The Five Neglects: Risks Gone Amiss
Introduction (Via Alan Berger, Case Brown, Carolyn Kousky, and Richard Zeckhauser)
We must constantly make decisions in situations of risk. Should we undertake a potentially beneficial medical procedure that has a small probability of harmful complications? Should the local government allow development in the floodplain? How much money should Congress allocate to fighting terrorism?
Economists have developed a “rational choice” based model for making decisions in these situations of risk, called expected utility (EU) theory. Under this approach, a utility value (utility being a measure of satisfaction or happiness) is first assigned to each potential outcome. These outcomes are then weighted by the probability that they will occur given a particular choice. The result is the expected utility reaped from that choice. All alternatives are evaluated in this way and the one with the highest expected utility is chosen. When applied to societal level decisions, often some metric of total benefits to the society is used in place of utility.
A rational choice based approach to decision making is thus comprised of five elements:
1. consideration of probability,
2. valuation of potential benefits and losses,
3. accurate use of (subjective) probability and statistics,
4. delineation and evaluation of all available alternatives, and
5. incorporation of all benefits and costs accruing to the decision maker.