L9. Decision under Risk and Uncertainty
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People often face problems of decision under risk. In general, models of decision under risk consist of two-component models: a model of preferences over outcomes and a model of risk perception. Rational models of decision under risk depend heavily on the assumption that people understand the potential outcomes of any risky choice and the probability of each of those outcomes. In the previous chapters, we discussed several anomalies related to how people deal with probabilistic information. Behavioral models of risky choice generally base the component model of beliefs on behavior observed in experimental settings. For example, people seem to treat certainty in a very different way than probabilistic outcomes, an effect that might make exploding job offers more profitable for inferior firms. Or people may be reluctant to invest in the stock market despite higher average returns, opting for low-returning savings accounts. Interestingly, experimental observations of choice under risk sometimes contradict the common behaviors discussed in the previous chapters.
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