Advanced Environmental Economics and Policy
ENP 32306
Summary
Anneli Janzer
, Theme 1 – Risk, expected utility, decision making, and consumer
choice/behaviour
Economics part
Some definitions and expected utility theory
• Preferences are presented in a Utility Function
• Set of actions and states of the world
• Expected utility of an action can be expressed as the
probability weighted sum of utilities of all states
• Typical utility curve=upward sloping and concave
• Decision might change, if subjective probabilities change
• Critique: people behave differently and often violate the expected utility theory
•
Von Neumann Morgenstern Axioms (Preferences must fulfil certain requirements, so choices are rational)
Completeness/Transitivity/Independence/Continuity
Risk preferences
• Risk-averse:
o Utility of expected value is higher than expected value of gamble
o The marginal utility decreases
o Higher returns generate higher utility (“more is better”)
• Risk-loving:
o The consumer prefers the (uncertain) gamble
over the (certain) expected value of the gamble
• Risk-neutral:
o The utility of the expected value equals the
expected utility of the gamble
• Risk premium: the amount a risk-averse person
would pay to avoid risk
• Certainty equivalent: the amount of money an
individual would regard as equally desirable as a
risky event
Expected utility/value= pA*U(A)+pB*U(B)
Prospect theory
• Endowment effect=distinguish between gains and losses
• People are risk-averse with gains but risk-loving to avoid losses
• Prospect= a contract that yields outcome xi with probability pi where all probabilities sum up to 1
• Concave in gains and convex in losses
• “Value”= reference point or change from reference point
Case study: green consumption and ecolabels
• Byer has a higher valuation than the seller
o Seller knows the quality, buyers do not
• Adverse selection
o Price has a signaling function; buyers know at what point the quality must be low, but their willingness
to pay does not exceed this point=only lemons sell
1
ENP 32306
Summary
Anneli Janzer
, Theme 1 – Risk, expected utility, decision making, and consumer
choice/behaviour
Economics part
Some definitions and expected utility theory
• Preferences are presented in a Utility Function
• Set of actions and states of the world
• Expected utility of an action can be expressed as the
probability weighted sum of utilities of all states
• Typical utility curve=upward sloping and concave
• Decision might change, if subjective probabilities change
• Critique: people behave differently and often violate the expected utility theory
•
Von Neumann Morgenstern Axioms (Preferences must fulfil certain requirements, so choices are rational)
Completeness/Transitivity/Independence/Continuity
Risk preferences
• Risk-averse:
o Utility of expected value is higher than expected value of gamble
o The marginal utility decreases
o Higher returns generate higher utility (“more is better”)
• Risk-loving:
o The consumer prefers the (uncertain) gamble
over the (certain) expected value of the gamble
• Risk-neutral:
o The utility of the expected value equals the
expected utility of the gamble
• Risk premium: the amount a risk-averse person
would pay to avoid risk
• Certainty equivalent: the amount of money an
individual would regard as equally desirable as a
risky event
Expected utility/value= pA*U(A)+pB*U(B)
Prospect theory
• Endowment effect=distinguish between gains and losses
• People are risk-averse with gains but risk-loving to avoid losses
• Prospect= a contract that yields outcome xi with probability pi where all probabilities sum up to 1
• Concave in gains and convex in losses
• “Value”= reference point or change from reference point
Case study: green consumption and ecolabels
• Byer has a higher valuation than the seller
o Seller knows the quality, buyers do not
• Adverse selection
o Price has a signaling function; buyers know at what point the quality must be low, but their willingness
to pay does not exceed this point=only lemons sell
1
