Utility Practice Problems (Solutions)

A1) Using the given utility function:

E[ U( d1) ] = 0.1 * U( 100,000) + 0.3 * U( 40,000) + 0.6 * U(-60,000)

= 0.1 * 1 + 0.3 * 0.9 + 0.6 * 0 (using the utility function table)

= 0.37

E[ U( d2) ] = 0.1 * U( 50,000) + 0.3 * U( 20,000) + 0.6 * U(-30,000)

= 0.1 * 0.94 + 0.3 * 0.8 + 0.6 * 0.4

= 0.574

E[ U( d3) ] = 0.1 * U( 20,000) + 0.3 * U( 20,000) + 0.6 * U(-10,000)

= 0.1 * 0.8 + 0.3 * 0.8 + 0.6 * 0.6

= 0.68

E[ U( d4) ] = 0.1 * U( 40,000) + 0.3 * U( 20,000) + 0.6 * U(-60,000)

= 0.1 * 0.9 + 0.3 * 0.8 + 0.6 * 0

= 0.33

The best decision for this utility function is decision 3 (d3).

A2) Since the decision maker is indifferent, their expected utility for the two decision is the same:

E[ U( sure payoff ) ] = E[ U( gamble ) ]

E[ U( $60 ) ] = 50% * U ( $100 ) + 50% * U ( $0 )

= 50% * 100 + 50% * 0

E[ U( $60 ) ] = 50

The Expected Value of the gamble is $50, and of the sure payoff is $60. A risk neutral decision maker
should take the sure payoff. Someone who values the gamble more than they should is risk seeking.
A3) Since the decision maker is indifferent, their expected utility for the two decision is the same:

E[ U(option i) ] = E[ U( option ii ) ]

65% * U ( $100 ) + 35% * U ( $0 ) = 50% * U ( $60 ) + 50% * U ( $40 )

65% * 1 + 35% * 0 = 50% * U(60) + 50% * 0.6

U( $60 ) = .7

The Expected Value of option i (riskier gamble) is $65, and of the expected value of option ii (less risky
gamble) is $50. Someone who is indifferent between a higher expected payoff with more risk (option i)
and a lower expected payoff with less risk (option ii) is risk averse.

Alternatively, we can sketch the utility function of the decision maker (the orange line) and compare it
with the utility function of the risk neutral person (the blue line) which is always a straight line. From the
graph, it is clear that the decision maker is risk averse.

1.2

0.8
Utility

0.6

0.4

0.2

0
0 20 40 60 80 100 120
Payoff

Decision Maker Risk Neutral

A4) The Expected Utility function for each alternative is as follows:

E(U(A1)) = p*U(25) + (1-p)*U(36) = p*5 + (1-p)*6 = 6-p

E(U(A2)) = p*U(100) + (1-p)*U(0) = p*10 + (1-p)*0 = 10p

E(U(A3)) = p*U(0) + (1-p)*U(49) = p*0 + (1-p)*7 = 7-7p

Graph of expected utility functions versus the value of p is as follows:

12

10

8
Expected Utility

0
0 0.2 0.4 0.6 0.8 1 1.2
prob p

E(U(A1)) E(U(A2)) E(U(A3))

As it can be seen, for very smaller values of p the best alternative is the blue line (A3), for values of p in
the middle range the red line (A1) gives us the highest utility, and for large values of p, the best
expected value is given by the green line (A2). Exact coordination of line intersections can be calculated:

A3 has highest expected utility when 0 ≤ 𝑝 ≤ $ = .1667

%

A1 has highest expected utility when 0.1667 ≤ 𝑝 ≤ %$$ = .545

A2 has highest expected utility when 0.545 ≤ 𝑝 ≤ 1