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CHAPTER 6

EXPECTED UTILITY AS A BASIS


FOR DECISION-MAKING: THE
EVOLUTION OF THEORIES
Expected Utility
Expected utility rests on the expected utility
hypothesis.
This hypothesis is related with peoples preferences
with regard to their choices that have uncertain
outcomes.
Three main pillars of expected utility are as follows:
Outcomes, which are objects of non-instrumental
preferences.
States are the things outside the decision-makers
control which influence the outcome of the
decision.
Acts are objects of the decision-makers
instrumental preferences
EXPECTED VALUE
In the presence of risky outcomes, usually a decision-
maker uses the expected value criterion for an
investment option.
The expected value (EV) is an anticipated value for a
given investment.
The EV is calculated by multiplying each of the
possible outcomes by the likelihood each outcome
will occur, and summing all of those values.
By calculating expected values, investors can choose
the scenario most likely to give them their desired
outcome.
UTILITY
The value of each outcome, measured in terms of real
numbers (mathematical form) is called a utility
DEVELOPMENT OF EXPECTED UTILITY
THEORY
Thought of Expected Utility Theory was
coined initially with the description given in
terms of mathematical explanations given by
Nicolas Bernoulli.
In a letter to Nicolas Bernoulli, Gabriel Cramer
explained that mathematicians estimate
money in proportion to its quantity.
RISK AVERSION AND EXPECTED
MARGINAL UTILITY
Risk aversion implies that the utility function of risk-
averse investors is concave in nature and show
diminishing marginal wealth utility.
Risk-neutral individuals have linear utility functions,
while risk-seeking individuals have convex utility
functions.
Hence the degree of risk aversion can be measured by
the curvature of the utility function.
It is further explained that concave expected utility
theory explains risk-averse behavior for both small-
stake gambles and large-stake gambles observed in
everyday life.
Expected Utility Theory & Loss
Aversion
The highlights of expected utility theory with
reference to loss aversion are given as below:
Investors are consistently deviated to one side only
from the point of view of prediction of risk neutrality
and these deviations are with risk aversion.
There is no relevance with the loss aversion in the
behavior of the investors.
In expected utility theory there is no implication of
calibration theory (comparison of measurement values).
EXPECTED UTILITY THEORY

Expected utility theory can be defined


as the theory of decision-making
under risk based on a set of outcomes
for preference ordering.
Expected Utility as a Basis for
Decision-Making
Expected Utility Theory (EUT) states that at the
time of decision-making, the decision maker
chooses among various risky or uncertain
options by comparing their expected utilities
with respect to his need.
EXAMPLES
You dont know if its going to rain, and you
have to decide whether to carry an umbrella.
If you carry an umbrella,
then there are 10 per cent chance you lose
it,
70 per cent chance you carry it around
needlessly,
20 per cent chance you use it.
Expected Utility theory with
Reference to lottery
A lottery [p1, p2, ..., pn] is a list of
probabilities, where pi is the probability with
the outcome i.
John Von Neumann and Oskar Morgenstern
developed expected utility theory with
reference to lottery as a financial
instrument.
Assumptions of utility function on lotteries
1. Completeness: which means that as per the
preference of individual lotteries can be ranked.
2. Transitivity: which means that the preferences
among different options are open.
3. Continuity: says that the upper and lower outline
sets of a preference range over lotteries are closed.
4. Monotonicity: means that a gamble which gives a
higher probability to a preferred outcome will be
preferred to one which assigns a lower probability to
a preferred outcome.
5. Substitution: the outcomes of different lotteries
with same probability can be substituted by each
other.
Criticism of Expected Utility
Theory
Many experimental economists agree that concave
expected-utility theory explains systematic, one-sided
deviations from the predictions of risk-neutral models
because of the belief that expected utility theory does
not give right explanation of risk attitudes over modest
stakes of investors in different asset classes. Also if the
investors or subjects considered in experiments are risk-
averse, then they are not expected-utility maximizes.
In order to clarify the fundamental differences between
expected utility theory and other decision theories, the
distinction between expected utility theory and expected
utility models need to be made.
EXPECTED UTILITY MODELS

1. The expected utility of income and


Initial wealth model (EUI & IW)
2. The expected utility of income model
(EUI)
3. The expected utility of terminal
wealth (EUTW)
THE EXPECTED UTILITY OF INCOME
UTILITY AND INITIAL WEALTH (EUI&IW)
MODEL
This model assumes that the prizes are ordered
pairs of amounts of initial wealth and income.
Indifference curves for this model are parallel
straight lines; therefore it is more or less an
expected utility model.
THE EXPECTED UTILITY OF INCOME
(EUI) MODEL
The expected utility of income (EUI) model is
based on the assumption that the prizes are
amounts of income.
The EUI model is mostly used in the theory of
auctions.
THE EXPECTED UTILITY OF TOTAL
WEALTH (EUTW) MODEL
The expected utility of terminal wealth (EUTW)
model is based on the assumption that the gains
are amounts of terminal wealth.
Terminal wealth is expected cash flow in future
by applying mathematical formula
It helps to explain some essential distinctions
among various models to briefly review the
familiar triangle-diagram representation of
indifference curves for simple gambles