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Decision Making Under Uncertainity PDF
Decision Making Under Uncertainity PDF
n
=
(
(p
1
...p
n
) [ p
i
_ 0 for all i 1...n and
n
i =1
p
i
= 1
)
Preferences % are dened on
n
.
Ani Guerdjikova Cornell Univeristy Decision Theory II Spring 2010 35 / 126
Decision Making Under Risk and Uncertainty
St. Petersburg Paradox
Consider the following game:
A coin is tossed.
If the coin lands heads after the n-th toss, you receive $2
n
and the
game stops.
If the coin lands tails, the game continues, until heads comes up.
How much would you be willing to pay to participate in this game?
The expected value of this game is...
i =1
p
i
u (z
i
)
Ani Guerdjikova Cornell Univeristy Decision Theory II Spring 2010 37 / 126
Decision Making Under Risk and Uncertainty
Compound Lotteries
How can we interpret convex combinations of lotteries?
Consider the object p + (1 ) q.
Intuitively, you rst use a randomization device, which gives you
lottery p with probability and lottery q with probability (1 ).
In a second step, either p or q is actually played and the outcomes are
determined according to the corresponding probability distribution.
Our representation suggests that:
p + (1 ) q ~ (p
1
+ (1 ) q
1
...p
n
+ (1 ) q
n
)
Ani Guerdjikova Cornell Univeristy Decision Theory II Spring 2010 38 / 126
Decision Making Under Risk and Uncertainty
The Von-Neumann-Morgenstern Axioms
Axiom A1 (Completeness) % on
n
is complete.
Axiom A2 (Transitivity) % on
n
is transitive.
Axiom A3 (Independence)
For all p, q and r
n
, and for all [0; 1],
p % q i
p + (1 ) r % q + (1 ) r
Axiom A4 (Archimedian Axiom / Continuity)
For all p, q and r
n
, such that p ~ q ~ r , there exist numbers and
(0; 1) such that
p + (1 ) r ~ q ~ p + (1 ) r
Ani Guerdjikova Cornell Univeristy Decision Theory II Spring 2010 39 / 126
Decision Making Under Risk and Uncertainty
The Expected Utility Theorem
Theorem
The following two statements are equivalent:
(i ) The preference relation % on
n
satises Axioms A1 A4
(ii ) There exists a utility function u : Z R such that for all p
and q
n
,
p % q i
n
i =1
p
i
u (z
i
) _
n
i =1
q
i
u (z
i
)
Furthermore, u is unique up to a positive-ane
transformation.
Ani Guerdjikova Cornell Univeristy Decision Theory II Spring 2010 40 / 126
Decision Making Under Risk and Uncertainty
Lemma 1
Assume A1, A2, A3 and A4.
(i ) If p ~ q and 0 _ < _ 1, then
p + (1 ) q ~ p + (1 ) q.
(ii ) If p % r % q and p ~ q, then there exists a unique
+
such
that:
+
p + (1
+
q) ~ r .
(iii ) If p ~ q, then for all r
n
and all [0; 1],
p + (1 ) r ~ q + (1 ) r .
Ani Guerdjikova Cornell Univeristy Decision Theory II Spring 2010 41 / 126
Decision Making Under Risk and Uncertainty
Lemma 2
Assume A1, A2, A3 and A4. Then, there exist z
0
and z
0
Z such that for
all p
n
,
z
0 % p %
z
0
.
Ani Guerdjikova Cornell Univeristy Decision Theory II Spring 2010 42 / 126
Decision Making Under Risk and Uncertainty
Uniqueness of the Von-Neumann-Morgenstern Utility
Function
If function u : Z R can be used to represent a preference order % on
n
, then so can any function v given by:
v (z) =: au (z) + b
for some positive a > 0.
Ani Guerdjikova Cornell Univeristy Decision Theory II Spring 2010 43 / 126