chance of ¥1000 B 0.4 chance of ¥5,000 1
0.1 chance of 0 0.6 chance of 0

C: 0.09 chance of ¥1000 D: 0.04 chance of ¥5,000

0.91 chance of 0 0.96 chance of 0

• Note that A and C have 0 probability of the best outcome

• B and D have zero probability of the middle outcome.
• Drawing helps, but we have to show that the lines ab and cd are parallel!
 A specific example
A: 0.9 chance of ¥1000 B 0.4 chance of ¥5,000
0.1 chance of 0 0.6 chance of 0

C: 0.09 chance of ¥1000 C: 0.04 chance of ¥5,000

0.91 chance of 0 0.96 chance of 0
A and B are related to C and D as follows:

0.1 B
0.1 A
D:
C:
0.9 0
0.9 0
C and D are constructed from A and B using the ‘common ratios’ of 0.9 and
0.1.
How did you choose?
 Common ratios and Common consequences.
When A and B are related to C and D as follows:

p A p B
C: D:
1-p 0 1-p 0
We often get a common ratio effect -. When there is a relatively safe option
(option A), individuals often choose it.
When both the alternatives offer a low chance of winning (C versus D), then
individuals often opt for the one with the higher winning payoff.
 Common ratios and Common consequences.
In some cases C and D are constructed from A and B like this:

p a p b
A: B:
1-p x 1-p x
p a
p b
C:
D:
1-p y
1-p y
A,B and C,D share ‘common consequences’.
For well-chosen values of x and y, A is chosen from {A,B} whereas D is
chosen from {C,D}
 Classic Experiment: Kahneman and Tversky
Kahneman and Tversky, 1979 using Israeli students. Their original questions
were hypothetical. The figures in brackets are the % choosing each
option.
 A development example: Humphries and Verschoor in Uganda,
Ethiopia and India.
The article is in Economics Letters. More detail about method can be found in
http://jae.oxfordjournals.org/cgi/reprint/13/1/44.pdf which covers only the
Ugandan data. There is a more recent paper in the Economic Journal with
Glenn Harrison that looks at individual data more carefully.
All choices were between a riskier lottery (R) and a safer lottery (S).
They run a within subjects test of EUT using lotteries like the ones below:

Example (Uganda):
Probabilities 5000 shillings 2000 shillings 0 shillings

Risky 1 0.25 0.50 0.25

Risky 2 0.25 0.75

Safe 1 1.0

Safe 2 0.5 0.5

 A development example: Humphries and Verschoor in Uganda,
Ethiopia and India.
E.g. farmers in East Uganda.
• 109 subjects in Sironko, 58% female
• 96 in Bufumbo, 40% female
• Most subjects had no education or primary education.
• Bags using coloured marbles used to depict the lotteries. E.g. for R1 the
bag contained one yellow (5000), two green (2000) and one blue
(nothing). Subjects were shown two bags and asked to choose one.
• Choice recorded by an assistant.
• 12 choices in all, 8 incentivised
• A random lottery used to pick the ‘real’ choice: a bag contained 8 pieces of
paper with numbers written on them.
• 10 subjects at a time in a village hall.
• One instructor on a stage demonstrating each choice. Individual
enumerators recording choices. 3 hours per session, including 1.5 hours
of initial training.
• Example tasks and practices.
• Spatial separation of subjects
 8. Alternatives - Prospect Theory
• In a famous article (Econometrica, 1979) Kahneman and Tversky identified
several other features of risky choice:
1. Individuals seemed to edit complex lotteries – combining some outcomes and
dropping other outcomes from the comparison.
2. Individuals seemed to be risk averse for lotteries with positive winnings and
risk loving for lotteries involving losses. E.g.
1. prefer winning 1,000 Yen to a lottery with a 50% chance of 2,200 Yen
2. Prefer a 50% chance of losing 2,200 Yen to a sure loss of 1,000 Yen
3. Individuals seemed to evaluate lotteries separately and not according to final
wealth.

• Feature 2 is compatible with EUT, but requires an unusual utility function that
changes shape at zero.
• Feature 3 means that ‘zero’ varies with our current situation.
 8. Alternatives - Prospect Theory
• Kahneman and Tversky offered an alternative theory: Prospect Theory
• In the next session we will consider its implications and how you calibrate it
EUT u

0 wealth

Prospect Theory v

x
Current wealth
 9. Risk experiments.

• One of the most common forms of experiment

• Used for calibration, but EUT is regularly rejected.

• Current work:
1. Into the field, looking for more representative samples and
correlations with sociodemographic variables
2. Getting more individual data, allowing for hetereogeneity
3. Trying to calibrate non-EUT models
4. Looking at risk attitudes of groups
5. Looking for quasi-experimental data (e.g. ‘who wants to be a
millionaire’ decisions)

1. Next: non-EUT models and their calibration.

2. See: Tomomi Tanaka, Colin Camerer and Quang Nguyen (2010) "Risk and time
preferences: Experimental and household data from Vietnam" American
Economic Review http://www.public.asu.edu/~ttanaka1/Vietnam.pdf
3. Do exercises on next page
 Seminar questions.
1. Three lotteries are described below. In each case there are only three possible
outcomes: winning Yen5, winning Yen10 or winning Yen25. The outcomes are
mutually exclusive. The table shows the probabilities of winning each of the
outcomes for each of the three lotteries.
Yen5 Yen10 Yen25
Lottery A 0.0 1.0 0.0
Lottery B 0.5 0.0 0.5
Lottery C 0.8 0.0 0.2
2. An individual, who obeys the axioms of expected utility theory, is indifferent
between A and B. Is this individual risk averse, risk neutral or risk loving? Explain
your answer.
3. D, gives a probability of zero for winning Yen25. According to expected utility
theory, what probability of winning Yen5 would make the same individual
indifferent between D and C?
4. Given a choice between C and a lottery E, which gives a probability of 0.7 for
winning Yen5, a probability of 0.15 for winning Yen25 and a probability of 0.15 for
winning Yen10, the individual strictly prefers C. Does this accord with the axioms
of expected utility theory? Explain your answer.
Appendix: Presenting information
 Typical formats (Hey and Orme, Bateman and Munro).
• Hey and Orme (students)

• Bateman and Munro (couples)

• In a typical experiment subjects face a series of choices as above. At

the end of the experiment for each player one choice is picked at
random and the choice is played for real.
• i.e. a random lottery device.