In this LP, the second of our series on Risk and Uncertainty, we’ll learn a bit more about risk, but also about uncertainty. We’ll start by seeing again how risk is analysed using Morgenstern and von Neumann’s expected utility theory. We’ll also learn about alternative approaches, such as the Friedman-Savage and Markowitz perspectives, but especially Daniel Kahneman’s prospect theory. We’ll end our study of risk and uncertainty by learning how game theory can help when analysing uncertainty.

Here’s the summary of this Learning Path:

Risk:

Risk, when outcomes are unknown but individuals can assign probabilities to each of them;

Risk aversion, or how to analyse individuals’ decisions using the expected utility theory;

Demand for insurance, the analysis of how to deal with risky situations.

EUT and alternative aproaches:

Expected utility theory, Morgenstern and von Neumann’s main contribution to economics;

Other approaches, such as the Friedman-Savage or Markowitz’s perspectives;

Prospect theory, Kahneman’s views on expected utility.

Uncertainty:

Uncertainty, when individuals cannot assign probabilities to each outcome;

Game theory, the perfect framework to analyse uncertainty.

Everyone has to make decisions, every day. However, it is not always clear to us what outcomes can derive from these decisions. When this happens, we say we are making decisions in situations under risk or uncertainty. When risk appears, although we are not sure about the possible outcomes of a given decision, we do know the probability of each outcome, while in situations under uncertainty we are not capable of making such assumptions.

In this Learning Path we’ll learn bout risk and uncertainty. We will see how risk can be analysed by using expected utility instead of expected value, and how different kind of people will behave differently when facing risk.

Risk and uncertainty:

Risk, when different outcomes are unknown but individuals can assign them probabilities;

Uncertainty, when individuals cannot assign probabilities to each outcome.

Expected utility:

Saint Petersburg paradox, solved by Daniel Bernoulli;

Expected utility, an alternative way to make decisions;

Expected utility theory, developed by John von Neumann and Oskar Morgenstern.

Risk aversion analysis:

Risk aversion, where we analyse different degrees of risk aversion;

Arrow-Pratt measures of risk aversion.