Level Dependence Expectancy Utility Model
The Level Dependence Expectancy Utility Model (LDEM), first introduced by economists Kenneth Arrow and Milton Friedman in the 1950s, is a game theory-based approach to decision making which holds that an individuals optimal decision-making strategy depends on the level of risk they are willing to assume. The key idea behind LDEM is that people will tend to take riskier decisions when the expected payoff is greater than the expected loss, and vice versa. As such, the LDEM posits that the optimal decision-making strategy is dependent on the level of risk associated with the decision.
The concept of LDEM is based on the assumption that individuals have a finite pool of resources, such as time or money, which can be used to make decisions that will have varying levels of risk. The idea is that individuals will weigh the expected payoffs and losses when considering a decision, and will choose the best decision based on their risk tolerance. As such, the LDEM assumes that individuals will make decisions which maximize their expected utility, or the expected value of the payoff minus the expected cost of the decision. The utility of a decision is then calculated based on the level of risk associated with it, with higher risk decisions having higher utilities.
The LDEM can be used to analyze a variety of different types of decisions, such as investment, employment, and education decisions. For example, when it comes to investing, the LDEM can be used to analyze the expected return on the investment versus the potential losses. Similarly, with employment decisions, the expected payoffs and potential losses associated with taking a job can be weighed against each other to determine the optimal decision.
In addition to its use in analyzing decisions, the LDEM can also be used as a tool for individuals to assess their own risk tolerance. By using the LDEM to analyze a particular decision, individuals can determine their willingness to take risks and make choices accordingly. For example, an individual with a high level of risk tolerance may be more willing to take risks when deciding on investments, whereas an individual who is risk-averse may be more likely to opt for low-risk investments. Similarly, low-risk individuals may choose to focus on jobs with lower salaries, whereas risk-tolerant individuals may be more willing to take jobs with higher salaries and higher potential rewards.
Although the LDEM can be used as a tool to analyze decisions and estimate risk tolerances, it is important to note that the model is not perfect, as it is subject to certain limitations and deficiencies. For example, the LDEM cannot account for every type of risk, as some risks are simply too difficult or impossible to measure. In addition, it is important to remember that the LDEM is a game theory-based approach to decision making, and as such, it is not always applicable in real-world scenarios.
Despite these limitations, the LDEM is still a useful tool for analyzing decisions and estimating risk tolerances. By taking the level of risk into account when making decisions, individuals can better ensure that they make the best choice for their current circumstances. Furthermore, by using the LDEM to analyze particular decisions, individuals can gain a better understanding of their own risk tolerance and make more informed decisions in the future.
