Decision Making under Uncertainty

Uni-dimensional Utility Theory

Attitudes to Risk
A Procedure for Assessing Utility Functions

Lecture 06
Single Attribute Utility Theory

Jitesh H. Panchal

ME 597: Decision Making for Engineering Systems Design

Design Engineering Lab @ Purdue (DELP)

School of Mechanical Engineering
Purdue University, West Lafayette, IN
http://engineering.purdue.edu/delp

September 17, 2014

Jitesh
c H. Panchal Lecture 06 1 / 38
 Decision Making under Uncertainty
Uni-dimensional Utility Theory
Attitudes to Risk
A Procedure for Assessing Utility Functions

Lecture Outline

1 Decision Making under Uncertainty

Alternate Approaches to Risky Choice Problem
Motivation for Using Utility Theory

2 Uni-dimensional Utility Theory

Fundamentals of Utility Theory
Qualitative Characteristics of Utility

3 Attitudes to Risk
Risk Averse and Risk Prone
Measuring Risk Aversion

4 A Procedure for Assessing Utility Functions

Keeney, R. L. and H. Raiffa (1993). Decisions with Multiple Objectives: Preferences and Value Tradeoffs. Cambridge, UK, Cambridge
University Press. Chapter 4.

Jitesh
c H. Panchal Lecture 06 2 / 38
 Decision Making under Uncertainty
Uni-dimensional Utility Theory Alternate Approaches to Risky Choice Problem
Attitudes to Risk Motivation for Using Utility Theory
A Procedure for Assessing Utility Functions

The Structure of a Design Decision

p11 O11 U(O11)

A1 O12 U(O12)
p1k
O1k U(O1k)

p21 O21 U(O21)

Decision A2 O22 U(O22) Select Ai

p1k
O2k U(O2k)

pn1 On1 U(On1)

An On2 U(On2)
pnk
Onk U(Onk)

Alternatives Outcomes Preferences Choice

Slide courtesy: Chris Paredis

Jitesh
c H. Panchal Lecture 06 3 / 38
 Decision Making under Uncertainty
Uni-dimensional Utility Theory Alternate Approaches to Risky Choice Problem
Attitudes to Risk Motivation for Using Utility Theory
A Procedure for Assessing Utility Functions

Focus of this Lecture

Problem Statement
Choose among alternatives A1 , A2 , . . . , Am , each of which will eventually
result in a consequence described by one attribute X .

Decision maker does not know exactly what consequence will result from
each alternative.

But he/she can assign probabilities to the various consequences that might
result from any alternative.

Jitesh
c H. Panchal Lecture 06 4 / 38
 Decision Making under Uncertainty
Uni-dimensional Utility Theory Alternate Approaches to Risky Choice Problem
Attitudes to Risk Motivation for Using Utility Theory
A Procedure for Assessing Utility Functions

Alternate Approaches to Risky Choice Problem:

a) Probabilistic dominance

Probability Probability
density fB of x or less
FA
fA
FB

0 0

Figure: 4.2 on page 135 (Keeney and Raiffa)

Jitesh
c H. Panchal Lecture 06 5 / 38
 Decision Making under Uncertainty
Uni-dimensional Utility Theory Alternate Approaches to Risky Choice Problem
Attitudes to Risk Motivation for Using Utility Theory
A Procedure for Assessing Utility Functions

Alternate Approaches to Risky Choice Problem:

b) Expected value of uncertain outcome

Consider the following acts

Act A: Earn $100,000 for sure
Act B: Earn $200,000 or $0, each with probability 0.5
Act C: Earn $1,000,000 with probability 0.1 or $0 with probability 0.9
Act D: Earn $200,000 with probability 0.9 or lose $800,000 with
probability 0.1
The expected amount earned is exactly $100,000. But not all acts are equally
desirable.

Jitesh
c H. Panchal Lecture 06 6 / 38
 Decision Making under Uncertainty
Uni-dimensional Utility Theory Alternate Approaches to Risky Choice Problem
Attitudes to Risk Motivation for Using Utility Theory
A Procedure for Assessing Utility Functions

Alternate Approaches to Risky Choice Problem:

c) Consideration of mean and variance

One possibility is to consider variance, in addition to the expected value of

the outcome.

But, Acts C and D have the same mean and variance:

Act C: Earn $1,000,000 with probability 0.1 or $0 with probability 0.9
Act D: Earn $200,000 with probability 0.9 or lose $800,000 with
probability 0.1

Are these acts equally preferred?

Therefore, any measure that considers mean and variance only cannot
distinguish between these two acts.

Considering mean and variance imposes additional problem of finding

relative preference between them.

Jitesh
c H. Panchal Lecture 06 7 / 38
 Decision Making under Uncertainty
Uni-dimensional Utility Theory Alternate Approaches to Risky Choice Problem
Attitudes to Risk Motivation for Using Utility Theory
A Procedure for Assessing Utility Functions

Primary Motivation for using Utility Theory

IF an appropriate utility is assigned to each possible consequence,

AND the expected utility of each alternative is calculated,

THEN the best course of action is the alternative with the highest expected
utility.

Jitesh
c H. Panchal Lecture 06 8 / 38
 Decision Making under Uncertainty
Uni-dimensional Utility Theory Fundamentals of Utility Theory
Attitudes to Risk Qualitative Characteristics of Utility
A Procedure for Assessing Utility Functions

Fundamentals of Utility Theory

Assume n consequences labeled x1 , x2 , . . . , xn such that xi is less preferred

than xi+1
x1 ≺ x2 ≺ x3 ≺ · · · ≺ xn
The decision maker is asked to state preferences about two acts a0 and a00 ,
where
1 Act a0 will result in consequence xi with probability pi0 for i = 1..n
2 Act a00 will result in consequence xi with probability pi00 for i = 1..n

Jitesh
c H. Panchal Lecture 06 9 / 38
 Decision Making under Uncertainty
Uni-dimensional Utility Theory Fundamentals of Utility Theory
Attitudes to Risk Qualitative Characteristics of Utility
A Procedure for Assessing Utility Functions

Fundamentals of Utility Theory (contd.)

Assume that for each i, the decision maker is indifferent between the
following options:

Certainty Option: Receive xi

Risky Option: Receive xn with probability πi and x1 with probability (1 − πi ).

This option is denoted as hxn , πi , x1 i

Clearly,

π1 = 0
πn = 1
π1 < π 2 < π 3 < · · · < π n

Jitesh
c H. Panchal Lecture 06 10 / 38
 Decision Making under Uncertainty
Uni-dimensional Utility Theory Fundamentals of Utility Theory
Attitudes to Risk Qualitative Characteristics of Utility
A Procedure for Assessing Utility Functions

Fundamentals of Utility Theory (contd.)

πi ’s can be thought of as numerical scaling of x’s.

π1 < π 2 < π 3 < · · · < π n

and
x1 ≺ x2 ≺ x3 ≺ · · · ≺ xn

Fundamental Result of Utility Theory

The expected value of the π’s can be used to numerically scale probability
distributions over the x’s.

The expected π scores for acts a0 and a00 are as follows:

π̄ 0 =
P 0
π̄ 00 =
P 00
pi πi and pi πi
i i

Act a ≡ giving the decision maker a π̄ chance at xn and 1 − π̄ 0 chance at x1

0 0

Act a00 ≡ giving the decision maker a π̄ 00 chance at xn and 1 − π̄ 00 chance at x1

Now, we can rank order acts a0 , a00 in terms of π̄ 0 , π̄ 00

Jitesh
c H. Panchal Lecture 06 11 / 38
 Decision Making under Uncertainty
Uni-dimensional Utility Theory Fundamentals of Utility Theory
Attitudes to Risk Qualitative Characteristics of Utility
A Procedure for Assessing Utility Functions

Fundamentals of Utility Theory (contd.)

Transforming π’s into u’s using a positive linear transformation

ui = a + bπi , b > 0, i = 1, . . . , n

Then,
u1 < u2 < · · · < un
The expected u values rank order a0 and a00 in the same way as the expected
π values X 0 X 0
ū 0 = pi ui = pi (a + bπi ) = a + bπ̄ 0
i i

Essence of the problem

How can appropriate π values be assessed in a responsible manner?

Jitesh
c H. Panchal Lecture 06 12 / 38
 Decision Making under Uncertainty
Uni-dimensional Utility Theory Fundamentals of Utility Theory
Attitudes to Risk Qualitative Characteristics of Utility
A Procedure for Assessing Utility Functions

Direct Assessment of Utilities

Define:
x o as a least preferred consequence, and
x ∗ as a most preferred consequence. Assign

u(x ∗ ) = 1 and u(x o ) = 0

For each other consequence x, assign a probability π such that x is indifferent

to the lottery hx ∗ , π, x o i. Note that the expected utility of the lottery is:

u(x) = πu(x ∗ ) + (1 − π)u(x o ) = π

Continue for all x’s (or fit a curve).

Jitesh
c H. Panchal Lecture 06 13 / 38
 Decision Making under Uncertainty
Uni-dimensional Utility Theory Fundamentals of Utility Theory
Attitudes to Risk Qualitative Characteristics of Utility
A Procedure for Assessing Utility Functions

Qualitative Characteristics of Utility

1 Monotonicity
2 Certainty equivalence
3 Strategic equivalence

Jitesh
c H. Panchal Lecture 06 14 / 38
 Decision Making under Uncertainty
Uni-dimensional Utility Theory Fundamentals of Utility Theory
Attitudes to Risk Qualitative Characteristics of Utility
A Procedure for Assessing Utility Functions

Qualitative Characteristics of Utility: Monotonicity

Definition (Monotonicity)
For a monotonically increasing utility function

[x1 > x2 ] ⇔ [u(x1 ) > u(x2 )]

For a monotonically decreasing utility function

[x1 > x2 ] ⇔ [u(x1 ) < u(x2 )]

Jitesh
c H. Panchal Lecture 06 15 / 38
 Decision Making under Uncertainty
Uni-dimensional Utility Theory Fundamentals of Utility Theory
Attitudes to Risk Qualitative Characteristics of Utility
A Procedure for Assessing Utility Functions

Qualitative Characteristics of Utility: Certainty Equivalence

Assume lottery L yields consequences x1 , x2 , . . . , xn with probabilities

p1 , p2 , . . . , pn .

Define:
x̃: Uncertain consequence of lottery (i.e., random variable)
x̄: Expected consequence
n
X
x̄ ≡ E(x̃) = pi xi
i=1

Definition (Certainty equivalence)

A certainty equivalent of lottery L is the amount x̂ such that the decision
maker is indifferent between L and the amount x̂ for certain.

u(x̂) = E[u(x̃)], or x̂ = u −1 Eu(x̃)

Jitesh
c H. Panchal Lecture 06 16 / 38
 Decision Making under Uncertainty
Uni-dimensional Utility Theory Fundamentals of Utility Theory
Attitudes to Risk Qualitative Characteristics of Utility
A Procedure for Assessing Utility Functions

Qualitative Characteristics of Utility: Certainty Equivalence (continuous

variables)

If x is a continuous variable, the associated uncertainty is described using a

probability density function, f (x). Then,
Z
x̄ ≡ E(x̃) = xf (x)dx

The certainty equivalent x̂ is a solution to

Z
u(x̂) = E[u(x̃)] = u(x)f (x)dx

Jitesh
c H. Panchal Lecture 06 17 / 38
 Decision Making under Uncertainty
Uni-dimensional Utility Theory Fundamentals of Utility Theory
Attitudes to Risk Qualitative Characteristics of Utility
A Procedure for Assessing Utility Functions

Qualitative Characteristics of Utility: Strategic Equivalence

Definition (Strategic equivalence)

Two utility functions, u1 and u2 , are strategically equivalent (u1 ∼ u2 ) if and
only if they imply the same preference ranking for any two lotteries.

If two utility functions are strategically equivalent, the certainty equivalents of

two lotteries must be the same. Therefore,

u1 ∼ u2 ⇒ u1−1 Eu1 (x̃) = u2−1 Eu2 (x̃), ∀x̃

Jitesh
c H. Panchal Lecture 06 18 / 38
 Decision Making under Uncertainty
Uni-dimensional Utility Theory Fundamentals of Utility Theory
Attitudes to Risk Qualitative Characteristics of Utility
A Procedure for Assessing Utility Functions

Qualitative Characteristics of Utility: Strategic Equivalence (contd.)

For some constants h and k > 0, if

u1 (x) = h + ku2 (x), ∀x

then u1 ∼ u2

Theorem
If u1 ∼ u2 , there exists two constants h and k > 0 such that

u1 (x) = h + ku2 (x), ∀x

Example: u(x) = a + bx ∼ x, b > 0

We can show that if the utility function is linear, the certainty equivalent for
any lottery is equal to the expected consequence of that lottery.

Jitesh
c H. Panchal Lecture 06 19 / 38
 Decision Making under Uncertainty
Uni-dimensional Utility Theory Risk Averse and Risk Prone
Attitudes to Risk Measuring Risk Aversion
A Procedure for Assessing Utility Functions

Definition of Risk Aversion

0 00
Consider a lottery hx 0 , 0.5, x 00 i whose expected consequence is x̄ = x +x
2
.
Assume that the decision maker is asked to choose between x̄ for certain
and the lottery hx 0 , 0.5, x 00 i.
Note: Both options have the same expected consequence

If the decision maker prefers the certain outcome x̄, then the decision maker
prefers to avoid risks ⇒ Risk Averse.

Definition (Risk Aversion)

A decision maker is risk averse if he prefers the expected consequence of
any non-degenerate lottery to that lottery.

Jitesh
c H. Panchal Lecture 06 20 / 38
 Decision Making under Uncertainty
Uni-dimensional Utility Theory Risk Averse and Risk Prone
Attitudes to Risk Measuring Risk Aversion
A Procedure for Assessing Utility Functions

Risk Aversion - An Illustration

Let the possible consequences of any lottery are represented by x̃, a

decision maker is risk averse if, for all nondegenerate lotteries, utility of
expected consequence is greater than expected utility of lottery, i.e.,

u[E(x̃)] > E[u(x̃)]

Theorem
A decision maker is risk averse if and only if his utility function is concave.

Corollary
A decision maker who prefers the expected consequence of any 50-50 lottery
hx 0 , 0.5, x 00 i to the lottery itself is risk averse.

Jitesh
c H. Panchal Lecture 06 21 / 38
 Decision Making under Uncertainty
Uni-dimensional Utility Theory Risk Averse and Risk Prone
Attitudes to Risk Measuring Risk Aversion
A Procedure for Assessing Utility Functions

Risk Prone

Definition (Risk Prone)

A decision maker is risk prone if he prefers any non-degenerate lottery to the
expected consequence of that lottery.

u[E(x̃)] < E[u(x̃)]

Jitesh
c H. Panchal Lecture 06 22 / 38
 Decision Making under Uncertainty
Uni-dimensional Utility Theory Risk Averse and Risk Prone
Attitudes to Risk Measuring Risk Aversion
A Procedure for Assessing Utility Functions

Risk Premium

Definition (Risk Premium of a lottery)

The risk premium RP of a lottery x̃ is its expected value (x̄) minus its
certainty equivalent (x̂).

RP(x̃) = x̄ − x̂ = E(x̃) − u −1 Eu(x̃)

u

u(x2)

u(x)
^
u(x)

u(x1) Risk
Premium
for
<x1, x2>

x
x1 x^ x x2

Figure: 4.5 on page 152 (Keeney and Raiffa)

Jitesh
c H. Panchal Lecture 06 23 / 38
 Decision Making under Uncertainty
Uni-dimensional Utility Theory Risk Averse and Risk Prone
Attitudes to Risk Measuring Risk Aversion
A Procedure for Assessing Utility Functions

Risk Premium and Risk Aversion

Theorem
For increasing utility functions, a decision maker is risk averse if and only if
his risk premium is positive for all nondegenerate lotteries.

The risk premium is the amount of the attribute that a (risk averse) decision
maker is willing to “give up” from the average to avoid the risks associated
with the particular lottery.

Jitesh
c H. Panchal Lecture 06 24 / 38
 Decision Making under Uncertainty
Uni-dimensional Utility Theory Risk Averse and Risk Prone
Attitudes to Risk Measuring Risk Aversion
A Procedure for Assessing Utility Functions

Measuring Risk Aversion

u u

u = -3e-x u = 1-e-x
u’ = 3e-x u’ = e-x
u’’ = -3e-x u’’ = -e-x

Risk Risk
Premium Premium

x x
x-h x x+h x-h x x+h

Certainty equivalent Certainty equivalent

Figure: 4.9 on page 159 (Keeney and Raiffa)

Jitesh
c H. Panchal Lecture 06 25 / 38
 Decision Making under Uncertainty
Uni-dimensional Utility Theory Risk Averse and Risk Prone
Attitudes to Risk Measuring Risk Aversion
A Procedure for Assessing Utility Functions

A Measure of Risk Aversion

Definition (Risk aversion)

The local risk aversion at x, written r (x), is defined by

u 00 (x)
r (x) = −
u 0 (x)

r (x) > 0 ⇒ Risk Averse

r (x) < 0 ⇒ Risk Prone

Characteristics of this measure:

1 it indicates whether the utility function is risk averse or risk prone
2 shows equivalence between two strategically equivalent utility functions

Jitesh
c H. Panchal Lecture 06 26 / 38
 Decision Making under Uncertainty
Uni-dimensional Utility Theory Risk Averse and Risk Prone
Attitudes to Risk Measuring Risk Aversion
A Procedure for Assessing Utility Functions

Local Risk Aversion - Some Results

Theorem
Two utility functions are strategically equivalent if and only if they have the
same risk-aversion function.

Theorem
If r is positive for all x, then u is concave and the decision maker is
risk-averse.

Theorem
If r1 (x) > r2 (x) for all x, then π1 (x, x̃) > π2 (x, x̃) for all x and x̃.

Jitesh
c H. Panchal Lecture 06 27 / 38
 Decision Making under Uncertainty
Uni-dimensional Utility Theory Risk Averse and Risk Prone
Attitudes to Risk Measuring Risk Aversion
A Procedure for Assessing Utility Functions

Constant, Decreasing and Increasing Risk Aversion

Let x denote a decision maker’s endowment of a given attribute X . Now, add

to x a lottery x̃ involving only a small range of X with an expected value of
zero. Let the risk premium of this lottery be π(x, x̃).

What happens to π(x, x̃) as x increases?

Example of decreasingly risk averse: As a person’s assets increase, they are

only willing to pay a smaller risk premium for a given task (as people become
richer, they can better afford to take a specific risk).

Jitesh
c H. Panchal Lecture 06 28 / 38
 Decision Making under Uncertainty
Uni-dimensional Utility Theory Risk Averse and Risk Prone
Attitudes to Risk Measuring Risk Aversion
A Procedure for Assessing Utility Functions

Constant, Decreasing and Increasing Risk Aversion

Implication
Many of the traditional candidates for a utility function (e.g., exponential and
quadratic) are not appropriate for a decreasingly risk averse decision maker.

Theorem
The risk aversion r is constant if and only if π(x, x̃) is a constant function of x
for all x̃.

Theorem

u(x) ∼ −e−cx ⇔ r (x) ≡ c > 0 (constant risk aversion)

u(x) ∼ x ⇔ r (x) ≡ 0 (risk neutrality)
−cx
u(x) ∼ e ⇔ r (x) ≡ c < 0 (constant risk proneness)

Jitesh
c H. Panchal Lecture 06 29 / 38
 Decision Making under Uncertainty
Uni-dimensional Utility Theory Risk Averse and Risk Prone
Attitudes to Risk Measuring Risk Aversion
A Procedure for Assessing Utility Functions

Non-monotonic Utility Functions

Theorem
For non monotonic preferences, a decision maker is risk averse [risk prone] if
and only if his utility function is concave [convex].

u u

x x
Risk Averse Risk Prone

Figure: 4.18 on page 188 (Keeney and Raiffa)

For non-monotonic utility functions, the certainty equivalent is not necessarily

unique. The risk premium and measure of risk aversion cannot be usefully
defined.
Jitesh
c H. Panchal Lecture 06 30 / 38
 Decision Making under Uncertainty
Uni-dimensional Utility Theory
Attitudes to Risk
A Procedure for Assessing Utility Functions

A Procedure for Assessing Utility Functions

1 Preparing for assessment.

2 Identifying the relevant quality characteristics.
3 Specifying quantitative restrictions.
4 Choosing a utility function.
5 Checking for consistency.

Jitesh
c H. Panchal Lecture 06 31 / 38
 Decision Making under Uncertainty
Uni-dimensional Utility Theory
Attitudes to Risk
A Procedure for Assessing Utility Functions

1. Preparing for Assessment

It is important to acquaint the decision maker with the framework that we use
in assessing the utility function.

Educate the decision maker (not bias him/her) and hopefully force him/her to
think about his/her preferences.

Jitesh
c H. Panchal Lecture 06 32 / 38
 Decision Making under Uncertainty
Uni-dimensional Utility Theory
Attitudes to Risk
A Procedure for Assessing Utility Functions

2. Identifying the Relevant Quality Characteristics

1 Determine monotonicity
2 Determine whether the decision maker is risk averse, risk neutral, or risk
prone
3 Determine whether the decision maker is increasingly, decreasingly, or
constantly risk averse.

Jitesh
c H. Panchal Lecture 06 33 / 38
 Decision Making under Uncertainty
Uni-dimensional Utility Theory
Attitudes to Risk
A Procedure for Assessing Utility Functions

3. Specifying Quantitative Restrictions

Fixing utilities for a few points on the utility function.

Involves determining the certainty equivalents of a few 50-50 lotteries.
A five point assessment procedure for utility functions.
u

1 1 0.75
u(x0.5 ) = u(x1 ) + u(x0 )
2 2
1 1
u(x0.75 ) = u(x1 ) + u(x0.5 ) 0.5
2 2
1 1
u(x0.25 ) = u(x0 ) + u(x0.5 ) 0.25
2 2

0 x
x0 x0.25 x0.5 x0.75 x1

Figure: 4.22 on page 195 (Keeney and Raiffa)

Jitesh
c H. Panchal Lecture 06 34 / 38
 Decision Making under Uncertainty
Uni-dimensional Utility Theory
Attitudes to Risk
A Procedure for Assessing Utility Functions

4. Choosing a Utility Function

Find a parametric family of utility functions that possesses the relevant

characteristics (such as risk aversion) previously specified for the decision
maker.

Using the quantitative assessments, try to find a specific member of that

family that is appropriate for the decision maker.

An example of monotonically increasing, decreasingly risk averse utility

function:
u(x) = h + k (−e−ax − be−cx ), a, b, c, and k ≥ 0

Jitesh
c H. Panchal Lecture 06 35 / 38
 Decision Making under Uncertainty
Uni-dimensional Utility Theory
Attitudes to Risk
A Procedure for Assessing Utility Functions

5. Checking for Consistency

Goal: to uncover discrepancy in a utility function.

Jitesh
c H. Panchal Lecture 06 36 / 38
 Decision Making under Uncertainty
Uni-dimensional Utility Theory
Attitudes to Risk
A Procedure for Assessing Utility Functions

Other Considerations for Using the Utility Function

Simplifying the expected utility calculations

Parametric/sensitivity analysis

Jitesh
c H. Panchal Lecture 06 37 / 38
 Decision Making under Uncertainty
Uni-dimensional Utility Theory
Attitudes to Risk
A Procedure for Assessing Utility Functions

References

1 Keeney, R. L. and H. Raiffa (1993). Decisions with Multiple Objectives:

Preferences and Value Tradeoffs. Cambridge, UK, Cambridge University
Press. Chapter 4.
2 Clemen, R. T. (1996). Making Hard Decisions: An Introduction to
Decision Analysis. Belmont, CA, Wadsworth Publishing Company.

Jitesh
c H. Panchal Lecture 06 38 / 38
 THANK YOU!

Jitesh
c H. Panchal Lecture 06 1/1