Decision Making Under Uncertainty

Overview The author says that economic decisions made under uncertainty are essentially gambles.
Let’s first look at some gambles, and then come back to decisions under uncertainty. Initially, our
gamble will be to flip a fair coin (one where the probability of a head is .5 and the probability of a tail
is .5). The payout will depend on which side of the coin is showing when the coin lands at rest.

Examples Facts about several gambles with a fair coin: Gamble 1 – heads means you win $100 and tails
means you lose $0.50 Gamble 2 – heads means you win $200 and tails means you lose $100 Gamble 3 –
heads means you win $20000 and tails means you lose $10000 Note what a person would lose on each
gamble. Many people would say the loses in gambles 2 and 3 make them uneasy and they wouldn’t take
those gambles. But, some folks out there might take gambles 2 and 3.

Digress – the mean What is the mean or the average of the numbers 4 and 6? You probably said 5 and
you are right. This could be written (4+6)/2 = (4/2) + (6/2) = (1/2)4 + (1/2)6, where in this last form you
see each number multiplied by ½. In this context the mean is said to be a simple weighted average, with
each value weighted by ½. What would the weights be if we wanted the average of 4, 5, and 6? 1/3! In
general with n numbers the weight is 1/n. In other situations we may look at a weighted average (not
simple), though the weights are found in a different way.

Back to example The expected value of a gamble is a weighted average of the possible payout values
and the weights are the probabilities of occurrence of each payout. We talk about EVi as the expected
value of gamble i. EV1 = .5(100) + .5(-0.50) = 50 – 0.25 = 49.75. (Notice when you lose the loss is
subtracted out.) EV2 = .5(200) + .5(-100) = 100 – 50 = 50 EV3 = .5(20000) + .5(-10000) = 10000 – 5000 =
5000

Example In our example the EV for each gamble is positive. The EV is the highest for gamble 3. But,
remember we said not many folks would probably like it because of the uneasiness they would feel by
losing the 10000. A couple of guys named Von Neumann (both names are just the person’s last name)
and Morgenstern created a model we now call the expected utility model to deal with situations like
this. They indicated folks make decisions based not on monetary values, but based on utility values. Of
course the utility values are based on the monetary values, but the utility values also depend on how
people view the world.
Expected Utility Say we observe a person always buying chocolate ice cream over vanilla ice cream when
both are available and both cost basically the same, or even when chocolate is more expensive and
always when chocolate is the same price or cheaper. So by observing what people do we can get a feel
for what is preferred over other options. When we assign utility numbers to options the only real rule
we follow is that higher numbers mean more preference or utility. Even when we have financial options
we can study or observe the past to get a feel for our preferences.