Decision Making Under Risk and Uncertainty

Decision Making Under Uncertainty: Classication

We distinguish between:
decision-making under risk
the decision maker is informed about the probabilities of dierent
events;
the objects of choice are probability distributions / lotteries
and
decision-making under uncertainty
the decision maker has no information about the probabilities of
dierent events;
the objects of choice are state-contingent acts.
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Decision Making Under Risk and Uncertainty
Questions
1
How can we model uncertainty?
2
How should one make decisions under uncertainty?
3
Are probabilities objective or subjective?
4
Can we measure probabilities?
5
How does new information change our perception of probabilities?
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Decision Making Under Risk and Uncertainty
Axiomatizations
Von Neumann and Morgenstern (1947)
Anscombe and Aumann (1963)
Savage (1956)
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Decision Making Under Risk and Uncertainty
Choice over Lotteries: The Von Neumann-Morgenstern
Theory
Consider a nite set of outcomes (e.g. monetary outcomes)
Z = z
1
...z
n

The set of probability distributions / lotteries on Z is given by:

n
=
(
(p
1
...p
n
) [ p
i
_ 0 for all i 1...n and
n

i =1
p
i
= 1
)
Preferences % are dened on
n
.
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Decision Making Under Risk and Uncertainty
St. Petersburg Paradox
Consider the following game:
A coin is tossed.
If the coin lands heads after the n-th toss, you receive $2
n
and the
game stops.
If the coin lands tails, the game continues, until heads comes up.
How much would you be willing to pay to participate in this game?
The expected value of this game is...

"...the mathematicians estimate money in proportion to its quantity,

and men of good sense in proportion to the usage that they may
make of it", Gabriel Cramer.
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Decision Making Under Risk and Uncertainty
The Expected Utility Representation
We are looking for the following representation:
U (p) =
n

i =1
p
i
u (z
i
)
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Decision Making Under Risk and Uncertainty
Compound Lotteries
How can we interpret convex combinations of lotteries?
Consider the object p + (1 ) q.
Intuitively, you rst use a randomization device, which gives you
lottery p with probability and lottery q with probability (1 ).
In a second step, either p or q is actually played and the outcomes are
determined according to the corresponding probability distribution.
Our representation suggests that:
p + (1 ) q ~ (p
1
+ (1 ) q
1
...p
n
+ (1 ) q
n
)
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Decision Making Under Risk and Uncertainty
The Von-Neumann-Morgenstern Axioms
Axiom A1 (Completeness) % on
n
is complete.
Axiom A2 (Transitivity) % on
n
is transitive.
Axiom A3 (Independence)
For all p, q and r
n
, and for all [0; 1],
p % q i
p + (1 ) r % q + (1 ) r
Axiom A4 (Archimedian Axiom / Continuity)
For all p, q and r
n
, such that p ~ q ~ r , there exist numbers and
(0; 1) such that
p + (1 ) r ~ q ~ p + (1 ) r
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Decision Making Under Risk and Uncertainty
The Expected Utility Theorem
Theorem
The following two statements are equivalent:
(i ) The preference relation % on
n
satises Axioms A1 A4
(ii ) There exists a utility function u : Z R such that for all p
and q
n
,
p % q i
n

i =1
p
i
u (z
i
) _
n

i =1
q
i
u (z
i
)
Furthermore, u is unique up to a positive-ane
transformation.
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Decision Making Under Risk and Uncertainty
Lemma 1
Assume A1, A2, A3 and A4.
(i ) If p ~ q and 0 _ < _ 1, then
p + (1 ) q ~ p + (1 ) q.
(ii ) If p % r % q and p ~ q, then there exists a unique
+
such
that:

+
p + (1
+
q) ~ r .
(iii ) If p ~ q, then for all r
n
and all [0; 1],
p + (1 ) r ~ q + (1 ) r .
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Decision Making Under Risk and Uncertainty
Lemma 2
Assume A1, A2, A3 and A4. Then, there exist z
0
and z
0
Z such that for
all p
n
,

z
0 % p %
z
0
.
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Decision Making Under Risk and Uncertainty
Uniqueness of the Von-Neumann-Morgenstern Utility
Function
If function u : Z R can be used to represent a preference order % on

n
, then so can any function v given by:
v (z) =: au (z) + b
for some positive a > 0.
Ani Guerdjikova Cornell Univeristy Decision Theory II Spring 2010 43 / 126