Common ratio effect:-Systematic violation of
Expected Utility Theory:
The common ratio effect is a classical example
of systematic violations of expected utility
theory.
In a typical setting, a decision maker has to
choose between a sure monetary payoff and a
two-outcome lottery that yields a higher
outcome with a probability greater than one half
(nothing otherwise).
)
PROBLEM 1: A: (4,000,.80), < B: (3,000).
N = 95 [20] [80]
PROBLEM 2: C: (4,000,.20), > D: (3,000,.25).
N= 95 [65] [35]
In this pair of problems over half the
respondents violated expected utility theory.
To show that the modal pattern of preferences
in Problems 1 and 2 is not compatible with the
theory.
set u(0) = 0, and recall that the choice of B
implies u(3,000)/u(4,000) >4/5, whereas the
choice of C implies the reverse inequality.
Note that the prospect C = (4,000, .20) can be
expressed as (A, .25), while the prospect D =
(3,000, .25) can be rewritten as (B,.25).
The substitution axiom of utility theory
asserts that if B is preferred to A, then any
(probability) mixture (B, p) must be preferred
to the mixture (A, p)
Now consider a second decision problem,
which differs from the first binary choice
problem only in one aspect—probabilities of
all non-zero outcomes are scaled down by
the same common ratio.
Expected utility theory implies that people,
who opted for a sure monetary payoff (a risky
lottery) in the first decision problem, should
also choose a safer lottery (a riskier lottery) in
the second decision problem.
However, many people often choose a sure
monetary payoff in the first decision problem
and a riskier lottery in the second decision
problem.
Typically, only a few people reveal the
opposite tendency to switch from choosing a
risky lottery in the “scaled-up” decision
problem to choosing a safer lottery in the
“scaled-down” decision problem.
This asymmetric pattern of expected utility
violations is known as the common ratio
effect.
.
This violates the independence axiom (which
states the preferences between risky
prospects should not be affected by
multiplying the probabilities of non –zero
outcome by a common factor. of Neumann
Morgenstern Theorem
The previous example discussed preferences
between positive prospects, i.e., prospects
that involve no losses.
What happens when the signs of the
outcomes are reversed so that gains are
replaced by losses?
PROBLEM 3: A: (-4,000,.80), > B: (3,000).
N = 95 [92] [8]
PROBLEM 4: C: (-4,000,.20), < D: (-3,000,.25).
N= 95 [42] [58]
In Problem 3, for example, the majority of
subjects were willing to accept a risk of .80 to
lose 4,000, in preference to a sure loss of
3,000, although the gamble has a lower
expected value.
The occurrence of risk seeking in choices
between negative prospects was noted early
by Markowitz
In addition to whatever you own, you have
been given 1,000 and has been asked to
choose between
A: (1,000,.50), < B: (500).
N = 70 [16] [84]
In addition to whatever you own, you have
been given 2,000 and has been asked to
choose between
C: (-1,000,.50), > D: (-500).
N= 68 [69] [31]
The preferences show the reflection effect i,e
risk aversion for positive prospects and risk
seeking for negative prospects.
But when viewed from final states both choice
problems are identical.
A=(2000,.50;1,000.50)=C
B=(1,500)=D
It shows bonus did not enter into the
comparison of prospects because it was
common to both options in each problem.
Two stage game
There is a probability of .75 to end the game
without winning anything and a probability of
.25 to move into the next stage.
If you reach the second stage you have a
choice between
(4000,.80) (3000)
Choice must be made before the game starts.
78% of the subjects have chosen the second
prospect.
Actually in this game there is a choice
between .25*.80=.20 chance to win 4000and
.25*1.0=.25chance to win 3000.
As both the results are uncertain people
should have gone by expected value but here
certainty effect has only worked.
Evidently people ignored the first stage of the
game whose outcome has been shared by
both the prospects.
