Game theory

: This article discusses the mathematical modelling of incentive structures. For other games (and their theories) see Game (disambiguation). For the band named Game Theory, please see Game Theory (band).

Risk aversion

For the above example to work, one must assume risk-neutral participants in the game. For example, this means that they would place an equal value on a bet with a 50% chance of receiving 20 points and a bet with a 100% chance of receiving 10 points. However, in reality people often exhibit risk averse behaviour and prefer a more certain outcome - they will only take a risk if they expect to make money on average. Subjective expected utility theory explains how to derive a measure of utility which will always satisfy the criterion of risk neutrality, and hence serve as a measure for the payoff in game theory.

Related Topics:
Risk - Subjective expected utility - Utility

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Game shows often provide examples of risk aversion. For example, if a person has a 1 in 3 chance of winning $50,000, or can take a sure $10,000, many people will take the sure $10,000.

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Lotteries can show the opposite behaviour of risk seeking: for example many people will risk $1 to buy a 1 in 14,000,000 chance of winning $7,000,000. This illustrates the nature of people's preferences over risk: they are risk-loving where losses are small and risk averse where losses are high, even if potential gains are greater - people care less about a marginal dollar than say a marginal $1000 - most people would not risk $1000 for the same chance of winning $7,000,000,000.

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