Risk-Taking and Expected Utility Theory

If life is free of failures you are not taking enough risks.
Jackson Brown, Jr.
Group-Clicker Question (1 pt): What is the

Expected Value of the lottery (0.25, 0.25, 0.50)
over the monetary prizes
($4, $16, $50)?
1.30
2.45
ECON 410
Preferences Over Risk
0%
0%
Class 16 - Uncertainty Fundamentals

2
HW3 Due Thursday, Feb. 14
http://www.unceminor.org/
Applications due 3/8

3
Existing Theory
Lottery Definition
Expected Value
Preference Over
Lotteries
Independence Axiom
Expected Utility
Theorem
Cardinality

4

5
Complete
A decision can be made
Symmetric
An individual is indifferent to
all options
Transitive
Preference rankings are
consistent
Local nonsatiation
No bliss points
Monotonicity
More is better
Strict Convexity
Preference for diversity
Continuity
No unexpected shifts in
preferences

6
Complete:
A preference relation over lotteries is
complete if, for each
lottery
x and y,
either x
y or y
x or both, where x
and y are lotteries.

7
Transitive:
A preference relation over lotteries is
transitive if, for every

x,
y, and z,
if x
y
and y
z then x
z where x, y, and z are
lotteries.

8
Continuity
Loosely, preferences over lotteries are continuous
if, whenever
(q1, q2,qn) and (p1,
(p1, p2,pn)
p2,pn)
(t1, t2,tn) then(t1, t2,tn)
(q1, q2,qn)

9
Existing Theory
Lottery Definition
Expected Value
Preference Over
Lotteries
Independence Axiom
Expected Utility
Theorem
Cardinality

10
Mixing
Given two lotteries, (p1, p2,pn) and (t1, t2,tn), a
mixture of these two lotteries is the new lottery
(ap +(1-a)t , ap +(1-a)t

1
2,
, apn+(1-a)tn

11
$0
(0.8, 0.2)
$0
(0.25, 0.75)

12
Independence
Preferences over lotteries display independence if,
whenever
(p1, p2,pn)
(q1, q2,qn) then
with (t1, t2,tn)

(p1, p2,pn) mixed
(q1, q2,qn) mixed with (t1, t2,tn)
when the mixing is done in the same manner.

13

14

15

16
Group-Clicker Question (P): You are offered a lottery over ($5 million,
$1 million, $0). Which lottery would you select?
1.
2.
(0, 1, 0)
(0.10, .89, .01)
Group-Clicker Question (P): You are offered a lottery over ($5 million,
$1 million, $0). Which lottery would you select?
1.
2.
(0, .11, .89)

(0.10, 0, .90)

19
($5 million, $1 million, $0)

Lottery 1: (0, 1, 0)
vs
Lottery 2: (0.10, .89, .01)
Option 1
Lottery 1
Lottery 2
Prize
Probability
Prize
Probability
$1
89%
$1
89%
$1
11%
$5
10%
$0
1%

20
($5 million, $1 million, $0)

Lottery 1: (0, .11, .89)
vs
Lottery 2: (0.10, 0, .90)
Option 2
Lottery 1
Lottery 2
Prize
Probability
Prize
Probability
$0
89%
$0
89%
$1
11%
$5
10%
$0
1%

21
Option 1
Lottery 1
Lottery 2
Prize
Probability
Prize
Probability
$1
89%
$1
89%
$1
11%
$5
10%
$0
1%
Option 2
Lottery 1
Lottery 2
Prize
Probability
Prize
Probability
$0
89%
$0
89%
$1
11%
$5
10%
$0
1%
Group-Clicker Question (P): You are offered a lottery over

(a trip to Cancun with your friends, staying home and watching a movie of your
friends having a great time in Cancun, staying home and watching no movie).
Which lottery would you select?
1.
2.
(.99, 0.01, 0)
(0.99, 0, .01)

23
Existing Theory
Lottery Definition
Expected Value
Preference Over
Lotteries
Independence Axiom
Expected Utility
Theorem
Cardinality

24
Why Economists Assume

Independence
Normative
Independence is how people should behave.
The night of the fight, you might

feel a slight sting. Thats pride
messing with you. Forget pride.
Pride only hurts. It never helps.
You fight through that nonsense.
-Marcellus Wallace, Pulp
Fiction

25

Independence
Large Organizations Should Be Rational
When looking at large questions, assuming
independence is very reasonable.

26

Independence
Money Pump
If an individuals preferences over lotteries do not
display Independence, there is an opportunity for a
money pump.

27

Independence
Tractability
If we assume Independence, we can do amazing
things.

28
Expected Utility Theorem

If an individuals preferences over lotteries are
complete, transitive, continuous, and satisfy the
independence
axiom, then
(p1, p2,pn)
(q1, q2,qn)
if and only if
p1u1+p2u2++pnun >= q1u1+q2u2++qnun
where the uis are known as von NeumannMorgenstern (vNM) utilities and can be interpreted
as the cardinal utility received from good i.

29
Things:
Lottery:
0.25
0.35
vNM
10
2
Utility:
Expected Utility of the Lottery =
0.40

30
Things:
Lottery:
0.25
0.35
vNM
10
2
Utility:
(10)(.25) +
0.40

31
Things:
Lottery:
0.25
0.35
vNM
10
2
Utility:
(10)(.25) +
(2)(.35) +
0.40

32
Things:
Lottery:
0.25
0.35
vNM
10
2
Utility:
(10)(.25) +
(2)(.35) +
0.40
(5)(.40)

33
Things:
Lottery:
0.25
0.35
vNM
10
2
Utility:
(10)(.25) +
(2)(.35) +
0.40
(5)(.40)
= 5.2

34
Things:
Lottery:
0.70
0.30
vNM
8
50
Utility:
(8)(.70) +
(50)(.30)
= 20.6

35
Group-Clicker Question (P): An individual is considering two

lotteries over ($100, 0, $50). Lottery 1 is (0.5, 0.5, 0). Lottery
2 is (0.1, 0.1, 0.8). vNM utilities are:
u($100)=10
u(0)=1
u($50)=5
Which lottery does the individual prefer assuming the Expected
Utility Theorem holds (which we will always assume unless told
otherwise)?
1.
2.
3.
Lottery 1
Lottery 2
The individual is
indifferent between
Lottery 1 and Lottery 2

37
Existing Theory
Lottery Definition
Expected Value
Preference Over
Lotteries
Independence Axiom
Expected Utility
Theorem
Cardinality

38

independence
axiom, then
(p1, p2,pn)
(q1, q2,qn)
if and only if

39
Things:
vNM
Utility:
10
Lottery over (Hug, (.10, .

90)
$0):
Expected Utility
=1
vNM
Utility:
Lottery over
(Sandwich, $0):
(1,0)
Expected Utility
=1

40
Working with the

Expected Utility
Theorem
Financial
Uncertainty
Decision-Making
Under Uncertainty

41

independence
axiom, then
(p1, p2,pn)
(q1, q2,qn)
if and only if

42

1. Given probabilities and vNM utilities, which
lottery is preferred?
2. Given probabilities and a given lottery
preference, how high/low must vNM utilities
be to be consistent with that preference?
3. Given vNM utilities and a given lottery
preference, how high/low must probabilities

43
Unless explicitly
contradicted, always
assume the
assumptions for the
Expected Utility
Theorem are
fulfilled.

44

Group-Clicker Question (P): An individual is considering purchasing car

insurance. If he purchases insurance, with a 100% probability he will lose
$100 per month (and any accidents will not cost him extra). If he does
not purchase insurance, with a 1% probability he will get in an accident
and lose $2000 in any given month. With a 99% probability he will not
get in an accident and he will not lose anything. Assume his vNM utilities
are as follows:
u(-$100)=-5
u(-$2000)=-1000
u(0)=0
Assuming it is not required by law, should he purchase insurance?
1.
2.
Yes indeed
No

46
Things:
$-100
$-2000
$0
Lottery:
vNM
-5
-1000
0
Utility:
Expected Utility of the Insurance Lottery =
(1)(-5)+(0)(-1000)+(0)(0)=-5

47
Things:
$-100
$-2000
$0
Lottery:
.01
.99
vNM
-5
-1000
0
Utility:
Expected Utility of the Non-Insurance Lottery =
(0)(-5)+(.01)(-1000)+(.99)(0)=-10

48

49

(1)(-5)+(0)(-1000)+(0)(0)=-5

(0)(-5)+(.01)(-1000)+(.99)(0)=-10

50

Group-Clicker Question (P): An individual is considering purchasing car insurance. If he

purchases insurance, with a 100% probability he will lose $100 per month (and any
accidents will not cost him extra). If he does not purchase insurance, with 10%
probability he will get in an accident in any given month. Otherwise, he will not get in an
accident and he will not lose anything. Assume his vNM utilities are as follows:
u(-$100)=-5
u(0)=0
How low must his utility be from getting in an accident to make him want to purchase
insurance?
1.
2.
3.
4.
-5
-50
-500
-1000

52
Things:
$-100
$0
Lottery:
vNM
-5
u
0
Utility:
(1)(-5)+(0)(u)+(0)(0)=-5

53
Things:
$-100
$0
Lottery:
.10
.90
vNM
-5
u
0
Utility:
(0)(-5)+(.10)(u)+(.90)(0)=.10u

54
The Expected Utility

Theorem tells us the
insurance lottery will be
preferred to the noninsurance lottery if and
only if its expected
utility exceeds the noninsurance expected
utility.

55
Expected Utility of the

Insurance Lottery

Non-Insurance Lottery
(1)(-5)+(0)(u)+(0)(0)=-5 > (0)(-5)+(.10)(u)+(.90)

(0)=.10u
-5>.10u
-50>u
u<-50

56

Group-Clicker Question (P): An individual is considering purchasing car insurance. If he

purchases insurance, with a 100% probability he will lose $100 per month (and any accidents
will not cost him extra). If he does not purchase insurance, with some probability he will get in
an accident and lose $2000 in any given month. Otherwise, he will not get in an accident and
he will not lose anything. Assume his vNM utilities are as follows:
u(-$100)=-5
u(-$2000)=-1000
u(0)=0
How high must his likelihood of getting in an accident be to make him want to purchase
insurance?
1.
2.
3.
4.
.005%
0.5%
2.0%
5%

58
Things:
$-100
$-2000
$0
Lottery:
vNM
-5
-1000
0
Utility:
(1)(-5)+(0)(-1000)+(0)(0)=-5

59
Things:
$-100
$-2000
$0
Lottery:
1-x-0
vNM
-5
-1000
0
Utility:
(0)(-5)+(x)(-1000)+(1-x)(0)=-1000x

60
The Expected Utility

Theorem tells us the
insurance lottery will be
preferred to the noninsurance lottery if and
only if its expected
utility exceeds the noninsurance expected
utility.

61

Insurance Lottery

Non-Insurance Lottery
(1)(-5)+(0)(-1000)+(0)(0)=-5
> (0)(-5)+(x)(-1000)+(1-x)(0)=-1000
-5>-1000x
.005<x
x>.5%
In other words, if the individual believes he will
get in an accident more than 0.5% of the time,
he should purchase insurance.

62
Working with the

Expected Utility
Theorem
Financial
Uncertainty
Decision-Making
Under Uncertainty

63
Things:
vNM
Utility:
vNM
Utility:
14

64
Things:
vNM
Utility:
$1
$10
vNM
Utility:
14

65
vNM Utility Function

A function that gives the vNM utility for every
amount of a specific (oftentimes cash) prize.

66
Example vNM Utility

Function:
u(x)=2x1/
2
Group-Clicker Question (P): An individual is considering purchasing

car insurance. He currently has $100. If he purchases insurance, with
a 100% probability he will lose $36 (and any accidents will not cost
him extra). If he does not purchase insurance, with a 10% probability
he will get in an accident and lose $64. With a 90% probability he
will not get in an accident and he will not lose anything. His vNM
utility function over final wealth is u(x)=x 1/2
Assuming it is not required by law, should he purchase insurance?
1.
2.
Yes indeed
No

68
u(x)=x1/2
Things:
$36
$100
Lottery:
.10
.90
vNM
(36)1/2=6
(100)1/2=1
Utility:
0
EU pu
1 (x1) p2u(x2 )
EU 0.1(36)1/ 2 0.9(100)1/ 2 9.6

69
u(x)=x1/2
Things:
$64
Lottery:
1.0
vNM
(64)1/2=8
Utility:
EU pu
1 (x1) p2u(x2 )
EU 1.0(64)1/ 2 8

70
EU 1.0(64)1/ 2 8
EU 0.1(36)1/ 2 0.9(100)1/ 2 9.6

71
Working with the

Expected Utility
Theorem
Financial
Uncertainty
Decision-Making
Under Uncertainty

health insurance. She currently has $10000. If she purchases full
insurance, with a 100% probability she will lose $100 (but any
medical bills will be paid for). If she does not purchase insurance,
with a 20% probability she will get sick and face medical bills of
$2000. With an 80% probability she will not get sick. Her vNM utility
function over final wealth is u(x)=ln(x)
What is her expected utility if she does NOT purchase insurance?
1.EU
2.EU
3.EU
4.EU
0.2(10000) 0.8(8000)
0.2ln(10000) 0.8ln(8000)
0.8ln(10000) 0.2ln(8000)
0.2ln(10000) 0.8ln(9000)

health insurance. She currently has $10000. If she purchases $H of
partial insurance, then if she gets sick shell lose $2000 due to
medical bills, but will get paid back $H<$2000 from her insurance
company. $H of insurance costs her 0.2*H whether she is sick or
healthy (i.e. her insurance premium is 0.2*H). Assume she gets sick
with a 20% probability. Her vNM utility function over final wealth is
u(x)=ln(x)
What is her expected utility if she purchases $H of insurance?
1.EU 0.2ln(10000 2000 H ) 0.8ln(10000)

2.EU 0.2ln(10000 2000 H 0.2H ) 0.8ln(10000)
3.EU 0.2ln(10000 2000 H 0.2H ) 0.8ln(10000 0.2H )
4.EU 0.2ln(10000 2000 H ) 0.8ln(10000 0.2H )

74
u(x)=ln(x)
Sick:
Things:
Lottery:
10000-2000 +H
Healthy:
0.2H
.20
10000 0.2H
.80
vNM
ln(10000-2000+Hln(10000-0.2H)
Utility:
0.2H)
EU pu
1 (x1) p2u(x2 )
EU 0.2ln(10000 2000 H 0.2H ) 0.8ln(10000 0.2H )

health insurance. She currently has $10000. If she purchases $H of
partial insurance, then if she gets sick shell lose $2000 due to medical
bills, but will get paid back $H<$2000 from her insurance company. $H
of insurance costs her 0.2*H whether she is sick or healthy (i.e. her
insurance premium is 0.2*H). Assume she gets sick with a 20%
probability. Her vNM utility function over final wealth is u(x)=ln(x)
We determined her Expected Utility 0.2ln(10000
equals 2000 H 0.2H ) 0.8ln(10000 0.2H )
If we wanted to figure out how much health insurance she will purchase,
what should we do?
1.
2.
3.
4.
Maximize her expected utility with

respect to H.
Maximize her expected utility subject to
a budget constraint.
Maximize her utility if shes sick. Then
maximize her utility if shes healthy.
Compare the results.
None of the above.

76
EU 0.2ln(10000 2000 H 0.2H ) 0.8ln(10000 0.2H )
And then you take first

order conditions and
solve

77
Steps to Determine the Optimal Decision Under

Uncertainty
1. Determine the possible states of the world.
2. Under each state, determine the wealth the
individual would have.
3. Set up the individuals Expected Utility
EU pu
1 (x1) p2u(x2 ) pnu(xn )
function:
where pi is the probability of the ith state of
the world, xi is the wealth in the ith state of
the world, and u(x) is the individuals vNM
utility function.
4. Take the first order condition(s) of the
expected utility function with respect to the
variable(s) the individual can choose.

78

Uncertainty
EU pu
1 (x1) p2u(x2 ) pnu(xn )
function:
utility function.

79

Uncertainty
EU pu
1 (x1) p2u(x2 ) pnu(xn )
function:
utility function.

80

Uncertainty
EU pu
1 (x1) p2u(x2 ) pnu(xn )
function:
utility function.

81

Uncertainty
EU pu
1 (x1) p2u(x2 ) pnu(xn )
function:
utility function.

82

Uncertainty
EU pu
1 (x1) p2u(x2 ) pnu(xn )
function:
utility function.

Risk-Taking and Expected Utility Theory

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If life is free of failures you are not taking enough risks.

Jackson Brown, Jr.

Group-Clicker Question (1 pt): What is the

Preferences Over Risk

Class 16 - Uncertainty Fundamentals

HW3 Due Thursday, Feb. 14

Applications due 3/8

Class 16 - Uncertainty Fundamentals

Class 16 - Uncertainty Fundamentals

Class 16 - Uncertainty Fundamentals

Class 16 - Uncertainty Fundamentals

Class 16 - Uncertainty Fundamentals

transitive if, for every

Class 16 - Uncertainty Fundamentals

Class 16 - Uncertainty Fundamentals

Class 16 - Uncertainty Fundamentals

(ap +(1-a)t , ap +(1-a)t

Class 16 - Uncertainty Fundamentals

Class 16 - Uncertainty Fundamentals

with (t1, t2,tn)

Class 16 - Uncertainty Fundamentals

Class 16 - Uncertainty Fundamentals

Class 16 - Uncertainty Fundamentals

Class 16 - Uncertainty Fundamentals

(0, .11, .89)

Class 16 - Uncertainty Fundamentals

($5 million, $1 million, $0)

Class 16 - Uncertainty Fundamentals

($5 million, $1 million, $0)

Class 16 - Uncertainty Fundamentals

Group-Clicker Question (P): You are offered a lottery over

Class 16 - Uncertainty Fundamentals

Class 16 - Uncertainty Fundamentals

Why Economists Assume

The night of the fight, you might

Class 16 - Uncertainty Fundamentals

Why Economists Assume

Class 16 - Uncertainty Fundamentals

Why Economists Assume

Class 16 - Uncertainty Fundamentals

Why Economists Assume

Class 16 - Uncertainty Fundamentals

Expected Utility Theorem

Class 16 - Uncertainty Fundamentals

Class 16 - Uncertainty Fundamentals

Class 16 - Uncertainty Fundamentals

Class 16 - Uncertainty Fundamentals

Class 16 - Uncertainty Fundamentals

Class 16 - Uncertainty Fundamentals

Class 16 - Uncertainty Fundamentals

Group-Clicker Question (P): An individual is considering two

Class 16 - Uncertainty Fundamentals

Class 16 - Uncertainty Fundamentals

Expected Utility Theorem

Class 16 - Uncertainty Fundamentals

Lottery over (Hug, (.10, .

Class 16 - Uncertainty Fundamentals

Working with the

Class 16 - Uncertainty Fundamentals

Expected Utility Theorem

Class 16 - Uncertainty Fundamentals

Expected Utility Theorem