UNCERTAINTY PART 2

A POTENTIAL PROBLEM
VNM Utility representations have more than ordinal meaning.
For instance,
Let A = {a, b, c} with a  b  c.
By G3 & G4, there is a unique (0, 1) satisfying
b ( a, (1 ) c).
Let u be a VNM utility representation of preference ordering %.
Then
u(b) = u(a) + (1 )u(c)

A PROBLEM CONTD
Add (1 )u(b) to both sides of previous equality; we get
u(a) u(b) 1
=
.
u(b) u(c)

Such ratio of differences is uniquely determined by

But depends only on preferences % (NOT on u)
Hence, VNM utility representations provide more than ordinal info about individuals preferences (or else, the ratio could assume many different values.)
Question: what is the class of VNM utility representation for a given % ?

THEOREM: POSITIVE AFFINE TRANSFORMATIONS

Suppose that the VNM utility function u represents the preferences %.
Then the VNM utility function v also represents % iff for all g G
v(g) = + u(g), for some scalars R, > 0
Proof (sufficiency, ):
Let v(g) = + u(g) with > 0 for all g G.
For any g % h G, v(g) = + u(g) + u(h) = v(h).
Outline of Proof (necessity, ):
Case 1: Degenerate gambles g (1 ai) G for some i = 1, . . . , n.
Case 2: Any gamble g G.

CASE 1: DEGENERATE GAMBLE g (1 ai)

Let v represent %. Consider a1 % a2 % . . . % an where a1  an.
Since u represents %, we have u(a1) u(a2) . . . u(an)
Hence, for any ai A, there exists unique i [0, 1] such that:
u(ai) = iu(a1) + (1 i)u(an)
By EUP:

(a convex combination of extrema)

u(i a1, (1 i) an) = iu(a1) + (1 i)u(an) = u(ai)

Since u represents % we thus have: ai (i a1, (1 i) an)

b/c v also represents %

b/c v has EUP

z
}|
{ z
}|
{
v(ai) = v((i a1, (1 i) an)) = iv(a1) + (1 i)v(an).

CASE 1 CONTD
(

In summary, we have:

u(ai) = iu(a1) + (1 i)u(an),

v(ai) = iv(a1) + (1 i)v(an).

Now solve for i:

u(ai) u(an) v(ai) v(an)

=
.
u(a1) u(an) v(a1) v(an)

i =

Hence: [u(ai) u(an)] [v(a1) v(an)] = [v(ai) v(an)] [u(a1) u(an)].

Now solve for v(ai):

v(ai) = + u(ai),

v(a1) v(an)
where :=
> 0 and := v(an) u(an).
u(a1) u(an)

CASE 2: GENERAL GAMBLE g G

By G6, consider gs (p1 a1, . . . , pn an) g.

v(g) = v(gs) =
=

n
X
i=1
n
X

piv(ai)
pi[ + u(ai)]

(by EUP)
(by part 1 of the proof)

i=1

=+

n
X

piu(ai)

i=1

= + u(gs)

(by EUP)

= + u(g).

(since u represents %)

and the proof is done. 

MEASURING RISK AVERSION

TWO ASSUMPTIONS

1. Consider only simple gambles g = (p1 w1, . . . , pn wn), where

wi A = R+ is a wealth level, for i = 1, . . . , n
n N with n <
p = (p1, . . . , pn) n1
2. The VNM utility function u is differentiable with u0(w) > 0 for all w R+.

DEFINITION: EXPECTED VALUE

expected value of g

For gamble g = (p1 w1, . . . , pn wn):

E[g] =

}|
n
X

p i wi

i=1

Hence:
VNM utility of gamble g:

u(g) =

VNM utility of expected value of g:

Pn

i=1 pi u(wi )

u(E(g)) = u (

Pn

i=1 pi wi )

If g is degenerate (some pi = 1), then E[g] = wi = g = 1 wi.

DEFINITION: RISK AVERSION, NEUTRALITY, & LOVE

Let u be a VNM utility function for simple gambles g over R+.
For a non-degenerate g the individual is said to be:
Risk averse at g if u(E(g)) > u(g),
Risk neutral at g if u(E(g)) = u(g),
Risk loving at g if u(E(g)) < u(g) (=gamble preferred to its expected value).

DEFINITION: CONCAVITY
A function f : D R, D a convex set, is concave iff for all x1, x2 D,
f (xt) tf (x1) + (1 t)f (x2)

for all t [0, 1]

with xt := tx1 + (1 t)x2, any convex combination of x1 and x2

If t (0, 1), x1 6= x2 & the inequality holds strictly, then f is strictly concave.
x can be a vector of variables.

THEOREM: CONCAVITY FOR A DIFFERENTIABLE FUNCTION

(see Mas Colell et al.)
The continuously differentiable function f : A R is concave if and only if
f (x + z) f (x) +

N
X

(1N )

fn(x)zn

1)
z }| { (N
z}|{
f (x)+ f (x) z

n=1

for all x A RN and z RN with x + z A.

The function f is strictly concave if the inequality holds strictly, with z 6= 0.

PROOF OF NECESSITY ()
From definition of concavity:
f (x0 + (1 )x) f (x0) + (1 )f (x) for all x, x0 A, (0, 1]
Let z := x0 x 6= 0 with z RN . Hence
f (x + z) f (x + z) + (1 )f (x)
f (x + z)

(x)
lim f (x+z)f

N
P

f (x) +

f (x + z) f (x)

fn(x)zn using chain rule on f (x1 + z1, . . . , xN + zN )

n=1

and lHospital rule (derivative w.r.t. in num. & den.) 

PROOF OF SUFFICIENCY ()
Let y = (1 )x + x0 be any convex combination of x, x0 A, (0, 1).
Hence:

x = y (x0 x),

x0 = y + (1 )(x0 x)

By assumption:
a scalar
z
}|
{
0
0
f (x) = f (y (x x)) f (y) f (y) (x x),

f (x0) = f (y + (1 )(x0 x)) f (y) + f (y) (1 )(x0 x).

Therefore
(1)f (x) + f (x0)
(1 )[f (y) f (y) (x0 x)] + [f (y) + f (y) (1 )(x0 x)]
= f (y) (1 )f (y) (x0 x) + f (y) (1 )(x0 x)
= f (y) = f ((1 )x + x0) 

JENSENS INEQUALITY
Let p n1, and f be a continuous concave function. Then
f

n
X

pi x i

i=1

n
X

pif (xi).

i=1

Proof: By definition of concavity.

By Jensens inequality,

the individual is risk

averse

strictly concave.

neutral iff his VNM utility function is linear.

loving
strictly convex.

DEFINITIONS
Consider any simple gamble g over R+.
Certainty equivalent: an amount wCE R+ offered with certainty s.t.
u(g) = u(wCE )

(= indifferent to lottery g)

Risk premium: the amount wP R+, s. t.

u(g) = u(E(g) wP )
Clearly, wP = E(g) wCE = pw1 + (1 p)w2 wCE

EXAMPLE
Let u(w) = ln(w) with initial wealth w0; u00 < 0, hence individual is risk averse.
Let g offer 50-50 odds of winning or losing h (0, w0):
g = ((1/2) (w0 + h), (1/2) (w0 h))
E(g) = w0 and wCE satisfies:

u(w

CE

ln(w0 + h) + ln(w0 h)
2
2 12
= ln[(w0 h ) ].
) = u(g) =
2

Thus
w

CE

(w02

h )

1
2

& w = E(g) w

CE

= w0

(w02

1
2

h ) > 0.

EXAMPLE: SIMPLE GAMBLE WITH TWO OUTCOMES

Gamble involving only two outcomes, g = (p w1, (1 p) w2) with w1 < w2
E(g) = pw1 + (1 p)w2

(Expected value of gamble)

u(g) = pu(w1) + (1 p)u(w2)

(Expected utility from gamble)

u(E(g)) = u(pw1 + (1 p)w2)

(Utility of expected value of gamble)

CONCAVITY, CERTAINTY EQUIVALENT,

AND RISK PREMIUM

R := (w1, u(w1)), S := (w2, u(w2)) T := pR + (1 p)S = (E(g), u(g))

FIGURE: DISCUSSION
u(E[g]) u(g)=disutility associated w/ risk
The implicit function of the line going through (x1, y1) and (x2, y2) is:

(y2 y)

x2 x1
(x2 x) = 0
y2 y1

Equation of line going through R and S defined by function

w2u(w1) w1u(w2) u(w2) u(w1)
h(w) =
+
w
w2 w1
w2 w 1
with w = E(g) pw1 + (1 p)w2, i.e., a convex combination of w1, w2.

FIGURE: THE MEANING OF THE LINE h(w)

Hence:
h(w) = pu(w1) + (1 p)u(w2) = expected utility from gamble g
h(w) lies below u(w) (by Jensens inequality)
Example:
p = 0 implies w = w1; so, h(w) = u(w1).
p = 1 implies w = w2; so, h(w) = u(w2).
w1 + w2
u(w1) + u(w2)
p = 1/2 implies w =
; so h(w) =
.
2
2
Note: the greater the curvature of u the greater the risk premium

MEASURES OF RISK AVERSION

Risk aversion and curvature of VNM utility function u(w) are positively related.
A natural candidate for such a measure is the second derivative u00(w).
But u00(w) is not invariant to positive affine transformation v(w) = a + bu(w)
v 00(w) = bu00(w) 6= u00(w),

if b > 0 and b 6= 1.

An invariant measure of risk aversion at point w is as follows.

Definition: The Arrow-Pratt measure of absolute risk aversion is
u00(w)
.
R(w) := 0
u (w)

ABSOLUTE RISK AVERSION

1. R(w) is

risk averse.

positive

when the individual is risk neutral.

zero

risk loving.
negative

Proof: By Jensens inequality.

2. R(w) is invariant under positive affine transformations.
Proof: If v(w) = a + bu(w) for all w 0 and b > 0, then
v 00(w) bu00(w) u00(w)
=
= 0
0
0
v (w)
bu (w)
u (w)
3. Effectiveness: the larger R(w), the lower the certainty equivalent wCE .

PROOF OF THE EFFECTIVENESS OF R(w)

Consider individuals j = 1, 2 and the gamble g = (p1 w1, . . . , pn wn).
Let uj : R+ R be VNM utility functions with u0j > 0 & wjCE R+ satisfy
uj (wjCE ) =

n
X

piuj (wi) for j = 1, 2 (wjCE = certainty equivalent)

i=1

Must show: if R1(w) > R2(w) for all w 0, then w1CE < w2CE .
Define h : R R+ with h(y) = u1(u1
2 (y)).
(w = u1
2 (y) is the inverse function of y = u2 (w))
Since u0j > 0 for all j & R1(w) > R2(w), h0 > 0 & h00 < 0 (do the algebra)
1
(recall: the derivative of u1
2 (y) is u0 (u1 (y)) )
2

PROOF OF THE EFFECTIVENESS

Idea: u1(w) = h(y) = h(u2(w)), with h concave (= u1 is concavification of u2).
More precisely,
from Jensens inequality

u1(w1CE ) =

n
X
i=1

piu1(wi) =

z
n
X

}|

pih(u2(wi)) < h

i=1

= h(u2(w2CE )) = u1(w2CE )
Since u01 > 0, we have the desired result. 

n
X
i=1

!{

piu2(wi)

DECREASING ABSOLUTE RISK AVERSION (DARA)

R(w) is only a local measure of risk aversion (around w).
The Arrow-Pratt measure varies with wealth.
Decreasing absolute risk aversion (DARA)
Individual is less averse to taking small risks at higher levels of wealth.
Example: u(c) = log c
00

1
u (c) 1
1
00
0
u (c) =
u (c) = 2 0
=
c
c
u (c) c

(for increasing ARA consider u(c) = cac )

CONSTANT ABSOLUTE RISK AVERSION (CARA) FUNCTIONS

Constant absolute risk aversion (CARA)
The individual is equally averse to risks at all levels of wealth.
Example: exponential function

u(c) = eac with a > 0

Then at all c > 0 we have

u0(c) = aeac u00(c) = a2eac

u00(c)
0
=a
u (c)

RELATIVE RISK AVERSION

u00(c)
0
c
u (c)
Example of constant relative risk aversion (CRRA) function
c1 1
u(c) =
,
1

u0(c) = c u00(c) = c1

u00(c)
0 c=
u (c)

Log and linear functions are also CRRA:

Log : u(c) = ln c

u00(c)
0 c=1
u (c)

Linear : u(c) = bc u0(c) = b & u00(c) = 0

u00(c)
0 c=0
u (c)

Consumers with linear preferences are risk neutral:

gamble g

z}|{
u(g) = u(

expected value of g

z}|{
E[g]

EXAMPLE

AN INVESTORS PROBLEM
Optimally allocate s [0, w] of initial wealth w > 0 in a risky asset
Asset has rate of return ri R with probability pi, i = 1, . . . , n.
Investor has VNM preferences u with u00 < 0 (Risk-averse)
Will the investor invest something?
Solution: Choose s to maximize the expected utility of wealth
max
s0

FOC :

F (s, w) :=

n
X
i=1

n
X

piu(w + sri) + (w s).

i=1

piu0(w + sri)ri 0

& complementary slackness

OPTIMAL DECISION
Study FOC at s = 0

If
If

n
P
i=1
n
P

Pn

Pn

>0

piri 0, then s = 0 since F (0, w) = u (w)

piri > 0, then s > 0 since F (0, w) = u (w)

i=1

Note: S.O.C.:

n
P
i=1

i=1 pi ri
i=1 pi ri

piu00(w + sri)ri2 < 0 for all s.

Note: In interior solution = 0 < s < w with F (s, w) = 0

DECISION MAKING
Consider interior solution. Under DARA:
n
P
00

p
u
(w
+
s
ri)ri
i

Fw (s , w)
ds
i=1
=
=

> 0.
n

P
dw
Fs(s , w)
piu00(w + sri)ri2
i=1

To see this,
DARA
z
}|
{
u00(w + sri)

R(w)ri > R(w + s ri)ri = 0

ri

u (w + s ri)
R(w)riu0(w + sri) > u00(w + sri)ri
Expectation of LHS

0 =R(w)
|

n
X
i=1

}|

Expectation of RHS

piriu0(w + sri) >

{z
}

by F.O.C.

n
X
i=1

}|

piu00(w + sri)ri