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LectureNotes6

The document discusses the expected utility theorem by von Neumann and Morgenstern, which establishes that rational preferences can be represented by a utility function that is linear in probabilities. It highlights the relationship between outcomes and their probabilities, emphasizing that while expected utility is linear in probabilities, it is not necessarily linear in outcomes. An example involving a consumer's demand for insurance illustrates how expected utility can be applied to analyze decision-making under risk.

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2 views

LectureNotes6

The document discusses the expected utility theorem by von Neumann and Morgenstern, which establishes that rational preferences can be represented by a utility function that is linear in probabilities. It highlights the relationship between outcomes and their probabilities, emphasizing that while expected utility is linear in probabilities, it is not necessarily linear in outcomes. An example involving a consumer's demand for insurance illustrates how expected utility can be applied to analyze decision-making under risk.

Uploaded by

menocarehonestly
Copyright
© © All Rights Reserved
Available Formats
Download as PDF, TXT or read online on Scribd
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46 6.

1 Expected utility

(1−α)h  αg +(1−α)h whenever f  g, as a result of consequentialism. That is, it


is either f or h that will happen/be consumed (never both), so the compound lottery
h should be irrelevant for preference between f and g. Note, that this in particular
means, that f  g if and only if αf + (1 − α)g  g, and f  αf + (1 − α)g. Therefore,
the axiom implies that the preferences relation is preserved for any linear combination
of the lotteries in question. Having that we can state the expected utility theorem.

Theorem 6.1 (von Neumann-Morgenstern) Suppose  is rational, continuous


preference relation satisfying independence. Then there exists numbers ui (unique up
to affine transformation) for each element of X such that
n
X n
X
(f1 , f2 , . . . , fn ) = f  g = (g1 , g2 , . . . , gn ) iff fi ui ≥ gi ui .
i=1 i=1

The von Neumann and Morgenstern (1944) theorem shows that the utility func-
tion we can use to evaluate (represent) lotteries take a very simple form of a linear
function, weighting utilities of outcomes ui with probabilities of these outcomes fi .
More generally, if we consider some random variable taking values x ∈ X with prob-
ability p(x), then the expected utility of choosing such a random variable is simply
P R
i u(xi )pi or X u(x)p(x)dx, where we set u(xi ) := ui . Observe that although the
expected utility is linear in probabilities it is not necessarily linear in outcomes, i.e.
x → u(x) need not be linear. That is to say that expected utility is not necessarily an
expected value of a random variable taking values in X. This observation is critical
to measure risk. Moreover although the utility u is defied on the set of outcomes X,
that in principle could be very general, and correspond to a consumption set, we often
focus on X as representing the wealth levels and u as an indirect utility function. As
we will mention later one needs to be cautious, though, when utilities are not defined
over monetary payoffs.

Example 6.1 (Demand for insurance) Consider a consumer with initial wealth
w facing a risk of loosing l with probability p. His expected utility from such a lottery
is pu(w − l) + (1 − p)u(w). There is also an insurance company selling policies to
cover a loss of q at price (premium) πq. To analyze the demand for such insurance
consider a maximization problem maxq≥0 pu(w − l + q − πq) + (1 − p)u(w − πq). The
fact that price −πq appears in both outcomes means that the premium must be paid
in advance of resolution of uncertainty, however, cover q is only present in case of a
loss. The first order condition for optimal cover q ∗ is then
pu0 (w − l + q ∗ − πq ∗ ) π
= ,
(1 − p)u0 (w − πq ∗ ) 1−π
equating marginal rate of substitution between states with the relative price of an
additional unit of a cover.

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