Decision & Game Theory

Chapter 5: Utility Functions

Sonia REBAI
Tunis Business School
University of Tunis
Introduction
²The expected value criterion offers an advantage of simplicity by
summarizing all the available information on a one score.

²However, this advantage represents as well his main weakness. In fact, by

summarizing the information, the criterion loses much of it, which can
make its application dangerous.

²The paradox of St. Petersbug, analyzed in the 18th century by Niclas

Bernoulli, displays this phenomenon.
² Consider the following game: Toss repeatedly a fair coin and obtain a profit
2n if head appears on the nth trial. As soon as head appears, the game is
completed. How much are you willing to pay for this game?
² Based on expected value criterion, to access the game we need to pay an
amount equal to the expectation of winning. The expected payoff of the
game is k
k =¥
kæ 1 ö
VE = å 2 ç ÷ = 1+1+! = ¥
k =1 è2ø

² Even if the expected payoff is infinite, still many people would not pay more
than few amount of money.
 0

Not 1/2 2
TH 1/22 22
.
.
∞ .
T……TH 1/2n
play 2n
.
.
.
1/2∞
2∞
² The EV criterion is not adequate to approach such situations.

² In addition, several real situations require the consideration of intangible

factors that are difficult to express by a simple measure of the EV.

² Suppose you have a choice between the following two options:

§ Toss a coin and win 1000 TD if head and zero if tail

§ or accept the sum of 600 TD.

 1
0.75

0.5

0.25

0
X* X0.75 X0.5 X0
X0.25 0.5
X0.5
X0.25 ⋍
0.5 X0

U(X0.75)= 0.5U(X*)+0.5U(X0.5) =0.5 +0.5*0.5

² We are interested in a measure that takes into consideration any
qualitative or quantitative objective .
² We need to use a new measure taking into account the risk factor and
reflecting the preferences of the DM (his attitude towards risk).
² How can we model a DM’s preferences?
² We introduce in the following an approach called utility theory that
allows us to incorporate the riskiness of an alternative when deciding on
the best course of action.
² The theory of utility allows individuals to have different attitudes towards
money and against hazards.
² Also, it takes into consideration the fact that the utility of any additional
monetary unit decreases with the increase of capital.

² The utility function is an ordinal concept (as opposed to a cardinal

concept).

² It permits to assign a value to each choice according to the preferences

of the decision maker.

² Such a measure must satisfy a number of axioms of rationality

Von Neumann-Morgestern axioms
Notations & Terminology

²A lottery L is any uncertain event having random outcomes.

²Consider two lotteries L and L’, then

§ L is more preferred than L’ is denoted by: L ! L’

§ L is less preferred to L’ is denoted by L ≺ L’

§ L is equally preferred to L’ is denoted by L » L’

Von Neumann and Morgenstern (1944) were the first to establish
the axiomatic theory of the rule of expected utility.

Total Ordering Axiom

Consider two lotteries L and L’, then exactly one of the following
types of preferences must hold:

L ! L’, L’ !"L, or L » L’

Transitivity Axiom

For all lotteries L, L’, L”, If L≻L' and L'≻L'' Then L≻L''
Independence Axiom

For all lotteries L, L’, and L’’, for all p Î [0,1], we have that

L ≻ L' ⇔ pL +(1− p)L'' ≻ pL' +(1− p)L''

Continuity Axiom
For all lotteries L, L’, and L’’
If L ≻ L' ≻ L'' ⇒ there is p ∈ [0,1] such that
L' = pL + (1− p)L''
An agent accepting all four axioms above is called Von Neumann-
Morgestern rational or just VNM-rational.
Von Neumann-Morgenstern Theorem

There exists a utility function U so that for any lotteries L and L’ such that
L ≻ L' if and only if U(L) ≥ U(L') (1)

How to develop a utility function?

²Set the utility of the best outcome (denoted by x*) to be 1 and that of

the worst (denoted by x0) to be 0.

U(x*) =1 and U(x0) =0

²Let x be an intermediate outcome and let p a probability in [0,1]. Then,
ask the DM whether he prefers x with certainty or the lottery, L, leading
to x* with probability p and x0 with probability 1-p.
²By trial & error find p so that the DM becomes indifferent between both
lotteries.
²Set U(x) = p. x is called the certainty equivalent of the lottery L, denoted
by CE(L).
²Take other intermediate values of x and find their corresponding p.
²Fit the curve (x, u(x)).
²It is important to note that x is not necessarily a monetary value. It can
even be a qualitative attribute.

An alternative approach: Keeney & Raiffa 5-points procedure.

²It is often difficult for DM to manipulate probabilities. However, they feel

more comfortable playing with 50-50 lotteries.

²With this approach, we proceed as follows:

§ U(x*) = 1 and U(x0) = 0.

§ Then, the DM is asked to determine CE(L), where L(x*, 0.5; x0, 0.5),
denoted x0.5. It is obvious that U(x0.5)= 0.5.

§ Next, find the CE of the lottery L(x*, 0.5; x0.5 , 0.5) denoted x0.75, with
U(x0.75) = 0.75.

§ Next, find the CE of the lottery (x0.5, 0.5; x0, 0.5) denoted x0.25, with
U(x0.25) = 0.25.

§ Fit the curve passing through (x*,1); (x0.75,0.75); (x0.5,0.5); (x0.25,0.25); and
(x0,0).
DM attitudes toward risk

²A DM is averse to risk if for any lottery L, the certainty equivalent of L is

worst than the expected value of the lottery L. In profit case, we have

E(L) > CE(L)

§ The difference RP(L) = E(L)-CE(L) > 0 is called the risk premium of L.

§ RP(L) is the amount of money the DM is willing to pay to avoid risk.

²A DM is risk-neutral if for any lottery L, the certainty equivalent

of L is equal to the expected value of L

E(L) = CE(L)

§ Therefore, the risk premium is zero

RP(L) = E(L)-CE(L) = 0
²A DM is prone to risk, risk seeker, or risk taker if for any lottery L,

the certainty equivalent of L is better than the expected value of

the lottery L. In profit case we have E(L) < CE(L)

§ The risk premium of L, RP(L)=E(L)-CE(L) < 0

§ RP(L) is the amount of money the DM is willing to receive in

addition to the expected value of the lottery to give up risk.

Profit case
Convexity/Concavity and Attitude toward risk

²A function f(x) is said to be convex if

" x, y; "α Î [0, 1]; f(αx+(1-α)y) ≤ αf(x)+(1-α)f(y)

²If f is differentiable, then f is convex if its derivative is an increasing

function

²If f is twice differentiable, then it is convex if its second derivative is

non-negative: f”(x)≥0.
Convex Function
²A function f(x) is said to be concave if –f is convex.

"x, y,"αÎ [0,1], f(αx+(1-α)y) ≥ αf(x)+(1-α)f(y)

²If f is differentiable, then f is concave if its derivative is a decreasing

function

²If f is twice differentiable, then it is concave if its second derivative is

non-positive: f”(x)≤0.
Concave Function
 Interpretation

²Let the lottery L have values x with probability p and y with probability 1-p.

²If the DM is neutral to risk, he would accept the expected value criterion.

²Therefore, he will be indifferent between the average z with certainty and

the risky lottery L. (z = E(L) = (px+(1-p)y))

²That is, u(z)=u(px+(1-p)y) = u(E(L)) = E(u(L)).

Cost case
That is,
u(E(L))=u(px+(1-p)y) = E(u(L))
U(x)

U(z)= U(E(L))
= pU(x)+(1-p)U(y)

U(y)

x z y
 ²If the DM is risk-averse, then the
certain situation, z, is preferred to
U(x)
the lottery L
U(z)
U(L)=
pU(x)+(1-p)U(y) ²z=px+(1- p)y
U(y)
²U(z)=U(E(L))≥E(U(L)).
x Z y

²The utility function is concave

 ²If the DM is risk-seeker, the
U(x)
lottery L is preferred to the
U(L)=
pU(x)+(1-p)U(y)
certain situation z (px+(1-p)y)
U(z)
²U(z) = U(E(L))≤E(U(L))
U(y)
²The utility function is convex
x z y
Theorem

² A DM is risk-averse if and only if his utility function is concave.

² A DM is risk-neutral if and only if his utility function is linear.

² A DM is risk-seeker if and only if his utility function is a convex

function
 U(M) U(M) U(M)

M M M
Risk Averse Risk prone Risk Neutral

²The higher the curvature the more averse or seeker the DM.
²The same DM may have different risk attitudes based on the
problem situation or the values considered.
 Example
An individual owns a house with a value of 150,000 TND. The risk to lose his

house from fire or other catastrophic event is 0.1% each year. His utility

function for the house is of the form:

U (x) = ax + b

How much he is willing to pay for an insurance company to preserve the value

of his asset? What is the corresponding risk premium?

 Solution
Let u be the utility function of the loss of the asset of the DM, where u(0)
=1 and u(150,000)=0. Then, b=1 and a=-1/150,000. That is,

1
u(x)= − x +1
150,000

Consider now the lottery L: [(0; 0.999), (150,000; 0.001)]. Then, E(u(L))=
0.999.
Let us find x, such that U(x) = 0.999; or the certainty equivalent of L, CE(L).

Then solving
1
0.999 = − x +1
150,000

yields x = 299.850 = 300 TND

The risk premium RP(L) = 300 -150,000*0.001 = 150 TD

That is the DM is willing to pay 150 TD to avoid losing his asset.