Utility Analysis PDF

IME634: Management
Decision Analysis
Raghu Nandan Sengupta
Industrial & Management Department
Indian Institute of Technology Kanpur
IME634:MDA RNSengupta,IME Dept.,IIT 1

Kanpur,INDIA
Utility Analysis
Consider the same type of construction project is being
undertaken by more than one company, who we will
consider are the investors. Now different investors
(considering they are investing their money, time,
energy, skill, etc.) have different attributes and risk
perception for the same project
That is to say, each investor has with him/her an
opportunity set. This opportunity set is specific to that
person only.

Kanpur,INDIA
Utility Analysis
Consider a shop floor manager has two
different machines, A and B, (both
doing the same operation) with
him/her. The outcomes for the two
different machines are given

Kanpur,INDIA
Utility Analysis
A B
Outcome value(i) P[i] Outcome value(i) P[i]
15 1/3 20 1/3
10 1/3 12 1/3
15 1/3 8 1/3
In reality what would a person do if he or she has two outcome sets in
front of him/her.
For A we have the expected value of outcome as 13.33 and for B also
it is 13.33

Kanpur,INDIA
Utility Analysis
A B
Outcome value(i) P[i] Outcome value(i) P[i]
15 ½ 20 1/3
10 ¼ 12 1/3
15 ¼ 8 1/3
Now for A we have the expected value of outcome as 13.75 and for B
it is still 13.33.

Kanpur,INDIA
Utility Analysis
Outcome Team X Team Y
Wins 40 45
Draws 20 5
Losses 10 20
Case I Case II
Outcome Points Outcome Points
Win 2 Win 5
Draw 1 Draw 1
Lose 0 Lose 0

Kanpur,INDIA
Utility Analysis
Case I
Team A = 100; Team B = 95, which means
A > B, i.e., A is ranked higher than B.
Case II
Team A = 220; Team B = 230, which means
B > A, i.e., B is ranked higher than A.

Kanpur,INDIA
Utility Analysis
On a general nomenclature we should have
the expected value or utility given by
N (W )
E[U ]   U (W )
W  N (W )
W
here U(W) is the utility function which is a
function of the wealth, W, while N(W) is the
number of outcomes with respect to a certain
level of income W.

Kanpur,INDIA
Utility Analysis
Remember in general utility values
cannot be negative, but many function
may give negative values.
For analysis to make the problem
simple we may consider the value to
be zero even though in actuality it is
negative.
Kanpur,INDIA
Utility Analysis
Consider an example where a single individual is facing the same set of outcomes at
any instant of time but we try to analyze his/her expected value addition or utility
separately based on two different utility functions
1) U[W(1)] = W(1) +1
2) U[W(2)] = W(2)2 + W(2)
Outcome W(1) U[W(1)] P(W(1) W(2) U[W(2)] P(W(2)
15 1.5 2.5 0.15 1.5 3.75 0.15
20 2.0 3.0 0.20 2.0 6.00 0.20
25 2.5 3.5 0.25 2.5 8.75 0.25
10 3.0 4.0 0.10 3.0 12.00 0.10
5 0.5 1.5 0.05 0.5 0.75 0.05
25 5.0 6.0 0.25 5.0 30.00 0.25
Accordingly we have E[U(1)] = 3.825 and E[U(2)] = 12.69. So we can have a different
decision depending on the form of utility function we are using.

Kanpur,INDIA
Utility Analysis
Now we have two different utility functions used one at a time for two different decisions
1) U[W(1)] = W(1) - 5 and
2) U[W(2)] = 2*W(2)-W(2)1.25
Outcome W U[W(1)] U[W(2)] Decision (A) Decision (B)
8 4 0 2.34 Yes No
3 5 0 2.52 No Yes
4 6 1 2.60 No Yes
6 7 2 2.61 Yes No
9 8 3 2.54 Yes No
5 9 4 2.41 No Yes
For utility function U[W(1)]

U(A,1)=0*8/(8+6+9)+2*6/(8+6+9)+3*9/(8+6+9)=1.69
U(B,1)=0*3/(3+4+5)+1*4/(3+4+5)+4*5/(3+4+5)=2.00
For utility function U[W(2)]

U(A,2)=2.34*8/(8+6+9)+2.61*6/(8+6+9)+2.54*9/(8+6+9)2.50
U(B,2)=2.52*3/(3+4+5)+2.60*4/(3+4+5)+2.41*5/(3+4+5) 2.50

Kanpur,INDIA
Utility Analysis
Example # 01: A venture capitalist is considering
two possibilities of investment. The first alternative is
buying government treasury bills which cost Rs.
6,00,000. While the second alternative has three
possible outcomes, the cost of which are
Rs.10,00,000, Rs. 5,00,000 and Rs. 1,00,000
respectively. The corresponding probabilities are 0.2,
0.4 and 0.4 respectively. If we consider the power
utility function U(W)=W1/2, then the first alternative
has a utility value of Rs.776 while the second has an
expected utility value of Rs. 609. Hence the first
alternative is preferred.

Kanpur,INDIA
Utility Analysis
Would the above problem give a
different answer if we used an
utility function of the form U(W)
= W1/2 + c (where c is a positive o
a negative constant)?

Kanpur,INDIA
Utility Analysis
In a span of 6 days the price of a security fluctuates and a person
makes his/her transactions only at the following prices. We
assume U[P] = ln(P)
Day P U[P] Number of Outcomes Probability
1 1000 6.91 35 0.35
2 975 6.88 20 0.20
3 950 6.86 10 0.10
4 1050 6.96 15 0.15
5 925 6.83 05 0.05
6 1025 6.93 15 0.15
Expected utility is 6.91
If U[P]= P0.25, then expected utility is 33.63

Kanpur,INDIA
Utility Analysis (Important properties)
General properties of utility functions
1) Non-satiation: The first restriction placed on
utility function is that it is consistent with
more being preferred to less. This means
that between two certain investments we
always take the one with the largest outcome,
i.e., U(W+1) > U(W) for all values of W.
Thus dU(W)/dW > 0

Kanpur,INDIA
2) If we consider the investors or the
decision makers perception of absolute
risk, then we have the concept/property
of (i) risk aversion, (ii) risk neutrality
and (iii) risk seeking. Let us consider
an example now

Kanpur,INDIA
Invest Prob Do not invest Prob
2 ½ 1 1
0 ½
Price for investing is 1 and it is a fair gamble,
in the sense its value is exactly equal to the
decision of not investing

Kanpur,INDIA
Thus
 U(I1)*P(I1) + U(I2)*P(I2) < U(DI)*1
 risk averse
 U(I1)*P(I1) + U(I2)*P(I2) = U(DI)*1
 risk neutral
 U(I1)*P(I1) + U(I2)*P(I2) > U(DI)*1
 risk seeker

Kanpur,INDIA
Another characteristic by which to classify a
risk averse, risk neutral and risk seeker person
is
 d2U(W)/dW2 = U(W) < 0 risk averse
 d2U(W)/dW2 = U(W) = 0 risk neutral
 d2U(W)/dW2 = U(W) > 0 risk seeker

Kanpur,INDIA
Utility curves
U (W )

Kanpur,INDIA
Utility Analysis and Marginal Utility
Marginal Utility Function
 Marginal utility function looks like a concave
function  risk averse
 Marginal utility function looks neither like a
concave nor like a convex function  risk
neutral
 Marginal utility function looks like a convex
function  risk seeker

Kanpur,INDIA
Marginal Utility Rate
 Marginal utility rate is increasing at a
decreasing rate  risk averse
 Marginal utility rate is increasing at a constant
rate  risk neutral
 Marginal utility rate is increasing at a
increasing rate  risk seeker

Kanpur,INDIA
Risk avoider
U (W )
W1 W1  1 W1  2
W

Kanpur,INDIA
Risk neutral
U (W )
W1 W1  1 W1  2 W

Kanpur,INDIA
Risk seeker
U (W )
W1 W1  1 W1  2 W

Kanpur,INDIA
Few other important concepts
Condition Definition Implication
Risk aversion Reject a U(W) < 0
fair gamble
Risk neutrality Indifference to U(W) = 0
a fair gamble
Risk seeking Select a U(W) > 0
fair gamble

Kanpur,INDIA
Utility Analysis
(Other concepts, i.e., A(W))
3) Absolute risk aversion property of utility
function where by absolute risk aversion we
mean
A(W) = - [d2U(W)/dW2]/[dU(W)/dW]
= - U(W)/U(W)

Kanpur,INDIA
Utility Analysis
• Assume an investor has wealth of amount W and a
security with an outcome represented by Z, which is a
random variable.
• Assume Z is a fair gamble, such that E[Z] = 0 and V[Z]
= 2Z and the utility function is U(W).
• If WC is the wealth such that we can write this as a
decision process having two chooses, i.e.,
Choice A Choice B
W+Z WC

Kanpur,INDIA
Utility Analysis
• Now if the person is indifferent between decision/choice
A and decision/choice B, then we must have E[A] =
E[B], i.e., E[U(W+Z)] = E[U(WC)] = U(WC)*1
• The person is willing to give maximum of (W – WC) to
avoid risk, i.e., the absolute risk (say ) = (W- WC).
• Expanding U(W+Z) in a Taylors series around W and
we would get the answer.
Assignment # 01: This is an assignment and for the
proof check any good book in economics or game theory
which has utility as a part of it

Kanpur,INDIA
Utility Analysis
For the three different types of persons
 Decreasing absolute risk aversion
 A(W) = dA(W)/d(W) < 0
 Constant absolute risk aversion
 A(W) = dA(W)/d(W) = 0
 Increasing absolute risk aversion
 A(W) = dA(W)/d(W) > 0

Kanpur,INDIA
Utility Analysis
Condition Definition Property
1) Decreasing As wealth A(W) < 0
absolute risk increases the amount
aversion held in risk assets
increases
2) Constant As wealth A(W) = 0
remains the same
3) Increasing As wealth A(W) > 0
decreases

Kanpur,INDIA
Utility Analysis
(Other concepts, i.e., R(W))
4) Relative risk aversion property of utility
function where by relative risk aversion we
mean
R(W) = - W * [d2U(W)/dW2]/[dU(W)/dW]
= - W * U(W)/U(W)

Kanpur,INDIA
Utility Analysis
• Consider the same example as the previous
prove but now with /= (W- WC)/W, which is
the per cent of money the person will give up in
order to avoid the gamble and E[Z]=1.
• Z represented the outcome per rupee invested.
• Therefore for W invested we obtain W*Z
amount of money. On the other hand we have a
sure investment of WC.

Kanpur,INDIA
Utility Analysis
• For the investor to be indifferent between the two
decision processes we must have: E[U(W*Z)] =
E[U(WC)]
• Consider now E(U(W*Z)] and expanding it in a
Taylors series around W and we would get our
result
Assignment # 02: This is an assignment and for
the proof check any good book in economics or
game theory which has utility as a part of it
Kanpur,INDIA
Utility Analysis
For the three different types of persons
 Decreasing relative risk aversion
 R(W) = dR(W)/dW < 0
 Constant relative risk aversion
 R(W) = dR(W)/dW = 0
 Increasing relative risk aversion
 R(W) = dR(W)/dW > 0

Kanpur,INDIA
Utility Analysis
Condition Definition Property
1) Decreasing As wealth increases R(W) < 0
relative risk the % held in risky
aversion assets increases
2) Constant As wealth increases R(W) = 0
aversion assets remains the
same
3) Increasing As wealth increases R(W) > 0
aversion assets decreases

Kanpur,INDIA
Examples of Utility Functions
Quadratic: U(W) = W – b*W2
Then:
 A(W)=4*b2/(1- 2*b*W)2
 R(W)=2*b/(1- 2*b*W)2
Hence we use this utility function for people
with
(i) increasing absolute risk aversion
(ii) increasing relative risk aversion

Kanpur,INDIA
W W-b*W^2 A(W) A'(W) R(W) R'(W)
2.00 3.00 -0.25 0.06 -0.50 -0.13
3.00 5.25 -0.20 0.04 -0.60 -0.08
4.00 8.00 -0.17 0.03 -0.67 -0.06
5.00 11.25 -0.14 0.02 -0.71 -0.04
6.00 15.00 -0.13 0.02 -0.75 -0.03
7.00 19.25 -0.11 0.01 -0.78 -0.02
8.00 24.00 -0.10 0.01 -0.80 -0.02
9.00 29.25 -0.09 0.01 -0.82 -0.02
10.00 35.00 -0.08 0.01 -0.83 -0.01
11.00 41.25 -0.08 0.01 -0.85 -0.01

Kanpur,INDIA

Kanpur,INDIA
Logarithmic: U(W) = ln(W)
Then:
 A(W) = - 1/W2
 R(W) = 0
We use this utility function for people with
(i) decreasing absolute risk aversion
(ii) constant relative risk aversion

Kanpur,INDIA
W ln(W) A(W) A'(W) R(W) R'(W)
1.00 0.00 -1.00 -1.00 -1.00 0.00
2.00 0.69 -0.50 -0.25 -1.00 0.00
3.00 1.10 -0.33 -0.11 -1.00 0.00
4.00 1.39 -0.25 -0.06 -1.00 0.00
5.00 1.61 -0.20 -0.04 -1.00 0.00
6.00 1.79 -0.17 -0.03 -1.00 0.00
7.00 1.95 -0.14 -0.02 -1.00 0.00
8.00 2.08 -0.13 -0.02 -1.00 0.00
9.00 2.20 -0.11 -0.01 -1.00 0.00
10.00 2.30 -0.10 -0.01 -1.00 0.00
Kanpur,INDIA
U(W)=ln(W)
2.50
2.00
1.50
1.00 U(W)
U(W)
A(W)
0.50
A'(W)
0.00 R(W)
.00 2.0
0 0
3.0 4.0
0 0
5.0 6.0
0
7.0
0 0 0
8.0 9.0 10.0
0 R'(W)
-0.50 1
-1.00
-1.50
W

Kanpur,INDIA
Exponential: U(W) = - e-aW
Then:
 A(W) = 0
 R(W) = a
(i) constant absolute risk aversion
(ii) increasing relative risk aversion

Kanpur,INDIA
W U(W) A(W) A'(W) R(W) R'(W)
2.00 -1.65 -0.25 0.00 0.50 0.25
3.00 -2.12 -0.25 0.00 0.75 0.25
4.00 -2.72 -0.25 0.00 1.00 0.25
5.00 -3.49 -0.25 0.00 1.25 0.25
6.00 -4.48 -0.25 0.00 1.50 0.25
7.00 -5.75 -0.25 0.00 1.75 0.25
8.00 -7.39 -0.25 0.00 2.00 0.25
9.00 -9.49 -0.25 0.00 2.25 0.25
10.00 -12.18 -0.25 0.00 2.50 0.25
11.00 -15.64 -0.25 0.00 2.75 0.25

Kanpur,INDIA
U(W)=-exp(-a*W)
5.00
0.00
2.00 3.00 4.00 5.00 6.00 7.00 8.00 9.00 10.00 11.00 U(W)
-5.00 A(W)
U(W)
A'(W)
-10.00 R(W)
R'(W)
-15.00
-20.00
W

Kanpur,INDIA
Power: U(W) = c*Wc
Then:
 A(W) = (c-1)/W2
 R(W) = 0.
(i) decreasing absolute risk aversion
(ii) constant relative risk aversion

Kanpur,INDIA
W U(W) A(W) A'(W) R(W) R'(W)
2.00 0.30 0.38 -0.19 -0.75 0.00
3.00 0.33 0.25 -0.08 -0.75 0.00
4.00 0.35 0.19 -0.05 -0.75 0.00
5.00 0.37 0.15 -0.03 -0.75 0.00
6.00 0.39 0.13 -0.02 -0.75 0.00
7.00 0.41 0.11 -0.02 -0.75 0.00
8.00 0.42 0.09 -0.01 -0.75 0.00
9.00 0.43 0.08 -0.01 -0.75 0.00
10.00 0.44 0.08 -0.01 -0.75 0.00
11.00 0.46 0.07 -0.01 -0.75 0.00
Kanpur,INDIA
U(W)=cW^c
0.60
0.40
0.20
U(W)
0.00
A(W)
U(W)
2.00 3.00 4.00 5.00 6.00 7.00 8.00 9.00 10.00 11.00
-0.20 A'(W)
-0.40 R(W)
R'(W)
-0.60
-0.80
-1.00
W

Kanpur,INDIA
Utility Function (An Example)
Example # 02:Suppose U(W) = W1/4 and we are required to
find the properties of this utility function and also draw the
utility function graph.
Now

Kanpur,INDIA
Let us find absolute risk aversion and relative risk aversion
properties of this particular utility function.

Kanpur,INDIA
Now from the two equations we easily see that:
1. We have decreasing absolute risk aversion property,
i.e., as the amount of wealth (W) increases the
amount held in risky assets also increases.
2. We have constant relative risk aversion property,
i.e., as the amount of wealth (W) increases the %
held in risky assets remains the same.

Kanpur,INDIA
Now the U(W) looks like as shown in the graph.

Kanpur,INDIA
Utility Analysis
The actual value of expected utility is of no
use, except when comparing with other
alternatives. Hence we use an important
concept of certainty equivalent, which is the
amount of certain wealth (risk free) that has
the utility level exactly equal to this expected
utility value.
We define U(C) = E[U(W)], where C is the
certainty value

Kanpur,INDIA
Utility Analysis
How is this value of certainty equivalent (C)
useful
 Suppose that we have a decision process with a
set of outcomes, their probabilities and the
corresponding utility values. In case we want to
compare this decision process we can find the
certainty equivalent so that comparison is easier.
 To find the exact form of the utility function for a
person who is not clear about the form of utility
function he/she uses.

Kanpur,INDIA
Utility Analysis
Example # 03: Suppose you face two options. Under
option # 1 you toss a coin and if head comes you win
Rs. 10, while if tail appears you win Rs. 0. Under
option # 2 you get an amount of Rs. M. Also assume
that your utility function is of the form U(W) = W –
0.04*W2. It means that after you win any amount the
utility you get from the amount you won.
For the first option the expected utility value would be
Rs. 3, while the second option has an expected utility of
Rs. M – 0.04*M2. To find the certainty equivalent we
should have U(M) = M – 0.04*M2 = 3. Thus M = 3.49,
i.e., C = 3.49, as U(3.49) = E[U(W)]

Kanpur,INDIA
Utility Analysis
The above example illustrates that you would be
indifferent between option # 1 and option # 2.
Now suppose if you face a different situation
where you have option # 1 as before but a
different option # 2 where you get Rs. 5. Then
obviously you would choose option # 2 here, as
U(5) = (5 - 0.04*52) = 4 > 3.49.
For the venture capital problem the certainty
value for the option # 2 is Rs. 370881, as
U(370881) = (370881)0.5 = 609

Kanpur,INDIA
Utility Analysis
 A risk averse person will select a
equivalent certain event rather than the
gamble
 A risk neutral person will be indifferent
between the equivalent certain event and
the gamble
 A risk seeking person will select the
gamble rather than the equivalent certain
event

Kanpur,INDIA
Utility Analysis
A B
Expected Value

Kanpur,INDIA
Utility Analysis
• A and B are wealth values, i.e., values of W. Also for
ease of our analysis we consider that U(W)=W.
• Form a lottery such that it has an outcome of A with
probability p and the other outcome is B with a
probability (1-p).
• Change the values of p and ask the investor how much
certain wealth (C) he/she will have in place of the
lottery. Thus C varies with p.
• Now the expected value of lottery is {p*A+(1-p)*B}. A
risk averse person will have C < {p*A+(1-p)*B}.
• Plot the values of C and you already have the expected
values of the lottery.

Kanpur,INDIA
Utility Analysis
• How would you find the explicit form of the utility
function of a person. Suppose you know that it is of the
form U(W) = - e –aW.
• You ask the person that given a lottery which has a 50-50
chance of winning Rs. 1,000,000 or Rs. 4,00,000. In order
to buy this lottery what was he/she willing to pay.
• Suppose the answer is Rs. 5,00,000 (say for example),
then it means that the person is indifferent between a
certain equivalent amount of Rs. 5,00,000 and the lottery
(which is a fair gamble).
• Hence: 1*(- e-500000*a)= 0.5*(-e-1000000*a) + 0.5*(-e-400000*a).
• Solving through iteration process we can find a.

Kanpur,INDIA
Utility Analysis (Axioms)
Axioms of utility functions
1) An investor can always say whether A = B, A > B or A <
B
2) If A > B and B > C, then A > C
3) Consider X = Y. Then assume we combine with X with
another decision Z, such that X is with P(X) = p and Z is
with P(Z) =1-p. On the same lines we have the same
decision Z with Y, such that Y is with P(Y) = p and Z is
with P(Z) = 1-p. The X+Z = Y+Z
4) For every gamble there is a certainty equivalent such
that a person is indifferent between the gamble and the
certainty equivalent

Kanpur,INDIA
Comparison of MV and Utility Analysis
Comparison between mean-variance and utility function
The utility function used is (U(W)=W-bW2), which is quadratic
Consider we have three assets and the prices are as follows
No A B C R(A) R(B) R(C) P(i)
1 100 105 80 --- --- --- 1/5
2 110 115 90 1.10 1.09 1.13 1/5
3 115 120 95 1.05 1.04 1.06 1/5
4 120 125 105 1.04 1.04 1.11 1/5
5 125 130 130 1.04 1.04 1.24 1/5

Kanpur,INDIA
Then:
R A  1.06 ; RB  1.05; RC  1.14
 A  0.025 ; B  0.022; C  0.052
W A  114 ;WB  119;WC  100
If risk less interest (in terms of total return) is 0.5, then using mean-
variance analysis we rank the assets as
     
B RB  R f /  B  25.0  A RA  R f /  A  22.4   
 
CRC  R f /  C  12.3
Using quadratic utility function U(W) = W – b*W2, with b = -0.002 we

rank the assets as
B [U(B) = 90.68] > A [U(A) = 88.01] > C [U(C) = 80.00]

Kanpur,INDIA
Consider the following example with two different sets of outcomes. The
utility function is U[W] = W2 + W
Outcome Outcome W U[W] P(W)
Scenario 1 Scenario 2
15 20 1.5 3.75 (15+20)/212
20 12 2.0 6.00 (20+12)/212
25 25 2.5 8.75 (25+25)/212
10 17 3.0 12.00 (10+17)212
5 8 3.5 15.75 (5+8)/212
25 30 4.0 20.00 (25+30)/212
Accordingly we have to calculate the expected utility value

Kanpur,INDIA
Decisions and Utility Analysis
Deterministic vs Probabilistic
b1
h1
w1
1  h1 0
p1 w2
p2
p3 w3
h4 b4
p4
w4
1  h4 0

Kanpur,INDIA
People have other criteria for
investment/project/portfolio solutions
and they are
 Geometric mean return
 Safety first criteria
 Stochastic dominance
 Analysis in terms of characteristics of
the return distribution

Kanpur,INDIA
Geometric mean return
For the selection process we consider
the maximum GM has:
 The highest probability of reaching or
exceeding any given wealth level in the
shortest possible time.
 The highest probability of exceeding
any given wealth level over any given
period of time
Kanpur,INDIA
Ri,j = ith possible return on the jth portfolio.
p1, j pn, j
RG , j  (1  R1, j )  ......  (1  Rn, j ) 1
pi,j = probability of ith outcome for jth

portfolio.
Then choose the maximum of the GM values

Kanpur,INDIA
Example # 04: Consider we have the following
combinations of assets A, B and C in the following ratios
(weights) to form a portfolio P. The returns are 10, 20, 30
respectively.
A B C
1 0.20 0.20 0.60
2 1/3 1/3 1/3
3 0.25 0.25 0.50
• RP,1 = (1+0.10)0.20*(1+0.20)0.20*(1+0.30)0.60 – 1 = 0.237
• RP,2 = (1+0.10)1/3*(1+0.20)1/3*(1+0.30)1/3 – 1 = 0.197
• RP,3 = (1+0.10)0.25*(1+0.20)0.25*(1+0.30)0.50 – 1 = 0.222
Note: Hence choose scenario # 1

Kanpur,INDIA
 Maximizing GM return is equivalent to
maximizing the expected value of log
utility function
 Projects/Investment/Portfolios that
maximize the GM return are also mean-
variance efficient if returns are log-
normally distributed

Kanpur,INDIA
Safety first principle
 Under safety first principle the basic
tenet is that the decision maker is unable
or unwilling to consider the utility
theorem for making his/her decision
process
 Under this methodology people make
their decision placing more importance
to bad outcomes
Kanpur,INDIA
(Concepts)
Safety first principles (rules)
 Min Pr[RP<RL]
 Max RL
 Max RP

Kanpur,INDIA
(Concepts)
If returns are normally distributed then the optimal
portfolio would be the one where RL was the maximum
number of SD away from the mean
Let us consider an example for Min P[Rp < RL].
Remember we consider the returns are normally
distributed and the suffix P denotes the portfolio while
RL means a fixed level of return (5).
A B C
RP 10 14 17
P 5 4 8
Diff from 5% -1*A -2.25* B -1.5*C

Kanpur,INDIA
(Concepts)
2 * A 2 * B
RL RA RB

Kanpur,INDIA
(Concepts)
In order to determine how many SDs, RL
lies below the mean we calculate RL minus
the mean return divided by the SD. Thus
we have
 RL  RP   RP  RL 
min    max  
 P   P 
 RP  RF 
This is equivalent to max  
 P 

Kanpur,INDIA
(Concepts)
Even though for our example we have
simplified our assumption by considering
only normal distribution, but this would
hold for any distributions having first and
second moments.

Kanpur,INDIA
(Concepts)
According to Tchebychev (Chebyshev)
inequality for any random variable X, such
that E(X) and V(X) exists, then
 X  EX   1  RP  RP  1
Pr  t   2  Pr  K   2
 V X   t
   P  K

Kanpur,INDIA
(Concepts)
As we are interested in lower limit hence
we simply it and have
 RP  RP  1
Pr  K   2
 P  K
 RP  RP RL  RP   P2
Pr   
   RL  RP 
2
 P P

Kanpur,INDIA
(Concepts)
The right hand side of the inequality is is
exactly equal to the decision process # 1
under safety first principle we have
considered previously
 RP  RP RL  RP   P2
Pr   
   RL  RP 
2
 P P
PrRP  RL 

Kanpur,INDIA
(Concepts)
For the second criterion we have
max RL
s.t.: Pr(RP < RL)  
We are given  (say 0.05), then we should
have
 RP  RP RL  RP 
Pr    0.05
 P P 

Kanpur,INDIA
(Concepts)
`
  0.05
z RB

Kanpur,INDIA
(Concepts)
RP P*
RL , 4
R L ,3
RL , 2
RL ,1
P

Kanpur,INDIA
(Concepts)
The criterion is max RP such that
Pr(RP  RL) = , here  is predertermined
depending on the investors own
constraints. Thus with the condition we
have RP  RL  z * P

Kanpur,INDIA
(Concepts)
A2
RP A1
B2
B1
RL
P

Kanpur,INDIA
Safety First Principle (Example)
Example # 05: Considering we have projects A, B,
C and D and we need to rank them using the
concept of safety first principle. The information is
as follows

Kanpur,INDIA
As per safety first principle we have: min {RP,jRL}
where: (i) i = 1, 2,….., m, (number of projects) and (ii)
j = 1, 2,….., n (number of jobs/activities/financial
decisions in each project).
Thus:

Kanpur,INDIA

Kanpur,INDIA
Stochastic Dominance
• First-order stochastic dominance
• Second-order stochastic
dominance
• Third-order stochastic
dominance

Kanpur,INDIA
First Order Stochastic (FOS)
Dominance
• A lottery F dominates G then the
decision maker prefers F to G
regardless of what U(W) is, as long as
it is
– Weakly increasing (i.e., U(Wi)  U(Wj),
where Wi  Wj)

Kanpur,INDIA
FOS Dominance (contd…)
• F dominates G iff
• Simply stated it means that every

individual with increasing utility
function prefers FW to GW regardless
of his/her risk preferences.

Kanpur,INDIA
FOS Dominance (contd…)
First-order stochastic dominance
• F dominates G iff FW(W)GW(W)
• This definition requires that FW gives
more wealth than GW realization by
realization.

Kanpur,INDIA
Second Order Stochastic (SOS)
Dominance
• A lottery F dominates G if the decision
maker prefers F to G as long as he/she
is
– Risk averse
– U(W) is weakly increasing (i.e., U(Wi) 
U(Wj), where Wi  Wj)

Kanpur,INDIA
Loss Functions
 In the course of a statistical estimation
problem, observations (collectively, the
sample) pertaining to a data set are regarded
as realizations of a random element (X) with
which is associated a probability law P
 Usually, P is specified by the cumulative
distribution function (d.f.) of X, namely, F(x)
= P(X x), xR=(-, )
 Generally, F is not completely known, and we
are usually interested in drawing statistical
conclusion about the parameters,  = (F)
which are functionals of the d.f. F

Kanpur,INDIA
Loss Functions (contd…)
 In a parametric model, the assumed functional
form of F may involve some unknown
algebraic constant(s), which are interpreted as
the parameters, e.g., in the normal d.f., the
algebraic constants are themselves the mean
() and the variance (2)
 The objective in point estimation is to utilize
the information in the given set (X1,….., Xn)
of sample observations (random variables) to
choose a suitable statistic Tn = T(X1, X2,..…,
Xn) such that Tn estimates  (parameter) in a
meaningful way

Kanpur,INDIA
Loss Functions (contd…)
 Imposing consistency and unbiasedness does
not always lead to a unique estimator of 
 A good idea is to locate an optimal estimator
within the class of consistent (and possibly,
unbiased) estimators
 One idea is to choose a nonnegative metric
L(Tn , ) defined for all , where  varies over
(the parameter space) while Tn varies over
(the sample space, which is usually a subset of
Rn, the n-dimensional Euclidean space)

Kanpur,INDIA
Squared Error Loss (SEL) Function
• The loss function is of the form L(Tn , ) =
(Tn - )2 and looks like as give below
L()

Squared Error Loss function
IME634:MDA Raghu N. SENGUPTA,IME Dept.,IIT 96

Kanpur,INDIA
SEL Function (contd…)
 Most widely used loss function and is used in estimation
problems when unbiased estimators of  are considered, since
the risk, R(Tn , ) ( = E[L (Tn , )] = E[(Tn - )2]) is the mean
square error (MSE) of Tn, which reduces to the variance of Tn
subject to unbiasedness
 The corresponding optimal estimator, if it exists, is called the
minimum variance unbiased (MVU) estimator
 Another reason for the popularity of SEL is due to its
relationship to the classical least square theory. Also, for most
analyses SEL makes calculation relatively straight forward.

Kanpur,INDIA
Weighted SEL Function
 A generalization of SEL, which is of
interest, is L( , Tn) = w()( - Tn)2 and it is
termed as the weighted squared error loss
which has the attractive feature of allowing
the squared error, to be weighted by a
function of , which may be useful for many
practical problems.

Kanpur,INDIA
Quadratic Loss Function
 If =(1,…,n) is a vector estimated
by T=(T1,…,Tn) and Q is (nXp)
positive definite matrix, then,
L(,T)=(-T)/Q(-T) is called a
quadratic loss function

Kanpur,INDIA
Linear Loss Function
• When the utility function is
approximately linear the loss
function will tend to be linear in
nature which is of the form,
• L( - Tn) = K1( - Tn) if ( - Tn)  0
= K2(Tn - ) if ( - Tn) < 0
Kanpur,INDIA
Absolute Error Loss Function
• The constants K1 and K2 are to be chosen to
reflect the relative importance of
overestimation and underestimation. In
general, these constants are different
• When they are equal, the equivalent loss
function is of the form L( , Tn) = | - Tn|,
which is called absolute error loss

Kanpur,INDIA
(contd…)
L()=L(Tn,)
=(Tn-)

Kanpur,INDIA
(contd…)
• The optimal estimator for this absolute
error loss function, if it exists, is called
the minimum mean absolute error
estimator
• If K1 and K2 are themselves functions of
, then the loss function is termed as the
weighted linear loss function

Kanpur,INDIA
Weighted Absolute Error Loss Function
L()=L(Tn,)
=(Tn,)

Kanpur,INDIA
Weighted Absolute Error Loss
Function (contd…)
L()=L(Tn,)
=(Tn,)

Kanpur,INDIA
0-1 Loss Function
• This is of the form
L( , Tn) = 1, if |Tn - | > ,
= 0, otherwise
for 0 <  < 1
• Here risk is P(|Tn - | > )
• This refers to the large deviation probability, and the
optimality of an estimator Tn is interpreted in terms of
minimization of this probability or in terms of the fastest
rate of decline (with n) of this probability

Kanpur,INDIA
Balanced Loss Function
 The BLF, (Zellner (1994)), reflects both
goodness of fit (lack of bias) and precision of
estimation
 A balanced loss function (BLF) is of the form
L(Tn,)=w{g(Tn)-g()}T{g(Tn)-g()} + (1-w) (Tn-
)T(Tn-)
with 0≤w≤1

Kanpur,INDIA
Balanced Loss Function (contd…)
 The first term represents the goodness of fit
while the second represents the precision of
estimation, which is also, termed as
accuracy
 The second term as originally used by
Zellner (1994) considers it in its quadratic
form or the squared error term

Kanpur,INDIA
Balanced Loss Function (contd…)
 The least square estimation reflects
goodness of fit consideration whereas the
use of quadratic loss function involves a sole
emphasis on precision of estimation
 Depending on the problem this term can be
modified as lin-lin, mod etc.

Kanpur,INDIA
Linear Exponential (LINEX) Loss
Function
 The fact the overestimation and
underestimation of  may be of unequal
consequence has not been properly or
adequately emphasized in any of the above
loss functions
 Varian (1975) first employs such a loss
function in real-estate assessment

Kanpur,INDIA
LINEX Loss Function (contd…)
 A loss function, which takes care of this, is the
linear exponential loss function (LINEX), (Zellner
(1986)), which is an asymmetric convex loss
function and is given by
L()=L(Tn,)=b[exp{a(Tn-)} - a(Tn-) -1]
 a determines the shape of the loss function
 b > 0 serves to scale the loss function

Kanpur,INDIA
LINEX Loss Function (contd…)
 When a > 0, the convex loss increases almost
linearly for negative error =(Tn-), and
almost exponential for positive error =(Tn-),
therefore, overestimation is of more serious
concern than underestimation
 When a < 0, the linear-exponential increases
are interchanged, whereby underestimation
becomes more serious than overestimation

Kanpur,INDIA
LINEX Loss Function (contd…) (a > 0)

Kanpur,INDIA
LINEX Loss Function (contd…) (a < 0)

Kanpur,INDIA
LINEX Loss Function: Example # 01
 Consider a company plans to launch a new
product, say a refrigerator in the consumer
market
 Also suppose that similar products from
different manufacturers already exist in the
market

Kanpur,INDIA
(contd…)
 Then the company is expected to give some
warranty for the particular product, i.e., the
refrigerator, to its customers in order to sell the
product
 Now if the value of this warranty is more than
the average time of failure for the product, then
the aforesaid mentioned company needs to
replace the damaged products it sells, or face
litigation charges

Kanpur,INDIA
(contd…)
 On the other if the warranty period is less
than the average failure time of similar
products available in the market, then the
company losses the market share to its
rivals, as naturally, customers are willing to
buy the refrigerator from the competitors
who assure a higher warranty period

Kanpur,INDIA
(contd…)
 Under such a situation it is definitely advisable
to estimate the warranty life time using an
asymmetric loss
 What values of a one should use would then
depend on the level of importance our company
places on overestimation versus
underestimation, i.e., the cost of litigation
versus the cost of a loss in the market share of
the company
Kanpur,INDIA
 As a second example, assume a civil
engineer is building a dam and he/she is
interested in finding the height of the dam
which is being built
 If due to some error the height is estimated
to be greater than the actual value then the
cost the engineer incurs are mainly due to
material and labour

Kanpur,INDIA
(contd…)
 On the other hand, if the estimated height is
less than what it should be, then the
consequences can be disastrous in terms of an
environmental impact, which in monetary
terms can be very high
 So it is logical to use a value of a < 0 in such
situations such that underestimation is
penalized more than over estimation

Kanpur,INDIA
 Finally to illustrate the significance of over
estimation when compared with
underestimation let us consider a different
real life example
 Consider an electrical company
manufactures vacuum circuit
breakers/interrupters, which are used as a
fuse in high voltage system

Kanpur,INDIA
(contd…)
 As for any product these circuit
breakers have a working life and it
is of utmost importance that this
value is estimated as accurately as
possible

Kanpur,INDIA
(contd…)
 In case they are underestimated
than what its value is in reality,
then the consequences is just labour
and man hour loss in terms of
production stoppage time

Kanpur,INDIA
(contd…)
 On the other hand if the working life of the
circuit breaker is over estimated than the actual
figure, then it would definitely signify an
exponential form of loss in monetary terms due
to an accident or major break down of
machineries
 So, for these categories of practical estimation
problems we always consider a > 0

Kanpur,INDIA

Utility Analysis PDF

Uploaded by

Document Information

Original Description:

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Utility Analysis PDF

Uploaded by

Copyright:

Available Formats

IME634: Management

IME634:MDA RNSengupta,IME Dept.,IIT 1

IME634:MDA RNSengupta,IME Dept.,IIT 2

IME634:MDA RNSengupta,IME Dept.,IIT 3

IME634:MDA RNSengupta,IME Dept.,IIT 4

IME634:MDA RNSengupta,IME Dept.,IIT 5

IME634:MDA RNSengupta,IME Dept.,IIT 6

IME634:MDA RNSengupta,IME Dept.,IIT 7

IME634:MDA RNSengupta,IME Dept.,IIT 8

IME634:MDA RNSengupta,IME Dept.,IIT 10

For utility function U[W(1)]

For utility function U[W(2)]

IME634:MDA RNSengupta,IME Dept.,IIT 11

IME634:MDA RNSengupta,IME Dept.,IIT 12

IME634:MDA RNSengupta,IME Dept.,IIT 13

If U[P]= P0.25, then expected utility is 33.63

IME634:MDA RNSengupta,IME Dept.,IIT 14

IME634:MDA RNSengupta,IME Dept.,IIT 15

IME634:MDA RNSengupta,IME Dept.,IIT 16

IME634:MDA RNSengupta,IME Dept.,IIT 17

IME634:MDA RNSengupta,IME Dept.,IIT 18

IME634:MDA RNSengupta,IME Dept.,IIT 19

IME634:MDA RNSengupta,IME Dept.,IIT 20

IME634:MDA RNSengupta,IME Dept.,IIT 21

IME634:MDA RNSengupta,IME Dept.,IIT 22

IME634:MDA RNSengupta,IME Dept.,IIT 23

IME634:MDA RNSengupta,IME Dept.,IIT 24

IME634:MDA RNSengupta,IME Dept.,IIT 25

IME634:MDA RNSengupta,IME Dept.,IIT 26

IME634:MDA RNSengupta,IME Dept.,IIT 27

IME634:MDA RNSengupta,IME Dept.,IIT 28

IME634:MDA RNSengupta,IME Dept.,IIT 29

IME634:MDA RNSengupta,IME Dept.,IIT 30

IME634:MDA RNSengupta,IME Dept.,IIT 31

IME634:MDA RNSengupta,IME Dept.,IIT 32

IME634:MDA RNSengupta,IME Dept.,IIT 33

IME634:MDA RNSengupta,IME Dept.,IIT 35

IME634:MDA RNSengupta,IME Dept.,IIT 36

IME634:MDA RNSengupta,IME Dept.,IIT 37

IME634:MDA RNSengupta,IME Dept.,IIT 38

IME634:MDA RNSengupta,IME Dept.,IIT 39

IME634:MDA RNSengupta,IME Dept.,IIT 40

IME634:MDA RNSengupta,IME Dept.,IIT 42

IME634:MDA RNSengupta,IME Dept.,IIT 43

IME634:MDA RNSengupta,IME Dept.,IIT 44

IME634:MDA RNSengupta,IME Dept.,IIT 45

IME634:MDA RNSengupta,IME Dept.,IIT 46

IME634:MDA RNSengupta,IME Dept.,IIT 48

IME634:MDA RNSengupta,IME Dept.,IIT 49

IME634:MDA RNSengupta,IME Dept.,IIT 50

IME634:MDA RNSengupta,IME Dept.,IIT 51

IME634:MDA RNSengupta,IME Dept.,IIT 52

IME634:MDA RNSengupta,IME Dept.,IIT 53

IME634:MDA RNSengupta,IME Dept.,IIT 54

IME634:MDA RNSengupta,IME Dept.,IIT 55

IME634:MDA RNSengupta,IME Dept.,IIT 56

IME634:MDA RNSengupta,IME Dept.,IIT 57

IME634:MDA RNSengupta,IME Dept.,IIT 58

IME634:MDA RNSengupta,IME Dept.,IIT 59

IME634:MDA RNSengupta,IME Dept.,IIT 60

IME634:MDA RNSengupta,IME Dept.,IIT 61

IME634:MDA RNSengupta,IME Dept.,IIT 62