BAC6030

Week 3: Expected Utility Theory

Learning Outcomes

 After Studying This Chapter, You Should Be Able to:

 Know how consumer tastes are measured or represented
 Describe the relationship between money and happiness
 Know how the consumer’s constraints are represented
 Understand how the consumer maximizes satisfaction or reaches equilibrium
 Describe how consumer tastes or preferences can be inferred without asking the
consumer
Misconception

 The more money you have the happier you are ! độ thỏa dụng của tài sản đấy đối với
một cá nhân (utility)
 Money can be used for things that lift the spirit
 So can more money by more satisfaction
 Yes … but only if you are careful how you use it and not to be
consumed by it
 Non-satiation ( we will return to this later)
Utility

 Why do people spend millions on a diamond Jewellery which is not essential to life
but spend pennies on water
 Answers to these questions provide an understanding of how people make personal
buying decisions
 Utility is a measure of enjoyment from the consumption of goods and services
 Measured by a util
 Measurement of Utility used in modelling and predicting what people are likely to buy
Utility
mức độ thỏa mãn của người tiêu dùng khi họ sử dụng một sản phẩm

 Utility The ability of a good to satisfy a want.

 Total utility (TU) The total satisfaction received from consuming a good or service.
 Marginal utility (MU) The extra utility received from consuming one additional unit of
a good.
 Util The arbitrary unit of measure of utility
Total and Marginal Utility
Assumptions

 Neo classical economics

– Individuals maximise utility( happiness) subject to constraints
– People have rational preferences across possible outcomes
– Price is determined by the forces of demand and supply
– People maximise utility, firms maximise profit
– People make independent decisions based on relevant information
– The decision maker choses the alternative with the highest utility
– Since people prefer to avoid risk , it is necessary to compensate them , the degree
of compensation depends on their risk aversion
Utility Example

 If John like chocolate brownies he may say it gives him 14 utils

 Some one who doesn’t like chocolate may say it give them 8 utils
 people derive different levels of satisfaction from the same good and services
depending on their personal preferences
 Investors derive different utility from different assets
 If John eats an apple pie and says it give him 5 Utils
 What conclusions can we draw regarding John, apple pie and brownies?
 Utility or satisfaction is a balance between economic and personal factors
 Rationality

 Traditional finance assumes individuals are rational

 What does that mean
 Foundations of modern finance, and rational decision making
 How people make decisions when faced with uncertainty
 Based on the assumption that people are risk averse
Rational Preferences

 Suppose you are confronted with two choices Brownies ( X) and apple pie (Y)
 X>Y means you prefer X is the preferred choice when offered X and Y
 X≥ Y indicates a weak preference and means the person prefers X or is indifferent
between X and Y. X ~Y
 X≤Y and X≥ Y means an individual is indifferent between X and Y therefore X ~ Y
Rational Preferences : Transitivity

 Now suppose an individual is confronted with three choices : Brownies (X), apple
(Y)pie and ice-cream (Z)
 According to transitivity if Brownies are preferred to apple pie and apple pie to ice
cream then Brownies are preferred to ice-cream
 If X >Y and Y>Z the X>Z
 If transitivity does not hold then individuals can not determine the optimal choice
 Therefore rational choices are transitive
Utility Maximisation

■ The utility theory describes preferences

■ Utility/ satisfaction is derived from a particular bundle of goods
choice between 2 bundles of water and bread
– U( 2 bread, 1 water ) > ( 1 bread, 2 water)
■ To reach optimal choice an individual considers all possible bundles ( subject to
wealth/ income constraints
■ Bundle chosen will be the one that maximises utility
Expected Utility Theory

 So far we have avoided uncertainty

 In financial decision making there is always uncertainty and risk ( markets are
unpredictable )
What is Expected Utility theory

■ Is a theory that takes into account how to choose rationally when you are not sure
which outcome will result from your act
– Making choices when faced with uncertainty
– Investors are faced with uncertainty when transacting in financial markets
– But …there is a difference between Uncertainty and risk
■ Demonstration
■ https://www.youtube.com/watch?v=IFnoaLSXKGg
Expected Utility Theory

 Expected Utility Theory by John Von Neumann and Oskar Morgenstern

 Individuals should act in a particular way when confronted with decision making
under uncertainty
 How people should rationally behave

 Expected Utility Theory deals with risk

 What is the difference
Uncertainty vs Risk

 Uncertainty is when you can not assign probabilities or even come up with a list of
alternative
 Is not measurable

 According to the standard ISO 31000:2009, risk is defined as “effect of uncertainty on

objectives”.
 A risk situation is one in which you know what the outcomes could be and can assign
a probability to each outcome
 Is measurable using probabilities
Risk Attitudes

 Research evidence shows that people avoid risk in most circumstances

 A risk averse investor is an investor who prefers lower returns with known risks rather
than higher returns with unknown risks
 A risk neutral investors who are insensitive to risk
 A Risk Seeker investor is an investor who prefers higher returns with known risks
Risk attitudes and Utility function
Expected Utility: Real World

■ A number of investment firms employ expected utility models as part of their security
selection process for clients
– Through the use of questionnaires and computer programs, they are able to discern
what investor preferences (utility functions) are

■ Problems:
– Investors do not always behave rationally
Properties of Utility Functions

■ Property 1: Non-satiation -- More is preferred to less (remember this from the

beginning)
■ Property 2: Risk Preferences
– Risk Averse
– Risk Loving
– Risk Neutral
■ Property 3: Preference changes with a change in wealth
– As wealth, say, increases, will the investor invest more or less in risky assets?
Property 2: Risk Preferences
■ What are the investors’ taste for risk?
■ To show the differences in individual taste for risk, it is
often explained in terms of a fair gamble

Invest Do not invest

Outcome Prob Outcome Prob
2 0.50 1 1
0 0.50
Property 2 cont’d:

Invest Do not invest

Outcome Prob Outcome Prob
2 0.50 1 1
0 0.50

The above example has an expected value of 1 if the individual decides

to invest.

Now assume that to invest, the individual would have to pay $1. If
she/he chooses not to invest, then the dollar is kept (hence, the do not
invest payoff)
Property 2 cont’d:

Invest Do not invest

Outcome Prob Outcome Prob
2 0.50 1 1
0 0.50

The point of all of this?

The expected value of making the gamble is exactly offset

by the cost
Property 2 cont’d:

■ Where does the notion of a fair gamble come in?

– It is the fact that the EXPECTATION of the investor is the same,
regardless of whether or not they make the bet

– Make note: the investor’s position may be improved or hurt if the

investment is made
■ But, the expectation (again) is that his/her position won’t change
So what does this all mean?
■ It means that we can now illustrate the difference between individual taste
towards risk
– Risk Averse:
■ If the investor is risk averse, she/he would not make the bet
– Risk Loving:
■ Would choose to make the bet
– Risk Neutral:
■ Individual is indifferent between making the bet and not
Risk Averse:
■ In the context of our previous example, this individual
prefers $1 with certainty, over an equal chance to
increase that $1 to $2.

■ In terms of modeling this type of behavior, it means that

the second derivative of utility with respect to wealth is
negative.

U (W )  0
Risk Averse cont’d:
■ Another way to put risk aversion is:
– The disutility that comes with losing is greater than the utility that is
associated with winning.

■ If we examine risk neutral and risk loving individuals, we would find that
their second derivatives are also able to explain peoples’ behavior
Risk Loving and Risk Neutral:
■ Recall
– A risk neutral investor would be indifferent between taking the
fair gamble and not
■ In other words,

U (1)  (1 / 2)U (2)  (1 / 2)U (0)

 2 and rearrange
 U (1)  U (0)  U (2)  U (1)
So, a change in utility from a one unit change in wealth is independent of
the relative magnitude; that is a change from 0 to 1, is the same as a change
from 1 to 2.
Risk Neutral and Risk Loving cont’d

■ Given the preceding analysis, we can say that an individual who is risk
neutral would have a second derivative of zero.

■ Using the above analysis, but applying the notion of risk loving would
yield a second derivative that is positive.
Summary Table:

Risk Attitude Fair Gamble Utility

Risk Aversion Reject Fair U”(0)<0
Gamble
Risk Loving Accept Fair U”(0)>0
Gamble
Risk Neutral Indifferent to Fair U”(0)=0
Gamble
Expected Utility Theory and Rationality

■ Expected Utility Theory is consistent with choice that would be made by examining the
investment directly
– That is, if people obey certain postulates of behavior (act in a certain way) they
expected utility theory will yield identical results as if we had engaged in direct
analysis
■ Problems:
– Investors do not always behave rationally