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In economics, game theory, and decision theory the expected utility hypothesis is a theory of utility in which "betting preferences" of people with regard to uncertain outcomes (gambles) are represented by a function of the payouts (whether in money or other goods), the probabilities of occurrence, risk aversion, and the different utility of the same payout to people with different assets or personal preferences. This theory has proved useful to explain some popular choices that seem to contradict the expected value criterion (which takes into account only the sizes of the payouts and the probabilities of occurrence), such as occur in the contexts of gambling and insurance. Daniel Bernoulli initiated this theory in 1738. The von NeumannMorgenstern utility theorem provides necessary and sufficient "rationality" axioms under which the expected utility hypothesis holds.[1]
Contents
1 Expected value and choice under risk 2 Bernoulli's formulation 3 Infinite expected value St. Petersburg paradox 4 von NeumannMorgenstern formulation 4.1 The von Neumann-Morgenstern axioms 4.2 Risk aversion 4.3 Examples of von Neumann-Morgenstern utility functions 4.4 Measuring risk in the expected utility context 5 Behavioral decision science: Deviations from expected utility theory 5.1 Conservatism in updating beliefs 5.2 Irrational deviations 5.3 Preference reversals over uncertain outcomes 5.4 Uncertain probabilities 6 See also 7 References 8 Further reading
Bernoulli's formulation
Nicolas Bernoulli described the St. Petersburg paradox (involving infinite expected values) in 1713, prompting two Swiss mathematicians to develop expected utility theory as a solution. The theory can also more accurately describe more realistic scenarios (where expected values are finite) than
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expected value alone. In 1728, Gabriel Cramer, in a letter to Nicolas Bernoulli, wrote, "the mathematicians estimate money in proportion to its quantity, and men of good sense in proportion to the usage that they may make of it."[2] In 1738, Nicolas' cousin Daniel Bernoulli, published the canonical 18th Century description of this solution in Specimen theoriae novae de mensura sortis or Exposition of a New Theory on the Measurement of Risk.[3] Daniel Bernoulli proposed that a mathematical function should be used to correct the expected value depending on probability. This provides a way to account for risk aversion, where the risk premium is higher for low-probability events than the difference between the payout level of a particular outcome and its expected value. Bernoulli's paper was the first formalization of marginal utility, which has broad application in economics in addition to expected utility theory. He used this concept to formalize the idea that the same amount of additional money was less useful to an already-wealthy person than it would be to a poor person.
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Transitivity assumes that, as an individual decides according to the completeness axiom, the individual also decides consistently. Axiom (Transitivity): For every A, B and C with and we must have .
Independence also pertains to well-defined preferences and assumes that two gambles mixed with a third one maintain the same preference order as when the two are presented independently of the third one. The independence axiom is the most controversial one. Axiom (Independence): Let A, B, and C be three lotteries with . , and let ; then
Continuity assumes that when there are three lotteries (A, B and C) and the individual prefers A to B and B to C, then there should be a possible combination of A and C in which the individual is then indifferent between this mix and the lottery B. Axiom (Continuity): Let A, B and C be lotteries with A > B > C; then there exists a probability p such that B is equally good as pA + (1 p)C. If all these axioms are satisfied, then the individual is said to be rational and the preferences can be represented by a utility function. In other words: if an individual always chooses his/her most preferred alternative available, then the individual will choose one gamble over another if and only if there is a utility function such that the expected utility of one exceeds that of the other. The expected utility of any gamble may be expressed as a linear combination of the utilities of the outcomes,with the weights being the respective probabilities. Utility functions are also normally continuous functions. Such utility functions are also referred to as von NeumannMorgenstern (vNM) utility functions. This is a central theme of the expected utility hypothesis in which an individual chooses not the highest expected value, but rather the highest expected utility. The expected utility maximizing individual makes decisions rationally based on the axioms of the theory. The von NeumannMorgenstern formulation is important in the application of set theory to economics because it was developed shortly after the Hicks-Allen "ordinal revolution" of the 1930s, and it revived the idea of cardinal utility in economic theory.[citation needed] Note, however, that while in this context the utility function is cardinal, in that implied behavior would be altered by a non-linear monotonic transformation of utility, the expected utilty function is ordinal because any monotonic increasing transformation of it gives the same behavior.
Risk aversion
The expected utility theory implies that rational individuals act as though they were maximizing expected utility, and allows for the fact that many individuals are risk averse,[citation needed] meaning that the individual would refuse a fair gamble (a fair gamble has an expected value of zero). Risk aversion implies that their utility functions are concave and show diminishing marginal wealth utility. The risk attitude is directly related to the curvature of the utility function: risk neutral individuals have linear utility functions, while risk seeking individuals have convex utility functions and risk averse individuals have concave utility functions. The degree of risk aversion can be measured by the curvature of the utility function. Since the risk attitudes are unchanged under affine transformations of u, the first derivative u' is not an adequate measure of the risk aversion of a utility function. Instead, it needs to be normalized. This leads to the definition of the ArrowPratt[5][6] measure of absolute risk aversion:
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Special classes of utility functions are the CRRA (constant relative risk aversion) functions, where RRA(x) is constant, and the CARA (constant absolute risk aversion) functions, where ARA(w) is constant. They are often used in economics for simplification. A decision that maximizes expected utility also maximizes the probability of the decision's consequences being preferable to some uncertain threshold (Castagnoli and LiCalzi,1996; Bordley and LiCalzi,2000;Bordley and Kirkwood, ). In the absence of uncertainty about the threshold, expected utility maximization simplifies to maximizing the probability of achieving some fixed target. If the uncertainty is uniformly distributed, then expected utility maximization becomes expected value maximization. Intermediate cases lead to increasing risk-aversion above some fixed threshold and increasing risk-seeking below a fixed threshold. Further information: Risk aversion
u(w) = log(w)
has relative risk aversion equal to unity. The functions
u ( w) = w
for have relative risk aversion equal to 1 . And the functions
u ( w) = w
for < 0 also have relative risk aversion equal to 1 . See also the discussion of utility functions having hyperbolic absolute risk aversion (HARA).
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Often people refer to "risk" in the sense of a potentially quantifiable entity. In the context of meanvariance analysis, variance is used as a risk measure for portfolio return; however, this is only valid if returns are normally distributed or otherwise jointly elliptically distributed.[7][8][9] However, D. E. Bell[10] proposed a measure of risk which follows naturally from a certain class of von NeumannMorgenstern utility functions. Let utility of wealth be given by u(w) = w be aw for individualspecific positive parameters a and b. Then expected utility is given by
Thus the risk measure is , which differs between two individuals if they have different values of the parameter a, allowing different people to disagree about the degree of risk associated with any given portfolio.
Irrational deviations
Behavioral finance has produced several generalized expected utility theories to account for instances where people's choice deviate from those predicted by expected utility theory. These deviations are described as "irrational" because they can depend on the way the problem is presented, not on the actual costs,rewards, or probabilities involved. Particular theories include prospect theory, rank-dependent expected utility and cumulative prospect theory and SP/A theory[12]
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Uncertain probabilities
Applying expected value and expected utility to decision-making requires knowing the probability of various outcomes. However, this is unknown in practice: one is operating under uncertainty (in economics, one talks of Knightian uncertainty). Thus one must make assumptions, but then the expected value of various decisions is very sensitive to the assumptions. This is particularly a problem when the expectation is dominated by rare extreme events, as in a long-tailed distribution. Alternative decision techniques are robust to uncertainty of probability of outcomes, either not depending on probabilities of outcomes and only requiring scenario analysis (as in minimax or minimax regret), or being less sensitive to assumptions.
See also
Allais paradox Bayesian probability Behavioral economics Decision theory Subjective expected utility generalized expected utility Rank-dependent expected utility Prospect theory Risk in psychology Risk aversion ambiguity aversion Marginal utility Two-moment decision models
References
1. ^ http://cepa.newschool.edu/het/essays/uncert/vnmaxioms.htm 2. ^ [1] 3. ^ Bernoulli, Daniel; Originally published in 1738; translated by Dr. Lousie Sommer. (January 1954). "Exposition of a New Theory on the Measurement of Risk". Econometrica (The Econometric Society) 22 (1): 2236. doi:10.2307/1909829. http://www.math.fau.edu/richman/Ideas/daniel.htm. Retrieved 2006-05-30. 4. ^ Neumann, John von, and Morgenstern, Oskar, Theory of Games and Economic Behavior, Princeton, NJ, Princeton University Press, 1944, second ed. 1947, third ed. 1953. 5. ^ Arrow, K.J.,1965, "The theory of risk aversion," in Aspects of the Theory of Risk Bearing, by Yrjo Jahnssonin Saatio, Helsinki. Reprinted in: Essays in the Theory of Risk Bearing, Markham Publ. Co., Chicago, 1971, 90-109. 6. ^ Pratt, J. W. (JanuaryApril 1964). "Risk aversion in the small and in the large". Econometrica 32 (1/2):
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122136. doi:10.2307/1913738. http://jstor.org/stable/1913738. 7. ^ Borch, K. (January 1969). "A note on uncertainty and indifference curves". Review of Economic Studies 36 (1): 14. doi:10.2307/2296336. http://jstor.org/stable/2296336. 8. ^ Chamberlain, G. (1983). "A characterization of the distributions that imply mean-variance utility functions". Journal of Economic Theory 29: 185201. doi:10.1016/0022-0531(83)90129-1. 9. ^ Owen, J., Rabinovitch, R. (1983). "On the class of elliptical distributions and their applications to the theory of portfolio choice". Journal of Finance 38 (3): 745752. doi:10.2307/2328079. http://jstor.org/stable/2328079. 10. ^ Bell, D.E. (December 1988). "One-switch utility functions and a measure of risk". Management Science 34: 141624. doi:10.1287/mnsc.34.12.1416. 11. ^ Subjects changed their beliefs faster by conditioning on evidence (Bayes's theorem) than by using informal reasoning, according to a classic study by the psychologist Ward Edwards: Edwards, Ward (1968). "Conservatism in Human Information Processing". In Kleinmuntz, B. Formal Representation of Human Judgment. Wiley. Edwards, Ward (1982). "Conservatism in Human Information Processing (excerpted)". In Daniel Kahneman, Paul Slovic and Amos Tversky. Judgment under uncertainty: Heuristics and biases. Cambridge University Press. Phillips, L.D.; Edwards, W. (October 2008). "Chapter 6: Conservatism in a simple probability inference task (Journal of Experimental Psychology (1966) 72: 346-354)". In Jie W. Weiss and David J. Weiss. A Science of Decision Making:The Legacy of Ward Edwards. Oxford University Press. pp. 536. ISBN 9780195322989. 12. ^ Acting Under Uncertainty: Multidisciplinary Conceptions by George M. von Furstenberg. Springer, 1990. ISBN 0-7923-9063-6, 9780792390633. 485 pages 13. ^ Lichtenstein, S.; P. Slovic (1971). "Reversals of preference between bids and choices in gambling decisions". Journal of Experimental Psychology 89 (1): 4655. ISSN 0096-3445. http://psycnet.apa.org/journals/xge/89/1/46/. 14. ^ Grether, David M.; Plott, Charles R. (1979). "Economic Theory of Choice and the Preference Reversal Phenomenon". American Economic Review 69 (4): 623638. JSTOR 1808708. 15. ^ Holt, Charles (1986). "Preference Reversals and the Independence Axiom". American Economic Review 76 (3): 508515. JSTOR 1813367.
Charles Sanders Peirce and Joseph Jastrow (1885). "On Small Differences in Sensation". Memoirs of the National Academy of Sciences 3: 7383. http://psychclassics.yorku.ca/Peirce/small-diffs.htm Ramsey, Frank Plumpton; Truth and Probability (PDF), Chapter VII in The Foundations of Mathematics and other Logical Essays (1931). de Finetti, Bruno. "Probabilism: A Critical Essay on the Theory of Probability and on the Value of Science," (translation of 1931 article) in Erkenntnis, volume 31, September 1989. de Finetti, Bruno. 1937, La Prvision: ses lois logiques, ses sources subjectives, Annales de l'Institut Henri Poincar, de Finetti, Bruno. "Foresight: its Logical Laws, Its Subjective Sources," (translation of the 1937 article in French) in H. E. Kyburg and H. E. Smokler (eds), Studies in Subjective Probability, New York: Wiley, 1964.
de Finetti, Bruno. Theory of Probability, (translation by AFM Smith of 1970 book) 2 volumes, New York: Wiley, 1974-5. Donald Davidson, Patrick Suppes and Sidney Siegel (1957). Decision-Making: An Experimental Approach. Stanford University Press. Pfanzagl, J (1967). "Subjective Probability Derived from the Morgenstern-von Neumann Utility Theory". In Martin Shubik. Essays in Mathematical Economics In Honor of Oskar Morgenstern. Princeton University Press. pp. 237251. Pfanzagl, J. in cooperation with V. Baumann and H. Huber (1968). "Events, Utility and Subjective Probability". Theory of Measurement. Wiley. pp. 195220. Morgenstern, Oskar (1976). "Some Reflections on Utility". In Andrew Schotter. Selected Economic Writings of Oskar Morgenstern. New York University Press. pp. 6570. ISBN 0814777716.
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Further reading
Schoemaker PJH (1982). "The Expected Utility Model: Its Variants, Purposes, Evidence and Limitations". Journal of Economic Literature 20: 529563. Anand P. (1993). Foundations of Rational Choice Under Risk. Oxford: Oxford University Press. ISBN 0198233035. Arrow K.J. (1963). "Uncertainty and the Welfare Economics of Medical Care". American Economic Review 53: 94173. Scott Plous (1993) "The psychology of judgment and decision making", Chapter 7 (specifically) and 8,9,10, (to show paradoxes to the theory).
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