Economics

Risk and Time

Preference
Dept. of Economics @ NCKU
Weng, Ming-Hung
Question
Why would people
still smoke even if
they know its
causing premature
death?
 Outline
Choice under Uncertainty and Risk attitude
Value of time and time preference
 Risk

Risk, Uncertainty, or Lottery

A situation when its outcome is not certain
in advance but the probability for each
possible outcome is known.
Probability
Frequency with which something (event)
occurs.
 Risk/Lottery
possible events of
pattern (probability)
Heart (25%)
A deck of four cards
Diamond (25%)
Club (25%)
Spare (25%)
possible events of
colors (probability)
Red (50%)
Black (50%)
 To bet or not to bet*
A $100 wager on
next card and
win on RED
lose on BLACK.

Are you in?

1.Yes
2.No
 Fair Gamble
Fair Gamble (Bet): Risks when to win and lose
the same amount are of equal chance.

A $100 wager on next card and

win on RED (50%) and lose on BLACK (50%)
Expected Value (EV) for evaluation, the
greater the more preferred.
Probabilities are weights given to uncertainties
(EV)=0.5(100)+0.5(-100)=0, vs. EV= 1(0)=0,
their comparisons not able to explain ours
choices
 To bet or not to bet*
A $200 wager on next card and
win quadruple ($800) on
Heart (+800)
lose bet on others. (-200)

Its EV is?
1. $0; 2. $50; 3. 100; 4; $200
 To bet or not to bet*
A $200 wager on next card and
win quadruple ($800) on
Heart
lose bet on others.
Its EV is
(0.25)(800)+(0.75)(-200)=50
 Risk attitude
Willing or not entering a fair gamble depends on
risk attitude

Risk averse (most of us)

Unwilling to enter a fair gamble
Discounts were given to risky objects

Risk seeking (loving)

Willing to enter a fair gamble

Risk neutral (most business decision making)

indifferent between entering or not
 To bet or not to bet*
A $500 wager on
next card and
win on RED
lose on BLACK.

Are you in?

1.Yes
2.No
 To bet or not to bet
A $500 wager on next card and
win on RED (+500; 50%)
lose on BLACK. (-500; 50%)

EV (Expected value)=? The greater the

more preferred, same as in a $100 wager
500 50% + 500 50% = 0
100 50% + 100 50% = 0
 To bet or not to bet
A $500 wager on next card and
win on RED (+500; 50%)
lose on BLACK. (-500; 50%)

Variance (risk)? The greater the less preferred

for decision makers who are risk averse
(500 0)2 50% + 0 500 2
50% = 250000
(100 0)2 50% + 0 100 2
50% = 10000
 A better investment*

1. +8% (50%) or +12% (50%); EV=+10%

2. +5% (50%) or +15% (50%); EV=+10%
3. +0% (50%) or +20% (50%); EV=+10%

Which investment project would you

prefer?
 Expected Utility Theory

Decision makers prefer the option with the

higher expected utility.
Different attitudes toward risk are due to
discrepancies in (monetary) utility function
How is u(.) increasing as money goes up?
+% 0 5 8 10 12 15 20
u(+%) 0 62 82 88 92 98 100
 Expected Utility Theory
+% 0 5 8 10 12 15 20
u(+%) 0 62 82 88 92 98 100
1. +8% (50%) or +12% (50%); EU=87
2. +5% (50%) or +15% (50%); EU=80
3. +0% (50%) or +20% (50%); EU=50
This agent prefers a certain 10%, then
option 1, then option 2, then option 3; the
greater the variance, the less preferred
u(.) increases in a decreasing way
 Expected Utility Theory
+% 0 5 8 10 12 15 20
u(+%) 0 62 82 88 92 98 100
(); EU
()
100
87
80

50

%
5% 10% 15% 20%
 Expected Utility Theory
+% 0 5 8 10 12 15 20
u(+%) 0 8 16 19 26 46 100
1. +8% (50%) or +12% (50%);
2. +5% (50%) or +15% (50%);
3. +0% (50%) or +20% (50%);
Which option will this agent prefer?
 Expected Utility Theory
+% 0 5 8 10 12 15 20
u(+%) 0 8 16 19 26 46 100
(); EU
() whos
100 risk loving

50
27
21
%
5% 10% 15% 20%
Prospect theory
Reference dependent
= ((1 ))(1) +
() ((2 ))(2) +
() is asymmetric. (loss
aversion)
() is distorted, usually
overestimates when p is very
small and underestimates
when p is very large.
Framing effect of the
reference point.
 Loss aversion
While being averse
to possible gains,
individuals tend to
be risk-loving while
facing chances to
recover possible
losses.
Twice sensitive to
loss than to gain
 Nonlinear probability weighting
(subjective prob.)
: the =
1
subjective weighting
function, of objective
Inverted S-shaped
probabilities of
possible outcomes, ()
( ).
Inverted S-shape
() > for very small
; over-estimate S-shaped

() < for close to 0 1

1; under-estimate (objective prob.)
 Preference for Time

Why is $1 not worth $1?

Future outcomes have In the future = less value?
risk.
Discounting everything in the future
Time preference for monkeys

now now

later later
The Marshmallow Test
 The Marshmallow Test
Choice between
1 marshmallow now
2 marshmallows later

Comparison based on their current

value (utility), discounts (their relative
importance) are given to future options.
 The Marshmallow Test
current value (utility)
1 marshmallow now
10
2 marshmallows later
. =
. : discount given to future satisfaction
2 marshmallows later is preferred
 The Marshmallow Test
A person with discount rate equal to
0.4 will choose ___ between the
following two options.
1. 1 marshmallow now
2. 2 marshmallows later
 The Marshmallow Test
current value (utility)
1 marshmallow now
10
2 marshmallows later
. =8
1 marshmallow now is preferred for
one with discount rate equal to 0.4
Patience and marshmallow
Time preference for monkeys

now now

As long as monkeys
give discounts (say
later 0.5) to future rewards, later
they will prefer
 starting a diet (*)

start start
a diet a diet
today tomorrow

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15.3 Time Preferences
Time Discounting

Starting a diet today:

Benefit is to become healthier more quickly
Cost is giving up food you enjoy earlier

Starting tomorrow:
Benefit is to be able to eat what you want for
another day
Cost is delaying becoming healthier

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15.3 Time Preferences
Time Discounting

Problem:

The benefit of starting today is in the

future, while its cost is immediate.

The benefit of starting tomorrow is

immediate, while the cost is in the future.

Result: diets that always start tomorrow

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15.3 Time Preferences
Time Discounting

One-third of long-
term smokers die
prematurely.

So what?

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 What do you like (*)

$100 $105
now next year

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 What do you like(*)

$100 $105
10 years 11 years
from now from now

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15.3 Time Preferences
Time Discounting
Evidenced-Based Economics Example:

Preference reversal
Distinct choices at
different reference
points.

Do people exhibit a
preference for immediate
gratification?
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