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Part 3 Uncertainty and Strategy Chapter 5 Uncertainty Probability Probability of an event happening; relative frequency with which an event occurs Probability of “heads” coming up on flip of fair coin is ?. That is, when coin is flipped many times, we can expect “heads” to come up in approximately one-half of flips. Expected Value Expected value of game with a number of uncertain outcomes: size of prize that player will win on average. On a single flip of a coin, Jones pays Smith $1 (X1 = +$1) if a tail comes up and Smith will pay Jones $1 (X2 = -$1) if a head comes up, the expected value of game for both players is Expected Value If game changes so that, from Smith’s point of view, X1 = $10, and X2 = -$1, expected value for Smith would be: Because Smith would stand to win $4.50 on average, she might be willing to pay Jones up to this amount to play. Fair games are games that cost precisely their expected value. Risk Aversion When people face risky but fair situations, they will usually choose not to participate. Risk aversion is tendency for people to refuse to accept fair games. Swiss mathematician Daniel Bernoulli theorized that not only the monetary payoff of a game matters to people; expected utility from the game’s prizes also affects people’s willingness to play. Diminishing Marginal Utility Bernoulli assumed that utility associated with payoffs in risky situation increases less rapidly than dollar value of payoffs. Extra (marginal) utility obtained from winning an extra dollar in prize money is assumed to decline as additional dollars are won. Diminishing Marginal Utility Fig. 5.1 reflects diminishing marginal utility; shows utility associated with possible prizes (or incomes) from $0 to $50,000. Concave shape of curve reflects assumed diminishing marginal utility. Gain in utility due to increased income from $1000 to $2000 exceeds gain from $49,000 to $50,000. Graphical Analysis of Risk Aversion Figure 5-1 shows person with three options. Conten
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