One-Switch Utility Functions and a Measure of Risk

Author(s): David E. Bell

Source: Management Science, Vol. 34, No. 12 (Dec., 1988), pp. 1416-1424
Published by: INFORMS
Stable URL: http://www.jstor.org/stable/2632032
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MANAGEMENT SCIENCE
Vol. 34, No. 12, December 1988
Printed in U.S.A.

ONE-SWITCH UTILITY FUNCTIONS

AND A MEASURE OF RISK*
DAVID E. BELL
HarvardBusinessSchool,SoldiersField, Boston,Massachusetts02163
Consider the relative attractivenessto a decision maker of two financial gambles as the wealth
of that individual varies. It may seem reasonable that either one alternative should be preferred
for all wealth levels or that there exists a unique critical wealth level at which the decision maker
switches from preferringone alternative to the other. Decreasing risk aversion is not sufficient for
this property to hold: we identify the small class of utility functions for which it does. We show
how the property leads naturally to a measure of risk.
The results of this paper apply equally well to discounting functions for cash flows: one-switch
discount functions permit at most one change in preference between cash flows as all payoffs are
deferred in time.
(DECISION ANALYSIS; UTILITY THEORY; RISK, DISCOUNTING)

1. Introduction
You are making choices among gambles and wish to abide by the axioms of expected
utility. In addition, you are risk averse and, indeed, decreasingly risk averse. For two
particular gambles A and B you prefer A to B. If you had more money, say $20,000
more, you feel you would then prefer B to A. Could it be that with even more money,
say another $20,000, you might switch back to preferring A to B? I suspect that you
think this shouldn't happen: that you would confine your choice of utility function to
one that does not allow such switching back and forth, that you think all well behaved
decreasingly risk-averse utility functions probably qualify.
DEFINITION
1. A decision maker obeys the one-switch rule if, for every pair of alternatives whose ranking is not independent of wealth level, there exists a wealth level above
which one alternative is preferred,below which the other is preferred.A one-switch utility
function permits an expected utility maximizer to satisfy the one-switch rule.
In general,an n-switch utility function permits at most n switches of preferencebetween
a pair of alternatives. For expositional convenience an (n - 1)-switch automatically
qualifies as an n-switch. The class of zero-switch utility functions is well known.
PROPOSITION1. Linear and exponential functions are the only zero-switch utility

functions.
A linear utility function is unsatisfactory if a decision maker is risk averse, preferring
less uncertainty in a gamble for any given expected value. An exponential utility function
is unsatisfactory if a decision maker is decreasingly risk averse since, due to its zeroswitch property, no amount of wealth can make the risk in a once rejected gamble
acceptable.
One purpose of this article is to propose the one-switch rule as a reasonable property
for utility functions to satisfy. Though many people find the rule intuitively appealing,
the alternatives shown in Figure 1 may help to explain how a violation might occur.
If you are poor, you may wish to avoid alternative B since it has the worst payoff. On
the other hand, if you are rich you should preferA since it offers a higher expected value,
* Accepted by Robert L. Winkler; received August 28, 1987. This paper has been with the author 2! months
for 1 revision.

1416
0025-1909/88/3412/1416$01.25
Copyright C) 1988, The Institute of Management Sciences

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1417

ONE-SWITCH UTILITY FUNCTIONS

FIGURE

1. Two Alternatives That May Switch Twice.

Alternative A

Alternative B
$3

$10
2

.9

$-2

$1

$2.80 as opposed to $2.50 for B. At moderate levels of wealth, however, you may prefer
B on the grounds of its lower variability (variance of $2.25 compared to $12.96 for A).
Is such behavior consistent with expected utility? The logarithmic utility function is
risk averse, decreasingly risk averse and generally well behaved, but switches from A to
B and back to A as wealth increases:
Wealth Level

Choice

Informal Criterion

u(w) = log w

Poor
Moderate
Rich

A
B
A

Max Min
Variance
Expected Value

2 < w < 3.4

3.5 < w < 7
7< w

How could our intuition lead us so far astray?I believe that our informal thinking about
the one-switch rule is as follows. If B becomes preferredto A as wealth increases, it must
be that B is riskier than A. Being decreasingly risk averse means that as wealth rises, risk
diminishes in importance so that furtherincreases in wealth can only reinforce our choice
of B. The mistake occurs with the assumption that one alternative can unilaterally be
declared more risky than another, even for one individual. At least that's where our
intuition and expected utility part company.
In the next section of the paper we identify the class of one-switch utility functions.
In ?3 and ?4 we pursue two applications of the one-switch rule. The first is based on the
close association between the one-switch rule and our notion of riskiness.For as a corollary
to my explanation of how the intuition of single switching comes about, we know that
only people with one-switch utility functions can unambiguously rank order gambles by
the property of riskiness.'
The second application is to the domain of discounted cash flows.2 The analogous
rule is that as two cashflows are deferred in time, preference between them should switch
at most once. ?5 identifies the class of n-switch utility functions.
Finally ?6 contains a proof that no assumptions of continuity and differentiability are
needed to prove our main result. That is, there are no "trick solutions" to the oneswitch rule.
2. One-Switch Utility Functions
The following proposition identifies the class of one-switch utility functions. The class
is identical to that previously discovered by Farquhar and Nakamura (1987) as a result
of their condition called augmented constant exchange risk. As with the one-switch rule
'The one-switch rule developed during discussions with Vijay Krishna after he questioned when such an
ordering was possible.
2 Drazen Prelec and Michael Rothkopf pointed out this connection to me.

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DAVID E. BELL

1418

their condition is a property holding for all wealth levels, but otherwise the two conditions
are not obviously equivalent. In Farquharand Nakamura ( 1988) they provide constructive
assessment procedures for this class. Their representation theorem assumes unlimited
differentiabilityof the utility function and we will too, at least in this section. ?6 provides
a proof that does not use either continuity or differentiability.
2. A utilityfunction satisfies the one-switch rule if and only if it belongs
to one of thefollowingfamilies:
(i) the quadratics, u(w) = aw2 + bw + c;
(ii) the sumex functions, u(w) = aebw + cedw,
(iii) linear plus exponential, u(w) = aw + becw,
(iv) linear times exponential, u(w) = (aw + b)ecw.
PROPOSITION

The first and fourth of these have the disadvantage, for practical applications, of being
increasingly risk averse for all choices of parameters a, b and c. The sumex function is
discussed by Schlaifer (197 1) as being convenient for assessment purposes and shown to
be increasing, risk averse and decreasingly risk averse so long as all its coefficients are
negative. The third class of one-switch utility functions, u( w) = aw + becwis a limiting
case of a sumex function in which one of the exponentials has converged to a linear
function.
PROPOSITION3. If a decisionmaker
(a) prefers more money to less,
(b) wishes to obey the axioms of expected utility,
(c) is risk averse at all wealth levels,
(d) is decreasingly risk averse at all wealth levels,
(e) wishes to obey the one-switch rule,
(f) will approach risk neutralityfor small gambles when extremely rich,
then the only feasible utilityfunction is u( w) = w - be-cwfor some positive parameters
b and c.
PROOFOF PROPOSITION2. We begin by demonstrating that the named functions are

one-switch functions.
Quadratics: If u(w) =
+ 2aw, + blu + bw + c +

+ bw + c and x is a gamble, then Eu(w + x) = aw2

E(x) and a2 = E(x -,)2.
For two
= 2aw(til
- A2) + b(zl - A2)
gambles xl and x2 we have E(u(w +.k1) - u(w + x2))
+ a( 2 - 2) + a(2 -2_ ). So long as A1 * A2, preferences between these gambles
will switch exactly once. If ti = ,U2they will not switch at all.
Sumex: If u(w) = aebw + cedw let a = E(ebxl - ebi2) and f3 = E(edxl - edi2) then
E(u(w +.k1) - u(w + x2)) = agaebw+ fcedw. Thus preferences for xl and x2 switch
This equation has exactly one solution if b # d.
whenever e (b-d)W =-c/aa.
If
Linear plus exponential:
u(w) = aw + becw, let a = E(x1 - x2) and: = E(edx
- ed2) and proceed as before.
Linear times exponential: If u(w) = (aw + b)ecw let a = E(1ecx' - g2ecx2) and:
E(ecx' -ec2). Then E(u(w +.k1) - u(w + X2)) = f(aw + b)ecw + aaecw. This equals
zero only when w = -(oaa + bo)/fa.
Now to show that these are the only one-switch functions. Let x and y be any distinct
gambles with suitably small spread. We may write:
aw2

au2 + aA2 where ,u =

c0

Eu(w + x)

Eu(w + E)=

mkUk(W)

k=l

where mk = (E(gk)

E(yk))/k!

and uk is the kth derivative of u. If u is to be one-

switch then the system of equations

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ONE-SWITCH UTILITY FUNCTIONS

1419

00

mkuk(wi) = ai,

i = 1, 2, 3,

k=1

cannot hold for w1 < W2 < W3if ala2 < 0 and a2a3 < 0. But if we can identify some set
of W1 < W2 < W3 such that the 3 X 3 matrix (Uk(Wi)) (k = 1, 2, 3) has a nonzero
determinant, then there will exist for any choice of a's a solution in terms of the m's
which will satisfy the equations. (The relevant gambles x and y are deduced from the
equations E(gk) - E( 5k) = Mkk! where Mk = 0 for k > 3.) Thus a necessary condition
for a one-switch function to satisfy is that the first 3 derivatives be collinear i.e. for some
coefficients b1, b2 we have U3(W) = blul(w) + b2u2(w). This differential equation has
the solutions stated in the proposition (see for example Piaggio 1965, p. 25). In general,
the solutions could involve imaginary coefficients. These can easily be dismissed in
the context of utility functions except in the case of sumex functions. For if u(w)
= ae(c+id)w + be(c-id)w where i = V-T then if a = b, u becomes real and equal to
2aecwcos dw. This function, however, is an infinite switch utility function since it alternates sign indefinitely.
PROOF OF PROPOSITION3. Pratt (1964) has shown that a necessary and sufficient
condition for a doubly differentiable utility function to be risk averse is that r(w)
= -u"(w)/u'(w) is positive. A necessary and sufficient condition for decreasing risk
aversion is that r be monotonically decreasing. The quadratic u( w) = aw2 + bw + c has
u'= 2aw + b, u" = 2a and r' = 4a2/(2aw + b)2 which shows that r is always increasing.
Similarly for u(w) = (aw + b)ecwwe have u' = (a + bc + acw)ec', u" = (2ac + bc2
+ ac2w)ecw,r = -c - ac/(a + bc + acw), r' = a2c2/(a
+ bc + acw)2 which is always
positive. The sumex functions u(w) = aebw + ce dw are increasing, risk averse and decreasingly risk averse so long as each of a, b, c, and d is negative but r(oo) = min(-b,
-d) which is not zero, as requiredby condition (f) of this proposition. This is a somewhat
artificial condition since a utility function is usually of interest only over some bounded
interval since infinite sums of money do not occur in practice.
For u(w) = aw + becw we have u' = a + bcecw, u" + bc2ecwso r(w) = -bc2/(ae-cw
+ bc) and r'(w) = -abc3e-cw/(ae-cw + bc)2. For r' < 0 we require abc > 0. For u' > 0
we require a > 0 and bc > 0. For r > 0 we require b < 0. Hence the conditions a > 0,
b < 0, c < 0 are necessary and sufficient for aw + becwto satisfy the conditions of the
proposition.

3. Measuring Risk
Many people wish to regard decisions under uncertainty as problems of trading off
risk against return. In this section we establish the conditions under which such a view
is compatible with expected utility and derive the relevant measure of risk.
The one-switch rule (Definition 1) does not incorporate a rather basic element of the
intuition that supports it. In the opening paragraph of this paper you were asked to
imagine that an increase in wealth of $20,000 caused you to switch from choosing A to
choosing B. A common interpretation of this switch is that B must have been riskier
than A. Hence we could strengthen the one-switch rule by requiring, not only that only
one switch may occur, but also that it be in favor of the more risky alternative. While
intuitively satisfying, this strengthening is rathervague without a definition of risk. However if we assume that our intuition presupposes some system by which risk is traded off
against return, then we may finesse this difficulty by recognizing that if the switch is in
favor of the alternative with the higher risk it must also be in favor of the alternative
with the higher return. Though a definition of risk may not be standard, a definition of
return most certainly is, namely the expected value E(x).

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1420

DAVID E. BELL

DEFINITION
2. A decision maker is risk consistent if, whenever a preference reversal
occurs due to an increase in wealth, the newly favored alternative has a higher expected value.
PROPOSITION4. Risk consistency implies the one-switch rule.

PROOF. To switch from x to y implies E(y) > E(x). Hence a switch back is not risk
consistent.
PROPOSITION5. An expected utility maximizer who is risk consistent and risk averse
is also decreasingly risk averse (or constantly risk averse).

PROOF. If c(w) is the certainty equivalent of a gamble x at wealth level w, then by

risk aversion c(w) < E(xf). By risk consistency, c(w) must be increasing (or constant)
in w.

PROPOSITION6. If a decision maker

(i) prefers more money to less,
(ii) wishes to obey the axioms of expected utility,
(iii) is risk averse at all wealth levels,
(iv) is risk consistent,
then the only feasible utilityfunction is u( w) = aw - be-cw where a
positive.

0 and b and c are

PROOF. From the proof of Proposition 3 we know that the only one-switch utility
functions that are increasing, risk averse and decreasingly risk averse are
(a) aw - be-cw for a, b, c positive and
(b) -ae-bw - ce-dw for a, b, c, d positive.
To see that (a) satisfies risk consistency note that for large w, gambles are ranked by
expected value, hence any switches that occur must be in the direction of the one with
the higher expected value. To see that (b) does not, it sufficesto note that two exponentials
will not agree on the ranking of all gambles with a given mean. However there are
counterexamples even for gambles with different means. For example, using the alternatives in Figure 1, alternative A is ranked lower than alternative B only when the coefficient of risk aversion is between 0.067 and 0.529.
Proposition 6 holds even when the assumptions are required to hold only on some
open interval of wealth levels (because the range of gambles is unrestricted), so that the
implications cannot be avoided simply by restricting the utility function's domain to
some small range.
To interpret Proposition 6, let us suppose that a decision maker wishes to order all
gambles x by their risk (or riskiness), R(x) and then to make decisions about relative
preference between gambles based solely on their levels of risk, R (x), and return, E(x).
What the proposition tells us is that such a scheme is compatible with expected utility
(and behavioral assumptions such as risk aversion) if and only if u( w) = w - be-cw (b,
c > 0) or the special case u(w) = -e-cw (c > 0).
We achieved this result without relying on any definition of risk, other than that
implicit in the concept of risk aversion, indeed without any presumption (except in the
motivation behind Definition 2) that a risk ordering existed at all.
But as a result of Proposition 6 we may infer a measure of risk for any decision maker
satisfying its assumptions. We have
Eu(w +xk) = w + E(x)

be-cwE(ecx).

A rather appealing definition of risk would be R(x) = E(ecx)

deCiSioncriterion Of

since this leads to a

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ONE-SWITCH UTILITY FUNCTIONS

E(x-,) - k(w)R(x)

1421
(1)

where k( w) is a tradeoff constant declining in w. With this definition of risk, the zeroswitch utility functions have a simple interpretation. The linear u(w) = w yields Eu(w
+ .) = w + E(x), a case of maximizing return, while the exponential u(w) = -e-'w
yields Eu(w + x) = -e -cwE(e`cx) a case of minimizing risk.
However it does not seem sensible to regard a person with constant risk aversion as
being interested only in minimizing risk. For this person will take a risk if the returns
are adequate.
I think it is better to regard risk and return as "orthogonal" concepts, that is the
riskiness of a gamble should be independent of its expected value.
ASSUMPTION. (Independence of risk and return). Two alternativeswhose distribution
of payoffs differs only by a translation of mean, have the same risk.
PROPOSITION7. The only definition of risk which is compatible with an increasing,
risk averse utilityfunction, with risk consistency and which is independent of return, is
R(x5) = E(e-c(x-E(x))) or a monotonic transformation thereof.

We may write Eu(w + x) = E(w + x - bec(v+x)) as w + E(xZ)

X Ee-c(x-E(x)). It is clear that R(xk) = Eec(xE(x)) is independent of E(x.)
and w. By assumption the expected utility for a given w depends solely on risk and return;
since E(x) is the return, R(xk) must be the risk.
Note that the exponential case has now a more appealing interpretation. Eu( w + x)
may be written as-e-cwecE(x)R(x). Taking logarithmswe see it is equivalent to evaluating
gambles with the formula E() - c-' log R(x) which of course does not depend on w.
The corresponding formula for u( w) = w - be-cw is
PROOF.

- be-e`E(x)

E(x)-

k(w + E(xZ))R(x&)

(2)

which makes some sense if one thinks of w + E(x) as the expected wealth upon taking
the gamble. The aesthetic value of criterion (1) must be balanced against the independence
of risk and return which led to (2).
Because both definitions of risk depend on the individual through the parameter c, it
is not possible to talk about the risk of a gamble. This is unfortunate for those who would
wish to separatethe measurement of risk from an individual's aversion to it. In retrospect
however it does seem sensible to permit disagreement on the relative importance of the
tails of a distribution: people with high c's place more emphasis on the possibility of bad
outcomes. For a given c, however, the parameter b does control the degree of aversion
to risk.
4. Discounting Cash Flows
Let x be a cashflow which pays off an amount $xi at time ti, i = 1, . , k. Analogous
axioms to those leading to expected utility for gambles give us discounted cashflows:
there exists a discount function d(t) such that cashflow x is preferred to cashflow y if
and only if
k

2: xid(ti) >

yid(ti).

i=l I=l

Since the scale of d is arbitrary,we may take d(O) = 1. Receiving money at t = oois
worthless so d(oo) = 0. It is also safe to assume that people are impatient, preferring
income sooner rather than later, so d(t) is decreasing in t.
One way to think about properties of the discount function is to consider how behavior
changes if all cashflows are delayed by a fixed interval of time, say T. As viewed from
time T the discount function may be regarded as d( T + t)/d( T) .

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DAVID E. BELL

1422

We will say that a decision maker is increasingly, decreasingly, or constantly impatient

according as d( T + t)/d( T) is less than, greater than, or equal to d(t) for all T and t.
(The relationship will not be in the same direction for all T and t in general.)
Koopmans (1960) showed that if a fixed delay never causes preference to change, then
the decision maker must be constantly impatient. The relation d( T + t) = d(T)d(t)
leads, of course, to the conclusion that d( t) = e-Ct for some c. In our terminology Koopmans' proposal was for a no-switch rule for cashflows. (The linear case is invalid because
d becomes negative.)
It is well known that if money is lent and borrowed at the same rate, then a rational
decision maker should use exponential discounting, but in the absence of such efficient
money markets, the no-switch rule may not be so attractive. It seems perfectly plausible
that someone would choose to receive $1,000 today over $2,000 in one year's time, but
prefer $2,000 in 6 years' time over $1,000 in 5 years' time.

d(t) satisfiesthe one-switchrule (and d(0) = 1,

PROPOSITION8. A discountfunction
d(oo) = 0 and d(t) decreasing)but is not exponentialif and only if d(t) = ae-bt
+ (1 - a)e-(b+c)t
wherea, b, c arepositiveand a < 1 + b/c. It is decreasinglyimpatient
if a < 1 and increasinglyimpatientif 1 < a < 1 + b/c.
PROOF. We need only check the four functional forms of Proposition 2. The quadratic
can never satisfy d(oo) = 0 and d(0) = 1. The linear plus exponential cannot both be
decreasing and always positive. This applies to the linear times exponential also.
For the sumex function we may as well write d(t) = ae-bt + ce-dt with b, d positive
so that d(oo) = 0. Now d(O) = 1 means a + c = 1. Without loss we may assume d > b.
Since d'(t) = -(bae-b1 + cde-dl) we must have ba + cd > 0. Also, for no positive t
mustbae-bt + cde-dt = 0 or e(d-b)t = -cd/ba. This will be so only if-cd/ba < 1. If a
> 0 this is ba + cd > 0 as before. If a < 0 this is ba + cd < 0. Thus we require a > 0

andba+(l

-a)d>Oora<d/(d-b).

To determine when the sumex is decreasingly impatient we simply consider whether

d( T + t) > d( T)d(t):
ae-bTe-bt

+ (1 -a)e-(b+c)Te-(b+c)t
> (ae-bT

+ (1 -

a)e-(b+c)T)(ae-bt

(1

a)e-(b+c)t)

if a(l - a)[e-bT- e-(b+c)TI[e-bt -e-(b+c)t] > 0.

Thus the sumex is decreasingly impatient if a(l - a) is positive, and increasingly
impatient if it is negative. O
It is not implausible for multiple switching to occur. If I need money urgently today
and again when my children go to college, one can easily imagine (again, in the absence
of borrowing/lending) that I would prefer
($1000 at t = 0) over ($2000 at t = 1),
($2000 at t = 6) over ($1000 at t = 5),
($1000 at t = 10) over ($2000 at t = 11),
($2000 at t = 16) over ($1000 at t = 15),
if my children graduate from college in year 10.
This is modest justification for the next section of the paper, which identifies the class
of n-switch utility functions.
5. Multiple Switching
The following result for n-switch utility functions is proved in identical fashion to that
of Proposition 2. Unlike Proposition 2, I do not have a proof that eliminates the need
for an assumption of continuity, but since the one-switch functions are continuous and
differentiable,it seems reasonable to conjecture that this is not an issue.

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ONE-SWITCHUTILITYFUNCTIONS

1423

PROPOSITION9. A utilityfunction that is infinitely differentiable is an n-switch utility

function if and only if it may be written as fo(w) + L1t-= fi(w)e'iw where fi(w) is a
polynomial of order ni such that z k=o ni < n + 1 - k. (If this last inequality is an equality
then u is not an (n - 1)-switch utilityfunction .)

Among the class of n-switch utility functions are (i) (n + 1)th order polynomials, and
(ii) a sum of (n + 1) exponentials.
The only one-switch utility functions that were decreasingly risk averse were sums of
two exponentials (counting a linear function as an exponential for this purpose). It is
also the case that for two-switch utility functions the only decreasinglyrisk averse functions
are sums of exponentials. However this is not true for all n. For example, the four-switch
function u(w) = -el/2w _ (w2 + 4)e-w - e-3/2"' is increasing, risk averse and decreasingly risk averse everywhere.
6. Removing Trick Solutions
We have noted that our results are not altered if attention is confined to a subinterval
of the real line. Another possible way around the restrictiveness posed by the one-switch
rule would be if it were possible to construct, say, piecewise linear functions, that obeyed
the rule. In this section we establish that no function, no matter how perversely constructed, can satisfy the one-switch rule, except as allowed by Proposition 2.
LEMMA 1. To satisfy the one-switch rule, a utilityfunction must be continuous.
PROOF. It suffices to consider the case u(w) = 0 for w < w*, u(w) = 1 for w ? w*.
Any pair of gambles whose cumulative probability functions cross at least twice is a
counterexample.
LEMMA 2. The certainty equivalent of any gamble is monotonic in w for any oneswitch utilityfunction.
PROOF. If, for three wealth levels w1 < W2 < W3, the certainty equivalent c(w) of a
gamble x satisfies, say, c(w1) < c(w2) > c(W3) then for any value c* such that c(w2) > c*
> max(c(wi),
C(W3)) the sure payoff c* is preferred to x at w1, less preferred at w2 and
preferredonce again at W3, a contradiction.
LEMMA 3. If u is one-switch, and X1I-X2

at two wealth levels wo and w1, then xl

x2 for all w.

PROOF. Clearly x I
x2 throughout the interval (wo, w1), for ifxg1 > x2 at some w2
E (wo, w1)then a slight improvement in x2 would produce a double switch. But suppose
there were some value w2 > w1 such that x1 > 2 say. In that case since u is not zeroswitch there must exist a pair of gambles -1 and -2 and a value w* such that <2
below w* and the reverse above. Define z1 as a 1- E chance at x1 and an Echance at fY1
2asa 1 - Echance at x2 and anEchance at y2 + w* - wl.Thenat
wowe have z1 > -2 and at w2 we have, for small enough E, z1 > z2. At w1, of course, z
+w*

-wl,and

z2. Now make z2 slightly more attractive to achieve a double switch.

The proof will proceed by demonstrating that for some pair of wealth levels w, and
w2, and for any increment x less than some positive upper bound, there exist probabilities
p and q (depending on x) such that the two gambles
a p chance at 2x and a (1 - p) chance at 0 and
a q chance at 3x and a (1 -q) chance at x
are indifferent at both w, and w2 and hence, by Lemma 3, at all w. If we let u, denote
u(wo + nx) for some base value wo then we have
pUn+2 + (1 - p)un

= qun+3 + (1

q)u+

for all n. We now rely on a well known result (e.g., Gray 1967, p. 126).
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DAVID E. BELL

1424

LEMMA 4. If {uu} is a sequence such that for all n Un+3= au,+2 + bu,+1+ (1 - a
- b)u, for some constants a and b then if zI, z2, z3 are the roots of the equation z3 = az2
+ bz + (1 - a - b) where z3 may be assumed to be equal to one, then un is given by
(i) b1n2 + b2n + b3 if ZI = z2 = 1,
(ii) b1zn+ b2Zn + b3 if zl # z2 and neither equals 1,
(iii) b1zn + b2n + b3 if zI # z2 = 1,
(iv) (bln + b2)zl + b3 if z1 = z2 = 1
for various constants b1, b2 and b3.

As x goes to zero, these formulas become the familiar functions of Proposition 2. We

will choose woand x so that the range(wo, wo+ 4x) lies entirely within a strictlymonotonic
range of u. We may as well assume u is increasing in this range. Let w1 = wo, w2 = wo
+ x.

We must show that if p and q are chosen so that pu2 + (1 - p)uo = qu3 + (1-q)u1
andpu3 + (1 -p)u1 = qu4 + (1 - q)u2 then O <p < 1 and O < q < 1. Solving forp we
find
(U4

U2)(1

Uo)

(U2 - U1)(u3

(U4

U2)(2

Uo)

(U3

U)(3

U1)

U1)

LetpI be such that u1 = p1u3 + (1 - p1)uo. If also u2 = p1u4 + (1 -p1)u1 then by Lemma
3 we know un+1 = plun+3 + (1 - p1)un for all n and we may use Lemma 4 at once.
Suppose then that u2 < p1u4 + (1 - p1)ui. We know that p, = (ul - Uo)/(u3 - uO) so
U2 <

ul - UO
U3-

UO

U4 +

u3-u1l
U3-

uo

IU

or u2(u3 - uO) < u4(u1 - uO) + u1(u3 - u1) or (U2 - U1)(u3 - U1) < (U4 - U2)(u1 - U0).
Hence the numerator of p is positive. By repeating this kind of exercise with a P2 such
that u2 = p2u3 + (1 - p2)u1 one can show that the denominator of p is greater than the
numerator and hence that 0 < p < 1. The various arbitrary inequality assumptions
(U3 > uO, U2 < pIU4 + (1 - pi)ul) can be reversed without affecting the conclusion. The
argument for q is similar.
References
FARQUHAR, P. H. AND Y. NAKAMURA, "Constant Exchange Risk Properties," Oper. Res., 35 (1987), 206-

214.
, "Utility Assessment Proceduresfor Polynomial-ExponentialFunctions," Naval Res. Logist.
AND
Quart., (1988) (to appear).
GRAY, J. R., Probability, Oliver & Boyd, Edinburgh, 1967.
T. C., "Stationary Ordinal Utility and Impatience," Econometrica, 28 (1960), 297-309.
KOOPMANS,
PIAGGIO, H. T. H., Differential Equations, G. Bell and Sons, London, 1965.
PRATT, J. W., "Risk Aversion in the Small and in the Large,"Econometrica, 32 (1964), 122-136.
SCHLAIFER,R. O., ComputerProgramsfor ElementaryDecision Analysis. Division of Research,HarvardBusiness
School, Boston, 1971.

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