Risk Averse Nature of Preferences - Assignment Example

Financial Management Student’s Name Institutional Affiliation Date Part B Problem 1 According to the results of the problem, it is clear that 84% of the respondents chose to receive 240 now instead of a 25% probability of receiving $1000 now. From the decision of the investors, it is evident that gains rather than losses have been the reference basis for the decisions of the investors. Instead of gambling for a 25% chance of receiving $1000 now, investors opted for the sure bet of receiving $240 now regardless of the fact that the former has the potential of yielding greater returns in the event that it occurs. In the case of the second decision, it is clear that majority of the investors (87%) chose 75% chance of losing $1000 now as compared to the sure bet of losing $50 now. In explaining the two problems and solutions selected by the investors, it would be proper to take into consideration the fact that the investors had an underlying state of affairs where there is the potential of receiving $1000 now. In order to look at the outcomes of their decisions, it is proper to look at two possible gains as well as the reference state (Kahneman & Tversky, 1984). The risk averse nature of preferences provides a viable explanation to the decision of the investors to opt for the sure bet of $240 now as compared to the 25% chance of receiving $1000 now. A review of the second case reveals a reference state where there is a chance of not losing anything from the available options. As shown in the second case, one should choose between the sure bet of losing $750 now or the 25% probability of losing $1000 now. Investors opted for the second decision since it gave an allowance of not incurring loss at all. According to Kahneman & Tversky, the best decision in such a case would be the decision that has the potential of maintaining the reference state or the status quo where the investor does not lose anything. As a result, the investors in the second case revealed a risk seeking preference for the gamble as opposed to the sure stake of losing $750 now. Problem 2 In the second problem, it is still evident that investors made a risk averse preference of choosing the sure gain of $100 as compared to the positive gamble of earning $200 with a probability of 0.5. At the same time as revealed in the second case, investors indicated a risk seeking preference when the majority opted for the sure loss of $100 now as compared to the 50% chance of losing $200 now. The consideration of the financial outcomes as states of wealth rather than potential gains and losses explains the differences noted in the decisions adopted by the investors in both problems. For instance, the investor is already $300 richer now of making the decision. The investor should make a decision that would guarantee a cumulative gain or a comparatively lower loss in an attempt to maintain the status quo. This explains the reason why majority of the investors opted for the sure gain of $100 now that would raise their status quo to $400 as compared to the alternative option that presented the chance of reducing preventing them from seeing any gain at all. The same decision applies to the second case where majority of the investors considered the option of the sure loss of $100 that would reduce their state of wealth to $400 instead of the alternative option that presented the chance of reducing their wealth status further to $300. Part C According to neoclassical economics and its influence on the behaviour of individuals in a market, economic factors are the sole determinants of the behaviour of individuals. The implication is that price variations of goods and services as well as the available personal income determine the demand and supply of goods and services in the market (Diacon & Calance, 2014). According to the neoclassical approach to human behaviour, neoclassical economics provide explanations for certain human behaviour such as the behaviour of an individual that continues to gamble or bet despite having incurred losses on several occasions. Even though the individual incurs losses each time she or he gambles or places a bet, the individual continues to place more bets. In essence, neoclassical economics explain why people engage in certain behaviour even after knowing that such behaviours would eventually hurt them. Behavioural economics refers to the scientific research of emotional and socio cognitive patters of individuals that explain the economic decisions made by individuals and their influence on the allocation of resources, returns, and market prices. As a result, the point of focus of behavioural economics is the rationality or lack of rationality of economic agents. It is evident that cognitive psychology has had a significant influence on behavioural economics. In relation to neoclassical economics, it is clear that neoclassical economics assumes the influence of cognitive psychology on the behaviour of economic agents in the market. As a result, the integration of neoclassical and behavioural economics could provide a viable explanation for the behaviours of economic agents in the market as opposed to separating neoclassical from behavioural economics. It is evident that neoclassical economics, also called marginal economics has dominated consumer behaviour in the 21st century (Zalega, 2014). Neoclassical economics assumes the rationality of the behaviour of consumers in the market. Therefore, it asserts that consumers select choices that maximise utility. As a result, procedural rationality is the primary factor that determines the choices irrespective of the associated financial burden or the objective importance with regard to the individual’s wellbeing. Some of the choices include the choice between work and leisure that has an influence on consumer income, income distribution between savings and consumption and the choice of particular goods in the market. Neoclassical economics also assumes the completeness of information on the conditions of the transaction and product knowledge. As a result, human actions reveal the maximisation or optimisation principle thereby revealing the hyper-rationality attribute of consumers in the market (Zalega, 2014). This implies that the consumer is already aware or has the capability of knowing all the existing market possibilities including the variations in prices and the differences in the use of the individual products. Therefore, neoclassical economics assumes that the consumer has free access to all required information. Neoclassical economics also assume that real markets exhibit perfect competition that is capable of eliminating monopoly that interferes with the competitive income distribution in the market. In order to ensure that the behaviour of companies or firms in the market does not deviate from the anticipated behaviour in a monopolistic or perfect competition, neoclassical economics assumes the guaranteed existence of market contestability. Finally, neoclassical economics also assumes that underestimating previous experiences makes it difficult for firms or economic agents to minimise or avoid the recurrence of similar adverse phenomena in the future (Zalega, 2014). In essence, underestimating previous experiences impedes effective decision-making by a firm or an economic agent. Part D It is evident that decision-making forms a critical component of the everyday lives of individuals (Polic, 2009). As a result, people have to make decisions on a daily basis. Apparently, the decisions that people make influence their lives and actions as well as the lives of other people. Heuristics refers to the strategies that ignore pertinent information in order to hasten the decision-making process and make more frugal or accurate decisions as opposed to the use of complex decision-making processes. The target of a heuristic is a specific attribute of a different attribute that is readily available to the mind. In essence, the objective of the use of heuristics in decision-making is the need to reduce the effort expended in decision-making (Beresford & Sloper, 2008). One of the probable approaches is the use of few cues to make a decision as opposed to other decision-making processes that require the use of all possible cues to arrive at the right decision. From the first three images, it is clear that one of the members of the decision-making team was not paying full attention to the facts that could be useful in making the right decision. From the message conveyed by one of the listeners, the decision team does not exhibit any interest of accumulating all possible cues before arriving at a decision. Listening to a presentation in turns would result in the omission of critical information that a member could fail to capture assuming that the piece of information is not relevant to the decision-making process. The use of heuristics in decision-making also entails a reduction of the effort required to make decisions (Gigerenzer & Gaissmaier, 2011). As evidenced in the images, one of the listeners that is also a member of the decision team reveals that it is the turn of a different member to listen to the presentation and capture the important cue. In essence, capturing cues in turns is an indicator of the use of little effort by the decision-making team to reach a decision. The other set of images reveal an investigation of a fraudulent case. In the investigation, it is evident that the head of the investigation has already come up with the outcome of the investigation before the actual commencement of the investigation process. In order to hasten the entire process, the leader of the investigation team assigns an investigator to carry out the investigation and come up with cues that validate the initial decision made before the onset of the decision-making process. The investigation process reveals the simplification of the weighting of cues thereby indicating the use of heuristics in the decision-making process. The use of heuristics in decision-making also entails the adoption of simplified weighting cues (Gigerenzer & Gaissmaier, 2011). The last image provides a good case of simplifying the weighting cues in the decision-making process. The image reveals the opinion of an individual regarding a certain project. The individual indicates that since the project is complex, it would be unnecessary to identify the logic and evidence. This indicates that the individual decided to simplify the research process by avoiding the search for logic and evidence. Examining fewer alternatives is the last case of using heuristics in decision-making. In such a case, an individual decides to ignore other options and chooses the simplest option that would provide the required objective or handle a specific task. The image that reveals a man that selects a razor instead of its alternatives that could yield a better shaving experience reveals the decision of the individual to ignore the available alternatives and select the simplest option. References Beresford, B., & Sloper, P. (2008). Understanding the dynamics of decision-making and choice: A scoping study of key psychological theories to inform the design and analysis of the Panel Study. York: Social Policy Research Unit, University of York. Diacon, P. E., & Calance, M. (2014). THE RELATIONSHIP BETWEEN BEHAVIOURAL AND NEOCLASSICAL ECONOMICS. CES Working Papers, 6(1), 71-76. Gigerenzer, G., & Gaissmaier, W. (2011). Heuristic decision making. Annual review of psychology, 62, 451-482. Kahneman, D., & Tversky, A. (1984). Choices, values, and frames. American psychologist, 39(4), 341. Polič, M. (2009). Decision making: Between rationality and reality. Interdisciplinary Description of Complex Systems, 7(2), 78-89. Zalega, T. (2014). Consumer and Consumer Behaviour in the Neoclassical and Behavioural Economic Approach. Konsumpcja i Rozwój, (4 (9)), 64-79. Read More