Risk and Choice
Overview
Many choices that individuals make involves an element of uncertainty. In particular, most choices that
represent investments involve some degree of randomness in outcomes. The standard model of rational choice
developed in
choice does not
accomodate random outcomes. The theory of rational choice over risky outcomes develops this framework.
Risky Outcomes
A risky outcome is an outcome that involves some degree of randomness or uncertainty. It does not necessarily connote
body outcomes. For example, a game that costs one dollar and returns five dollars with a 50% chance, and
returns 10 dollars with a 50% chance, would still be consdered a risky even though all outcomes are positive.
Utility Framework
The
utility framework
was developed initially assuming no random chance. However, it can be extended to cover risky situations as well.
In the case of risk, the agent is assumed to maximized the
expected
utility over outcomes.
{% max \; \mathbb{E}[u(\omega)] %}
Topics
Arbitrage Pricing
arbitrage
