Decision Theory under
Uncertainty
Basic concepts of Expected Value And
Expected Utility
Choice Under Uncertainty
(contd..)
Consumer and firms are usually uncertain
about the payoffs from their choices. Some
examples…
Example 1: A farmer chooses to cultivate
either apples or pears
When he takes the decision, he is uncertain
about the profits that he will obtain. He does not
know which is the best choice
This will depend on rain conditions, world
prices…
Uncertainty
Example 2: playing with a fair die
We will win Rs2 if 1, 2, or 3,
We neither win nor lose if 4, or 5
We will lose Rs 6 if 6
Example 3: John’s monthly consumption:
Rs3000 if he does not get ill
Rs 500 if he gets ill (so he cannot work)
Our objectives in this part
Review how economists make
predictions about individual’s or firm’s
choices under uncertainty
Review the standard assumptions
about attitudes towards risk
Economist’s jargon
Economists call a lottery a situation
which involves uncertain payoffs:
Cultivating apples is a lottery
Cultivating pears is another lottery
Playing with a fair die is another one
Monthly consumption
Each lottery will result in a prize
Probability
The probability of a repetitive event
happening is the relative frequency with
which it will occur
probability of obtaining a head on the fair-
flip of a coin is 0.5
If a lottery offers n distinct prizes and the
probabilities of winning the prizes are pi
(i=1,…,n)n then
i 1
p i p1 p 2 ... p n 1
An important concept: Expected Value
The expected value of a lottery is the average
of the prizes obtained.
Expected Value. Formal definition
For a lottery (X) with prizes x1,x2,…,xn and the
probabilities of winning p1,p2,…pn, the expected value
of the lottery is
E ( X ) p 1 x 1 p 2 x 2 ... p n x n
n
E ( X ) p i xi
i 1
The expected value is a weighted sum of the prizes
the weights are the respective probabilities
The symbol for the expected value of X is E(X)
Expected Value of monthly
consumption (Example 3)
Example 3: John’s monthly consumption:
X1=Rs4000 if he does not get ill
X2=Rs 500 if he gets ill (so he cannot work)
Probability of illness 0.25
Consequently, probability of no illness=1-0.25=0.75
The expected value is:
E ( X ) p 1 x1 p 2 x 2
E ( X ) 0 .7 5 * ( R s 4 0 0 0 ) 0 .2 5 ( R s 5 0 0 ) 3 1 2 5
Introducing another lottery in John’s
example
Lottery A: Get Rs 3125 for sure independently of illness state
(i.e. expected value= Rs 3125). This is a lottery without risk
Lottery B: win Rs 4000 with probability 0.75,
and win Rs 500 with probability 0.25
(i.e. expected value also Rs 3125)
Is the expected value a good criterion to
decide between lotteries?
One criterion to choose between two lotteries is to
choose the one with a higher expected value
Does this criterion provide reasonable predictions?
Let’s examine a case…
Lottery A: Get Rs3125 for sure (i.e. expected
value= Rs 3125)
Lottery B: win Rs 4000 with probability 0.75,
and lose Rs 500 with probability 0.25
(i.e. expected value also £3125)
What will you choose?
Is the expected value a good criterion to
decide between lotteries?
Probably most people will choose Lottery A
because they dislike risk (risk averse)
However, according to the expected value
criterion, both lotteries are equivalent. The
expected value does not seem a good criterion
for people those who dislike risk
If someone is indifferent between A and B it is
because risk is not important for him (risk
neutral)
Expected Utility Theory
The most famous example of such a theory was published
by von Neumann and Morgenstern (1944) (VNM).
They proposed it as a “normative” theory of behaviour.
That is, classical utility theory as a “normative” theory of
behaviour.
Classical utility theory was not intended to describe how
people actually behave, but how people would behave if
they followed certain requirements of rational decision-
making.
One of the main purposes of such a theory was to provide
an explicit set of assumptions or axioms that underlie
rational decision-making.
Once VNM specified these axioms, decision researchers
were able to compare the mathematical predictions of
expected utility theory with the behaviour of real decision
makers.
When researchers documented violations of an axiom, they
often revised the theory and made new predictions. In this
way, research on decision making cycled back and forth
between theory and observation.
What are the axioms of rational decision-making?
Most formulations of expected utility theory are based
at least in part on some subset of the following
principles.
1. Ordering of alternatives. First of all, rational
decision makers should be able to compare any two
alternatives. They should either prefer one alternative
to the other, or they should be indifferent to them.
2. Dominance. Rational actors should never adopt
strategies that are “dominated” by other strategies
(here adopting a strategy is equivalent to making a
decision).
A strategy is weakly dominant if, when you compare it
to another strategy, it yields a better outcome in at
least one respect and is as good or better than the
other strategy in all other respects (where “better”
means that it leads to an outcome with greater utility).
3. Transitivity. If a rational decision maker prefers
Outcome A to Outcome B, and Outcome B to Outcome
C, then that person should prefer Outcome A to
Outcome C.
a>b and b>c ⇒ a>c
4. If one is indifferent between A and B then
for any probability α, one is indifferent
between αA and αB
Expected utility: The standard criterion to
choose among lotteries
Individuals do not care directly about the monetary
values of the prizes
they care about the utility that the money provides
U(x) denotes the utility function for money
We will always assume that individuals prefer more
money than less money, so:
U '( x i ) 0
Expected utility: The standard criterion to
choose among lotteries
The expected utility is computed in a similar way to
the expected value
However, one does not average prizes (money) but
the utility derived from the prizes
The formula of expected utility is:
n
E U p iU ( x i ) p 1U ( x1 ) p 2U ( x 2 ) ... p nU ( x n )
i 1
The individual will choose the lottery with the
highest expected utility
Indifference curve
The indifference curve is the curve that gives us the
combinations of consumption (i.e. x1 and x2) that
provide the same level of Expected Utility
Drawing an indifference curve
Are indifference curves decreasing or increasing?
EU p1U ( x1 ) p2U ( x2 )
EU p1U ( x1 ) (1 p1 )U ( x2 )
dEU 0 p1U '( x1 )dx1 (1 p1 )U '( x2 )dx2
dx2 p1 U '( x1 )
* MRS
dx1 (1 p1 ) U '( x2 )
dx2
AsU '( x ) 0 0 decrea sin g
dx1
What shape is the utility function of a
risk averse individual?
U(x)
X=money
U’(x)>0, increasing
U’’(x)<0, strictly
concave
Measuring Risk Aversion
The most commonly used risk aversion
measure was developed by Pratt
U "( X )
r(X )
U '( X )
For risk averse individuals, U”(X) < 0
r(X) will be positive for risk averse
individuals
Risk Aversion
If utility is logarithmic in consumption
U(X) = ln (X )
where X> 0
Pratt’s risk aversion measure is
U "( X ) 1
r(X )
U '( X ) X
Risk aversion decreases as wealth
increases
Risk Aversion
If utility is exponential
U(X) =1 -e-aX = 1-exp (-aX)
where a is a positive constant
Pratt’s risk aversion measure is
U "( X ) a 2 e aX
r(X ) aX a
U (X ) ae
Risk aversion is constant as wealth
increases
