Chapter 3 - Utility Theory: ST Petersburg Paradox

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AMA484 Decision Analysis 1

Chapter 3 - Utility Theory

St Petersburg Paradox

• Suppose that a coin is to be tossed repeatedly until the head appears. The gambler
will be paid $2n if the head appears in the n-th toss.

• The expected return from the gamble is:

• What price will you pay for the gamble?

Reference: Wayne L. Winston, Introduction to Probability Models, Operations Research v2, 2004 Thomson
AMA484 Decision Analysis 2

Problem with EMV Criterion

• In insurance, amount of premium > expected payout because the premium


includes also overhead cost and profit.

• A lottery ticket has negative expected return.

• All types of Casino games have negative expected returns.

• A businessman rules out potential decision because it could bankrupt the firm,
even expected return is high. It is because the monetary value is not always a true
indicator of the overall value of the result of the decision.

• The overall worth of a particular outcome is called utility, and rational people
make decisions that maximize the expected utility.
AMA484 Decision Analysis 3

Representation of Lotteries

A lottery L

Event Consequence
Θ1 c1
Θ2 c2
Θ3 c3

Or
L = {(Θ1 , c1 ), (Θ2 , c2 ), (Θ3 , c3 )}.
AMA484 Decision Analysis 4

Lotteries
If a decision maker will

(1) quantify his preference and judgments,

(2) accept certain principles of reasonable/consistent behavior,

then, we can by pure deductive logic find the solution of any decision problem, which
is logically consistent with the decision maker’s own preferences and judgments.
Choosing among the available alternatives (different lotteries).
Lotteries: Possible course of action

• List of events: All the events on the list are mutually exclusive if no more than one
of them can occur;

• The events taken together are collectively exhaustive if one of them must occur.
AMA484 Decision Analysis 5

Utility Theory

• Von Neumann-Morgenstern concept of a utility function can be used as an aid to


decision making under uncertainty.

• Consider a situation in which a person will receive, for i = 1, 2, · · · , n, a reward


ri with probability pi .

• This is denoted as the lottery

(p1 , r1 ; p2 , r2 ; · · · ; pn , rn ).

• A lottery is often represented by a tree in which each branch stands for a possible
outcome of the lottery.
AMA484 Decision Analysis 6

• The number on each branch represents the probability that the outcome will occur.

• Our goal is to determine a method that a person can use to choose between
lotteries.

• Suppose he or she must choose to play L1 or L2 but not both.


– L1 pL2 , if the person prefers L1 .
– L1 iL2 , if he is indifferent between choosing L1 and L2 ,
i.e., L1 and L2 are equivalent lotteries.

• More formally, a lottery L is a compound lottery if for some i, there is a


probability pi that the decision maker’s reward is used to play another lottery L′ .
AMA484 Decision Analysis 7

• Simple lottery is a lottery which is not a compound lottery.

• The utility of the reward ri , written u(ri ), is the number qi such that the decision
maker is indifferent between the following lotteries:
(i.e., u(ri ) = qi )
qi
Most favorable outcome
1 ri and
1 − qi
Least favorable outcome

A decision maker wishes to choose among several acts (lotteries) when the
consequences of one or more of these acts depends on which one of a set of possible
events occurs.
AMA484 Decision Analysis 8

Preliminary Evaluations
If the decision maker wishes to solve his problem by formal analysis, then there are
two sets of preliminary evaluations which he must make:

(a) quantify his judgments about the possible events by assigning a probability P (Θi )
to each event Θi in a mutually exclusive and collectively exhaustive list,

{Θ1 , · · · , Θi , · · · , Θn }.

(b) quantify his preferences among consequences by choosing appropriate reference


consequences c⋆ and c⋆ .
Then assigning a number to every consequence ci , such that he would be
indifferent between ci for certain and a lottery giving a chance π(ci ) at c⋆ and a
complementary chance at c⋆ .
AMA484 Decision Analysis 9

Estimating an Individual’s Utility Function

• How might we estimate an individual’s utility function?

• We begin by assuming that the least favorable outcome (say, −$10, 000) has a
utility of 0 and that the most favorable outcome (say, $30, 000) has a utility of 1.
1
• Next we define a number x 12 having u(x 12 ) = 2
1
2
$30, 000 (Most favorable outcome)
1 x 12 and 1
2
−$10, 000 (Least favorable outcome)

• Eventually the utility function can be approximated by drawing a curve (smooth,


we hope) joining the points.
AMA484 Decision Analysis 10

0.8

0.6
u(x)

0.4

0.2

0
−10,000 0 10,000 20,000 30,000
x
AMA484 Decision Analysis 11

Interpretation of u(x)
If {(1, c)} ∼ {(α, c2 ), (1 − α, c1 )} or written as c ∼ {(α, c2 ), (1 − α, c1 )},
then
u(c) = αu(c2 ) + (1 − α)u(c1 ).

Thus
u(c) − u(c1 )
α= .
u(c2 ) − u(c1 )

If u is such that u(c1 ) = 0, u(c2 ) = 1, then α = u(c).


That is
c ∼ {(u(c), c2 ), (1 − u(c), c1 )}.
AMA484 Decision Analysis 12

Example: Determining u
Let C = {−$10, 000, $11, 000, $30, 000, $60, 000}.
Rank all monetary returns from the best to the worst and assign a utility of 1.0 to the
best and 0 to the worst:
Monetary value Utility
$60, 000 1.0
$30, 000 not yet known
$11, 000 not yet known
−$10, 000 0
Determine the utilities to the intermediate monetary values:
A series of questions are asked until the decision-maker is indifferent to the certain
money and the lottery.
AMA484 Decision Analysis 13

Probability-equivalence Approach
Question: Which of the following would you prefer?

(A) $30, 000 for certain; or

(B) A lottery which will give a 70% chance of $60, 000 and a 30% chance of
−$10, 000?

Answer: A 30% chance of losing $10, 000 is too risky, I will take the certain money.

Question: Which of the following would you prefer?

(A) $30, 000 for certain; or

(B) A lottery which will give a 90% chance of $60, 000 and a 10% chance of
−$10, 000?

Answer: I now stand such a good chance of winning the lottery that I will buy the
lottery.
AMA484 Decision Analysis 14

Question: Which of the following would you prefer?

(A) $30, 000 for certain;

(B) A lottery which will give a 85% chance of $60, 000 and a 15% chance of
−$10, 000?

Answer: I am indifferent between the certain money and the lottery ticket

$30, 000 ∼ {(0.85, 60, 000), (1−0.85, −10, 000)} ∼ {(0.85, 60, 000), (0.15, −10, 000)}.

The utility of $30, 000 is defined by

u($30, 000) = 0.85u($60, 000) + 0.15u(−$10, 000) = 0.85.

Note: The point 85% is called the point of indifference.


AMA484 Decision Analysis 15

Question: Which of the following would you prefer?

(A) $11, 000 for certain;

(B) A lottery which will give a 60% chance of $60, 000 and a 40% chance of
−$10, 000?

Answer: I am indifferent between the certain money and the lottery ticket.

$11, 000 ∼ {(0.6, 60, 000), (1 − 0.6, −10, 000)} ∼ {(0.6, 60, 000), (0.4, −10, 000)}.

Thus
u($11, 000) = 0.6u($60, 000) + 0.4u(−$10, 000) = 0.6.
AMA484 Decision Analysis 16

Hence, the complete set of utilities are obtained:

Monetary value Utility


$60, 000 1.0
$30, 000 0.85
$11, 000 0.6
−$10, 000 0
AMA484 Decision Analysis 17

Compound Lotteries
Suppose we ask a decision maker to rank the following lotteries:
0.5
$30, 000
1
L1 $10, 000 L2
0.5
$0

0.02
−$10, 000
1
L3 $0 L4
0.98
$500
AMA484 Decision Analysis 18

The Von Neumann-Morgenstern approach to ranking these lotteries is as follows.


Begin by indentifying the most favorable ($30, 000) and the least favorable
(−$10, 000) outcomes that can occurs. For all other possible outcomes (r1 = $10, 000,
r2 = $500 and r3 = $0), the decision maker is asked to determine a probability pi
such that he or she is indifferent between two lotteries:
pi
$30, 000
1 ri and
1 − pi
−$10, 000

Suppose that for r1 = $10, 000, the decision maker is indifferent between
0.9
$30, 000
1
(1) $10, 000 and
0.1
−$10, 000
AMA484 Decision Analysis 19

and for r2 = $500, indifferent between


0.62
$30, 000
1
(2) $500 and
0.38
−$10, 000

and for r3 = $0, indifferent between


0.6
$30, 000
1
(3) $0 and
0.4
−$10, 000
AMA484 Decision Analysis 20

Using (1)–(3), the decision maker can construct lotteries L′1 , L′2 , L′3 and L′4 such that
L′i iLi and each L′i involves only the best ($30, 000) and the worst (−$10, 000) possible
outcomes. Thus, from (1), we find that L1 iL′1 , where
0.9
$30, 000
L′1
0.1
−$10, 000

We find that L2 iL′′2 , where


0.5
$30, 000
L′′2
0.6
$30, 000
0.5
0.4
−$10, 000

which is a compound lottery.


AMA484 Decision Analysis 21

Returning to our discussion of L′′2 , we observe that L′′2 is a lottery that yields a
0.5 + 0.5 × 0.6 = 0.8 chance at $30, 000 and a 0.4 × 0.5 = 0.2 chance at −$10, 000.
Thus, L2 iL′′2 iL′2 , where
0.8
$30, 000
L′2
0.2
−$10, 000

Similarly, using (3), we find that L3 iL′3 , where


0.6
$30, 000
L′3
0.4
−$10, 000
AMA484 Decision Analysis 22

Using (2), we find that the decision maker is indifferent between L4 and L′′4 , where
0.02
−$10, 000
L′′4
0.62
$30, 000
0.98
0.38
−$10, 000

In actuality, however, L′′4 yields a 0.98 × 0.62 = 0.6076 chance at $30, 000 and a
0.02 + 0.38 × 0.98 = 0.3924 chance at −$10, 000. Thus, L4 iL′′4 iL′4 , where
0.6076
$30, 000
L′4
0.3924
−$10, 000
AMA484 Decision Analysis 23

Since Li iL′i , we may rank L′1 , L′2 , L′3 , L′4 .


Consider two lotteries whose only possible outcomes are $30, 000 (most favorable)
and −$10, 000 (least favorable).
If he is given a choice between two lotteries of this type, the decision maker simply
chooses the lottery with the larger chance of receiving the most favorable outcome.
Applying this idea yield L′1 pL′2 pL′4 pL′3 , which implies

L1 pL2 pL4 pL3 .


AMA484 Decision Analysis 24

Utility Theory (Summary)

• The specification of u(ri ) for all rewards ri is called the decision maker’s utility
function.

• For a given lottery L = (p1 , r1 ; p2 , r2 ; · · · ; pn , rn ), define the expected utility of


the lottery L, written E(U for L), by
n
X
E(U for L) = pi u(ri ).
i=1
AMA484 Decision Analysis 25

• Thus, in our example

E(U for L1 ) = 1 × 0.9 = 0.9,


E(U for L2 ) = 0.5 × 1 + 0.5 × 0.6 = 0.8,
E(U for L3 ) = 1 × 0.6 = 0.6,
E(U for L4 ) = 0.02 × 0 + 0.98 × 0.62 = 0.6076.

• Given two lotteries L1 &L2 , we may choose between them via the expected utility
criteria

L1 pL2 if and only if E(U for L1 ) > E(U for L2 ),


L2 pL1 if and only if E(U for L2 ) > E(U for L1 ),
L2 iL1 if and only if E(U for L2 ) = E(U for L1 ).
AMA484 Decision Analysis 26

Von Neumann-Morgenstern Axioms

• Axiom 1: Complete Ordering Axiom


– For any two rewards r1 and r2 , one of the following must be true:
The decision maker
(1) prefers r1 to r2 ,
(2) prefers r2 to r1 ,
(3) is indifferent between r1 and r2 .

Also, if the person prefers r1 to r2 and r2 to r3 , then he must prefer r1 to r3


(transitivity of preferences).
AMA484 Decision Analysis 27

• Axiom 2: Continuity Axiom


– If the decision maker prefers r1 to r2 and r2 to r3 , then for some c
(0 < c < 1), L1 iL2 , where
c r
1

L1 r2 and L2
1−c
r3
AMA484 Decision Analysis 28

• Axiom 3: Independence Axiom


– Suppose the decision maker is indifferent between rewards r1 and r2 .
Let r3 be any other reward.
Then for any c (0 < c < 1), L1 iL2 , where
c r c r2
1

L1 and L2
1−c 1−c
r3 r3

L1 and L2 differ only in that L1 has a probability c of yielding a reward r1 ,


whereas L2 has the probability c of yielding a reward r2 .
– Independence Axiom implies that the decision maker views a chance c at r1 ≡
a chance c at r2 , and this view holds for all values of c and r3 .
AMA484 Decision Analysis 29

We applied the independence Axiom when we claim that L2 iL′′2 .


0.5
$30, 000
L2
0.5
$0

and

0.5
$30, 000
L′′2
0.6
$30, 000
0.5
0.4
−$10, 000
AMA484 Decision Analysis 30

• Axiom 4: Unequal Probability Axiom


– Suppose the decision maker prefers reward r1 to reward r2 .
If two lotteries have only r1 and r2 as their possible outcomes, he will prefer
the lottery with the higher probability of obtaining r1 .
– We used this Axiom when we concluded that L′1 has a 0.9 chance at $30, 000
was preferred to L′2 which had only a 0.8 chance at $30, 000.
AMA484 Decision Analysis 31

• Axiom 5: Compound Lottery Axiom


– Suppose that when all possible outcomes are considered, a compound lottery L
yields a probability pi of receiving a reward ri , (i = 1, · · · , n).
Then LiL′ where L′ = (pi , ri ; i = 1, · · · , n).
0.5
$30, 000
L′′2
0.6
$30, 000
0.5
0.4
−$10, 000

and

0.5 + 0.5 × 0.6 = 0.8


$30, 000
L′2
0.5 × 0.4 = 0.2
−$10, 000
AMA484 Decision Analysis 32

Why We May Assume u (Worst Outcome) = 0 and u (Best Outcome) = 1

• Up to now, we have assumed that u (least favorable outcome) = 0 and u (most


favorable outcome) = 1.

• Even if a decision maker’s utility function does not have these values, we can
transform his utility function into a utility function having u = 1.
AMA484 Decision Analysis 33

Lemma 1

Lemma 1 Given a utility function u(x), a real number a > 0 and any b, we define
v(x) = au(x) + b. Given any two lotteries L1 and L2 it will be the case that
1. A decision maker using u(x) as his utility function will have L1 pL2

a decision maker using v(x) as his utility function will have L1 pL2 .
2. A decision maker using u(x) as his utility function will have L1 iL2

a decision maker using v(x) as his utility functions will have L1 iL2 .
AMA484 Decision Analysis 34

Proof. Let
L1 = (p1 , r1 ; p2 , r2 ; · · · ; pn , rn ),
L2 = (p′1 , r1′ ; p′2 , r2′ ; · · · ; p′m , rm

).
Suppose the decision maker using u(x) prefers L1 to L2 . Then by the expected utility
criterion, we know that
n
X m
X
pi u(ri ) > p′j u(rj′ ). (1)
i=1 j=1

Now the v(x) decision maker will have L1 pL2 if


n
X m
X
pi [au(ri ) + b] > p′j [au(rj′ ) + b]. (2)
i=1 j=1
AMA484 Decision Analysis 35

Since
n
X m
X
pi = p′j = 1,
i=1 j=1

the inequality (2) simplifies to


n
X m
X
a pi u(ri ) + b > a p′j u(rj′ ) + b. (3)
i=1 j=1

Since a > 0, the inequality (3) follows from (1). Thus, if the u(x) decision maker has
L1 pL2 , the v(x) decision maker has L1 pL2 .
Similarly, if (3) holds, then (1) will hold. Thus, if v(x) decision maker will also have
L1 pL2 . A similar argument can be used to prove part (2) of Lemma 1.
AMA484 Decision Analysis 36

• Using Lemma 1, we can show that without changing how an individual ranks
lotteries, we can transform the decision maker’s utility function into one having u
(least favorable outcome) = 0 and u (most favorable outcome) = 1.
AMA484 Decision Analysis 37

Utility Function
Let C be a set of consequences (monetary values) and u : C → [0, +∞) be a function.
For example,

(i) C = [0, 1000], u(x) = x2 ;



(ii) C = {1, 2, 5, 10, 20}, u(x) = x;

(iii) C = {1, 5, 10}, u(1) = 0, u(5) = 0.5, u(10) = 1.


AMA484 Decision Analysis 38

Utility of a Lottery
A lottery is L = {(pi , ri ) : i = 1, 2, · · · , n}, where ri is the value and pi is the
corresponding probability. Its utility value is given by
n
X
U (L) = pi u(ri ).
i=1

Let u : C → [0, +∞). Then u is a utility function if, for any two lotteries

 L = {(pi , ri ) : i = 1, 2, · · · , n}, L = {(pj , rj ) : j = 1, 2, · · · , m},
 ′ ′ ′ ′′ ′′ ′′

n
X Xm

 U (L′ ) = p′i u(ri′ ), U (L′′ ) = p′′j u(rj′′ ),

i=1 j=1

we have    
′ ′′


 L pL 

  > 

 

L′ iL′′ ⇐⇒ U (L′ ) = U (L′′ ).

   
 ′′ ′   
L pL <
  
AMA484 Decision Analysis 39

u is Monotone
The monotonicity of u means

x1 , x2 ∈ C, c⋆ ≤ x1 < x2 ≤ c⋆ ⇐⇒ u(x1 ) < u(x2 ).

In fact, let L′ = (x1 , 1), L′′ = (x2 , 1).


Then
x1 < x2
⇐⇒ L′′ pL′
⇐⇒ U (L′ ) < U (L′′ )
⇐⇒ u(x1 ) = U (L′ ) < U (L′′ ) = u(x2 )
⇐⇒ u(x1 ) < u(x2 )
AMA484 Decision Analysis 40

Cash Equivalence (CE)


Cash equivalence, CE(L), of a lottery L = {(pi , ri ) : i = 1, 2, · · · , n} is the amount
such that the decision maker is indifferent between

(i) obtaining the amount q = CE(L) for certain, and

(ii) obtaining the lottery L.

More formally, the cash equivalence of L is that amount q such that


n
X
u(q) = pi u(ri ), q = CE(L).
i=1

For example, if Jill was indifferent between


0.5
$30, 000
1
−$3, 400 and L
0.5
−$10, 000

Thus CE(L) = −$3, 400.


AMA484 Decision Analysis 41

Interpreting Utility Functions


Let C = [c⋆ , c⋆ ].
If the decision maker’s utility function is linear, then CE(L) = EM V (L).
Equivalently, a utility function is linear if and only if
x1 + x2
CE({(0.5, x1 ), (0.5, x2 )}) = , ∀c⋆ ≤ x1 ≤ x2 ≤ c⋆ ,
2
1 1  x1 + x2 
u(x1 ) + u(x2 ) = u .
2 2 2

c⋆ c⋆
AMA484 Decision Analysis 42

Risk neutral
Risk neutral (DM considers every lottery as its EMV):

CE(L) = EM V (L), ∀L.

Risk neutral is equivalent to the linearity of the utility function

u(αx1 + (1 − α)x2 ) = αu(x1 ) + (1 − α)u(x2 ), ∀0 < α < 1, x1 , x2 .


AMA484 Decision Analysis 43

Concave Utility Function


A utility function is concave if

u(αx1 + (1 − α)x2 ) ≥ αu(x1 ) + (1 − α)u(x2 ), ∀0 < α < 1, x1 , x2 .

Risk averse (DM considers no lottery more desirable than its EMV):

EM V (L) ≥ CE(L), ∀L.

c⋆ c⋆
AMA484 Decision Analysis 44

Risk averse is equivalent to concavity of the utility function. A utility function is


concave if and only if
x1 + x2
≥ CE{(0.5, x1 ), (0.5, x2 )}, ∀c⋆ ≤ x1 ≤ x2 ≤ c⋆ ,
2
x + x  1 1
1 2
u ≥ u(x1 ) + u(x2 ).
2 2 2
AMA484 Decision Analysis 45

Convex Utility Function


Risk seeking (DM considers every lottery more desirable than its EMV):

CE(L) ≥ EM V (L), ∀L.

Risk seeking is equivalent to the convexity of the utility function

αu(x1 ) + (1 − α)u(x2 ) ≥ u(αx1 + (1 − α)x2 ), ∀0 < α < 1, x1 , x2 .

c⋆ c⋆
AMA484 Decision Analysis 46

Explaining Utility Function


Consider a utility function in the following figure, which is a concave utility function,
i.e., the decision maker is risk averse.
Utility

Increase in utility
0.8
through winning

0.6

0.4
Decrease in utility
through losing the 0.2
gamble
0 $
0 1000 2000
AMA484 Decision Analysis 47

Assume that the decision-maker has $1, 000 assets.


The decision maker is offered a gamble which provides a 50% chance of doubling
$1, 000 to $2, 000 and a 50% chance of losing it all.
The expected monetary value (EMV) of this gamble is

0.5 × $2000 + 0.5 × $0 = $1, 000.

By the EMV criterion, he should be indifferent between keeping his money and
gambling.
AMA484 Decision Analysis 48

When applying the utility function to the decision, it provides $1, 000 with a utility of
0.9.
If gambling, he has a 50% chance of increasing his assets so that the utility is increased
to 1 and a 50% chance of ending with assets with a utility of 0.
Hence the expected utility of the gamble is

0.5 × 1 + 0.5 × 0 = 0.5.

which is less than 0.9. Thus, by the (maximum) expected utility criterion, the certain
money is more attractive than the risky option of gambling.
AMA484 Decision Analysis 49

Relation Between an Individual’s Utility Function and His Attitude Toward Risk

Definition 1 The risk premium of a lottery L, written RP (L), is given by

RP (L) = EM V (L) − CE(L),

where EM V (L) is the expected monetary value of the lottery’s outcomes and CE(L)
is the cash equivalence of L.

• Let a nondegenerate lottery be any lottery in which more than one outcome can
occur.

• w.r.t. attitude toward risk, a decision maker is


– Risk-averse ⇐⇒ for any nondegenerate lottery L, RP (L) > 0;
– Risk-neutral ⇐⇒ for any nondegenerate lottery L, RP (L) = 0;
– Risk-seeking ⇐⇒ for any nondegenerate lottery L, RP (L) < 0.
AMA484 Decision Analysis 50

Example
0.5
$30, 000
L
0.5
−$10, 000

Then
EM V (L) = $30, 000 × 0.5 + (−$10, 000) × 0.5 = $10, 000.
We have already see that CE(L) = −$3, 400. Thus,

RP (L) = $10, 000 − (−$3, 400) = $13, 400.

Jill values L at $13, 400 less than its expected value, because she does not like the large
degree of uncertainty that is associated with the reward yielded by L.
AMA484 Decision Analysis 51

Example
Utility

RP (L)
E(U for L) Point 1

Why a Concave Utility


Function Implies
Risk-Averse Behavior
x
x1 CE(L) x2
px1 + (1 − p)x2
= EM V (L)
AMA484 Decision Analysis 52

p
x1
L (Assume x1 < x2 )
1−p
x2

Suppose u(x) is strictly concave. Then, from the above figure, we see that

E(U for L) = p(x)u(x1 ) + (1 − p)u(x2 ) = y-coordinate of Point 1.

Since CE(L) is the value x⋆ having u(x⋆ ) = E(U for L), the figure shows that
CE(L) < EM V (L), so RP (L) > 0.
This follows because the strict concavity of u(x) implies that the line segment joining
the points (x1 , u(x1 )) and (x2 , u(x2 )) lies below the curve u(x).
AMA484 Decision Analysis 53

We can also give an algebraic proof that u(x) strictly concave implies that
RP (L) = EM V (L) − CE(L) > 0. Recall that for
p
x1
L
1−p
x2

EM V (L) = px1 + (1 − p)x2 . Now the strict concavity of u(x) implies that

u(px1 + (1 − p)x2 ) > pu(x1 ) + (1 − p)u(x2 ) = E(U for L).

Thus, the decision maker prefers px1 + (1 − p)x2 = EM V (L) with certainty to the
prospect of playing L.
The certainty equivalent of L must be less than px1 + (1 − p)x2 = EM V (L).
This implies that RP (L) = EM V (L) − CE(L), and the decision maker exhibits
risk-averse behavior.
AMA484 Decision Analysis 54

Example
1
Joan’s utility function for her asset position x is given by u(x) = x 2 .
Currently, Joan’s assets consist of $10, 000 in cash and a $90, 000 home.
During a given year, there is a 0.001 chance that Joan’s home will be destroyed by fire
or other causes.
How much would Joan be willing to pay for an insurance policy that would replace her
home if it were destroyed?
AMA484 Decision Analysis 55

Example
Let x = annual insurance premium. then Joan must choose between the following
lotteries:
Asset Position
1
Buy insurance: L1 $100, 000 − x

0.001
$100, 000 − $90, 000 = $10, 000
Do not buy insurance: L2
0.999
$100, 000
AMA484 Decision Analysis 56

Joan will prefer L1 to L2 if L1 ’s expected utility exceeds L2 ’s expected utility. Thus


L1 pL2 if and only if
1 1 1
(100, 000 − x) 2 ≥ 0.001 × (10, 000) 2 + 0.999 × (100, 000) 2
≥ 0.1 + 315.91154
≥ 316.01154.

Suppose both sides of the last inequality we find that L1 pL2 if and only if

100, 000 − x ≥ 316.011542


x ≤ 136.71.

Thus, Joan would pay up to $136.71 for insurance. Of course, if x = $136.71, L1 iL2 .
AMA484 Decision Analysis 57

Risk Premium
Let’s compute the risk premium for L2 :

EM V (L2 ) = 0.001 × $10, 000 + 0.999 × $100, 000 = $99, 910.

(an expected loss of $100, 000 − $99, 910 = $90).


Since E(U for L) = 316.01154, we can find CE(L2 ) from the relation
1
u(CE(L2 )) = 316.01154, or [CE(L2 )] 2 = 316.01154.

Thus
CE(L) = 316.011542 = $99, 863.29,
and

RP (L2 ) = EM V (L2 ) − CE(L2 ) = $99, 910 − $99, 863.29 = $46.71.


AMA484 Decision Analysis 58

Therefore, Joan is willing to pay for annual home insurance $46.71 more than the
expected loss of $90.
(Recall that Joan was willing to pay up to $90 + $46.71 = $136.71 to avoid the risk
involved in her home being destroyed.)
Joan exhibits risk-averse behavior (RP (L) > 0). Since
− 32
−x
u′′ (x) = < 0,
4
u(x) is strictly concave, and RP (L) > 0 would hold for any nondegenerate lottery.
AMA484 Decision Analysis 59

Exponential Utility

• One important class is called exponential utility and has been used in many
financial investment analyzes.

• An exponential utility function has only one adjustable numerical parameter, and
there are straightforward ways to discover the most appropriate value of this
parameter for a particular individual or company.

• An exponential utility function has the following form:


x
u(x) = 1 − e− R .
AMA484 Decision Analysis 60

• An exponential utility function has the following form:


x
u(x) = 1 − e− R .

• Here x is a monetary value (a payoff if positive, a cost if negative) u(x) is the


utility of this value, an R > 0 is an adjustable parameter called the risk tolerance.

• To assess a person’s (or company’s) exponential utility function, we need only to


assess the value of R.

• A person with a large value of R is more willing to take risks than a person with a
small value R.
AMA484 Decision Analysis 61

It has been shown that the risk tolerance ≈ dollar amount R such that the decision
maker is (seem to be) indifferent between the following two options

• Option 1 – Obtain no payoff at all.


R
• Option 2 – Obtain a payoff of R dollars or a loss of 2 dollars, depending on the
flip of a fair coin.

• Check: u(R) = 0.6321, u(− R2 ) = −0.6487.

• u(0) = 0

• Indifference implies u(0) ≈ 0.5 × u(R) + 0.5 × u(− R2 ).


AMA484 Decision Analysis 62

A second tip for finding R is based on empirical evidence found by Ronald Howard, a
prominent decision analyst.
He discovered tentative relationships between risk tolerance and several financial
variables – net sales, net income, and equity.
specifically, he found that R was approximately 6.4% of net sales, 124% of net
income, and 15.7% of equity for the companies he studied.
For example, according to to this prescription, a company with net sales of $30 million
should have a risk tolerance of approximately $1.92 million.
Howard admits that these percentages are only guidelines.
However, they do indicate that larger and more profitable companies tend to have
larger values of R, which means that they are more willing to take risks involving
given dollar amounts.
AMA484 Decision Analysis 63

More utility functions showing mixed behaviour


Other types of utility functions are given below.

In reality, many people exhibit both risk-seeking behavior (they purchase lottery
tickets, go to Las Vegas) and risk-averse behavior (they buy home insurance).
A person whose utility function contains both convex and concave segments may
exhibit both risk-averse and risk-seeking behavior.
AMA484 Decision Analysis 64

Example
Consider a decision maker whose utility function u(x) for change in current asset
position is given the figure below.
Utility
1 •
u(−2, 000) = 0
u(−300) = 0.18
0.8 u(−200) = 0.19
u(0) = 0.2
u(2, 500) = 0.5
0.6

0.4

0.2 •••

0• x
−2, 000 0 2, 000 4, 000 6, 000
AMA484 Decision Analysis 65

If forced to choose between


0.1
$2, 500
1
L1 0 and L2
0.9
−$300

What would this person do?


From the figure above, we find u(0) = 0.20, u(2, 500) = 0.50 and u(−300) = 0.18.
Thus, E(U for L1 ) = 0.20 and E(U for L2 ) = 0.10(0.50) + 0.90(0.18) = 0.212.
Thus, L2 pL1 . This means that L2 has a certainty equivalent of at least $0. Since
EM V (L2 ) = −$20, this implies that RP (L2 ) = EM V (L2 ) − CE(L2 ) < 0.
The decision maker exhibits risk-seeking behavior in this situation, because for
changes in asset position between $0 and $2, 500, u(x) is a convex function.
AMA484 Decision Analysis 66

Now suppose the decision maker can, for $200, insure himself against a loss of
$2, 000, which occurs with probability 0.08. Then he must choose between
0.08
−$2, 000
1
L3 −$200 and L4
0.92
$0

From the figure, u(−200) = 0.19, u(0) = 0.20 and u(−2, 000) = 0. Thus,
E(U for L3 ) = 0.19 and E(U for L4 ) = 0.80 × 0 + 0.92 × (0.20) = 0.184, and
L3 pL4 .
This shows that CE(L4 ) < −$200. Since EM V (L4 ) = 0.08(−2, 000) + 0.92(0) =
−$160, RP (L4 ) = EM V (L4 ) − CE(L4 ) > 0, and the decision maker is exhibiting
risk-averse behavior, because u(x) is concave for −2, 000 < x < 0.
Thus, if his utility function has both convex and concave segments, a person can
exhibit both risk-seeking and risk-averse behavior.
AMA484 Decision Analysis 67

Flaws in Expected Utility Maximization

• Utility theory is very important in micro-economics to explain consumers’


behaviour.

• The axioms underlying expected maximization of utility (EMU) seem reasonable,


but in practice people’s decisions often deviate from the predictions of EMU.

• Psychologists Kahneman and Tversky developed prospect theory and framing


effects for values to try and explain why people deviate from the predictions of
EMU.
AMA484 Decision Analysis 68

Prospect Theory
Here is one example of a decision that cannot be explained by EM U . Ask a person to
choose between lottery 1 and lottery 2:

• Lottery 1: $30 for certain

• Lottery 2: 80% chance at $45 and 20% chance $0.

Most people prefer lottery 1 to lottery 2.


Next ask the same person to choose between lottery 3 and lottery 4:

• Lottery 3: 20% chance at $45 and 80% chance $0.

• Lottery 4: 25% chance at $30 and 75% chance $0.

Most people choose lottery 3 over lottery 4.


AMA484 Decision Analysis 69

Now let u(0) = 0 and u(45) = 1. A decision maker following EM U will choose
lottery 1 over lottery 2 if and only if

u(30) > 0.8.

A decision maker following EM U will choose lottery 3 over lottery 4 if and only if

0.2 > 0.25 × u(30) or u(30) < 0.8.

This implies that a believer in EMU cannot choose lottery 1 over lottery 2 and lottery 3
over lottery 4. Thus, for this situation, the choices of most people contradict EMU.
AMA484 Decision Analysis 70

Weight Applied to Utility

π(p)

0.8 p π(p)

0.6

0.4

0.2

p
0 0.2 0.4 0.6 0.8 1
AMA484 Decision Analysis 71

• The shape of the π(p) function in the figure implies that individuals are more
sensitive to changes in probability when the probability of an event is small (near
0) or large (near 1).

• Prospect theory (Tversky and Kahneman):


We treat probability p for an event as a “distorted” probability as π(p) rather than
the prob. given in decision-making problem.

The equation we used to construct our π(p) curve is

π(p) = 1.89799p − 3.55995p2 + 2.662549p3 .

How does prospect theory explain our paradox?


AMA484 Decision Analysis 72

From the value of π(p) given in the figure, we can compare the expected “prospects”
of lottery 1 versus lottery 2 and lottery 3 versus lottery 4.

• Prospect for lottery 1: u(30)

• Prospect for lottery 2: 0.602

• Prospect for lottery 3: 0.258

• Prospect for lottery 4: 0.293 × u(30)

Thus, lottery 1 is preferred to lottery 2 if u(30) > 0.602, while lottery 3 is preferred to
0.258
lottery 4 if 0.258 > 0.293 × u(30) or u(30) < 0.293 = 0.88.
Our paradox evaporates, because for many people, u(30) will be between 0.602 and
0.88.
AMA484 Decision Analysis 73

Framing

• Kahneman and Tversky’s idea of framing is based on the fact that people often set
their utility functions from the standpoint of a frame from which they view the
current situation.

• Most people’s utility functions treat a loss of a given value as being more serious
than a gain of an identical value.
AMA484 Decision Analysis 74

Framing
Utility

outcome
Losses Gains

Reference point
AMA484 Decision Analysis 75

To see how framing can explain the failure of EM U , consider the following problem
that Kahneman and Tversky gave to a group of students. The U S is preparing for the
outbreak of a disease that is expected to kill 600 peoples. Two alternative programs
have been proposed

• Program 1: 200 people are saved

• Problem 2: with probability 13 , 600 people are saved.

Most students preferred program 1, probably because with program 2 there is a large
risk of saving nobody. Since the programs are phrased in terms of lives saved, most
people take the frame or reference point for this problem to be no lives saved or 600
people dead. Since the effect of each program is expressed in gains, and the utility
function is concave for gains, we find that
2 1 1 2 1
u(200) = u(( )0 + ( 600)) > ( )u(600) + ( )u(0) = ( )u(600).
3 3 3 3 3
This implies, of course, that the person chooses program 1 over program 2.
AMA484 Decision Analysis 76

Next, Kahneman and Tversky rephrased the problem as follows:

• Program 1: 400 people die.

• Problem 2: with probability 32 , 600 people die.

Now most people choose program 2. Note that both program1’s are identical, as are
both program 2’s. Why do most people choose program 2 for the second phrasing of
the alternatives? The second phrasing shifts most people’s reference points from “No
lives saved” (in first phrasing) to “Nobody dies”. The outcomes are expressed as losses
(deaths), so the convexity of the utility curve for losses implies that
2 2 1 2 1
( )u(−600) = ( )u(−600) + ( u(0)) > u(( )(−600) + (0)) = u(−400)
3 3 3 3 3
This implies, of course, that the person chooses program 2 over program 1.
AMA484 Decision Analysis 77

Prospect theory

• The interplay of overweighting of small probabilities and concavity-convexity of


the value function leads to the so-called four-fold pattern of risk attitudes:
risk-averse behavior in gains involving moderate probabilities and of small
probability losses; risk-seeking behavior in losses involving moderate probabilities
and of small probability gains. This is an explanation for the fact that people, e.g.,
simultaneously buy lottery tickets and insurances, but still invest money
conservatively.

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