Utility Theory

John Lee
Department of Political Science
Florida State University

Utility
The idea that we can assign value to an action
and then choose amongst a set of possible
actions based on their value.
My grandma could offer me $50 or $100. I
choose the offer that maximizes my utility. In
this case, I choose $100.

Utility
Previous example/slide based on action with
certain outcome. In other words, I know that if I
accept $50 I get $50.
What if I am uncertain?
Grandma could say that if I choose $50 option I get
$50 with a probability (p) of 4/10 (.4) and $0 with a
probability of 6/10.
Alternatively, she says if I choose the $100 option I get
$100 with a probability of 3/10 and $0 with a
probability of 7/10.

What should I do?

Expected Utility
Determining utility when an action results in a
set of possible outcomes.
For example, for each offer from grandma I might
get $50/$100, or I might get $0.
Since I might not get $50 if I choose the $50 dollar
option, what is my expected utility of this action?

Expected Utility
Expected Utility The utility one expects to
receive in an uncertain situation.
Some Notation
p(a) = probability of event a
EUi(x) = Expected Utility of action x for
individual i.
Ui(x) = Utility of action x for individual i.

Expected Utilities
For any given p(a) it must meet some criterion
(probability rules):
p(a) must be greater than or equal to zero.
p(a) must be less than or equal to one.
The probability of all outcomes must sum to one.
So if a & b are possible outcomes then the following
must be true.
p(a) + p(b) = 1

Grandma Example
EUme($50) = p(gives money)*50 + p(withholds money)*0
EUme($50) = (4/10)*50 + (6/10)*0
EUme($50) = (4/10)*50
EUme($50) = 20

EUme($100) = p(gives money)*100 + p(withholds money)*0

EUme($100) = (3/10)*100 + (7/10)*0
EUme($100) = (3/10)*100
EUme($100) = 30
EUme($100) > EUme($50)
30 > 20

Lottery Example
Say you buy a lottery ticket. There is a 1/1000 chance
that you win the lottery. If you win you get $1000.
Finally, the lottery costs $2.
What is your expected utility?

EUi(L) = p(W)*BW + p(L)*BL c

Where BW equals the benefits of winning and BL equals
the benefits of losing. If you lose you zero. c
represents the cost. Ergo, the following equation
represents the Expected Utility of this lottery.
EUi(L) = p(W)*BW c

Lottery Example
Since we know that p(W) equals 1/1000, BW
equals 1000, and c equals 2 we can now compute
the expected utility of participating in the lottery.

EUi(L) = p(W)*BW c
EUi(L) = (1/1000)*1000 2
EUi(L) = 1000/1000 2
EUi(L) = 1 2
EUi(L) = -1

Should you do it?

Lottery Example
In this case you have two possible actions, you
can (1) play the lottery or (2) not play the lottery.
If you play the lottery we determined your
expected utility equals $-1.
If you do not play the lottery you lose or gain
nothing, so your utility is $0.
EU(lottery) < EU(~lottery)
-1 < 0
Clearly you should not play the lottery.

Lottery Example (2)

Should you buy a lottery ticket? Well, you need
to know three things before answering this
question.
What are the probabilities of winning/losing?
What are the benefits of winning?
What are the costs of participating in the lottery?

Once we know these we can compute the

expected utility of buying a lottery ticket and
compare it to our expected utility of not buying a
lottery ticket.

Lottery Example (2)

Should you buy a lottery ticket?
EUi(L) = p(W)*BW + p(L)*BL c

Where BW is equal to the benefits of winning

(lets say $1000) and BL is equal to the benefits
of losing ($0). Also, lets say the lottery costs
$2. But lets say we DO NOT know the
probability of winning the lottery.
EUi(L) = p(W)*1000 - 2

Lottery Example (2)

Now that we know the expected utility of
participating in the lottery, what is the
expected utility of not participating in the
lottery? Well you get nothing if you dont buy
a ticket so we are left with the following
utility.
EUi(~L) = 0

Lottery Example (2)

So how do we figure out if we should play the
lottery? Much the case of simple Utilities we
compare our expected utilities and see which
one is greater.

EUi(L) > EUi(~L)

p(W)*1000 2 > 0
p(W)*1000 > 2
p(W) > 2/1000
p(W) > 1/500

The probability that we win must be greater than or

equal to 1/500 for us to rationally play this lottery.
Since the probability of winning a lottery is never
greater than 1/500 we know that we should never play
the lottery.