C H A P TER 6

EX P EC TED U TILITY A S A
B A S IS FO R D EC IS IO N -
M A K IN G : TH E EV O LU TIO N
O F TH EO R IES
 Expected U tility
Expected utility rests on the expected utility
hypothesis.
This hypothesis is related with peoples
preferences with regard to their choices that
have uncertain outcomes.
Three main pillars of expected utility are as follows:
Outcomes, which are objects of non-
instrumental preferences.
States are the things outside the decision-
makers control which influence the outcome of
the decision.
Acts are objects of the decision-makers
instrumental preferences
 EX P EC TED VA LU E
In the presence of risky outcomes, usually a
decision-maker uses the expected value
criterion for an investment option.
The expected value (EV) is an anticipated
value for a given investment.
The EV is calculated by multiplying each of the
possible outcomes by the likelihood each outcome
will occur, and summing all of those values.
By calculating expected values, investors can
choose the scenario most likely to give them their
desired outcome.
UTILITY
The value of each outcome, measured in terms of real
numbers (mathematical form) is called a utility
D EV ELO PM EN T O F EX PECTED U TILITY
TH EO RY

Thought of Expected Utility Theory

was coined initially with the
description given in terms of
mathematical explanations given by
Nicolas Bernoulli.
In a letter to Nicolas Bernoulli,
Gabriel Cramer explained that
mathematicians estimate money
in proportion to its quantity.
 R ISK AV ER SIO N A N D EX PECTED
M A R G IN A L U TILITY
Risk aversion implies that the utility function of
risk-averse investors is concave in nature and
show diminishing marginal wealth utility.
Risk-neutral individuals have linear utility
functions, while risk-seeking individuals have
convex utility functions.
Hence the degree of risk aversion can be
measured by the curvature of the utility function.
It is further explained that concave expected
utility theory explains risk-averse behavior for
both small-stake gambles and large-stake
gambles observed in everyday life.
 Expected U tility Theory & Loss A version

The highlights of expected utility theory with

reference to loss aversion are given as
below:
Investors are consistently deviated to one side
only from the point of view of prediction of risk
neutrality and these deviations are with risk
aversion.
There is no relevance with the loss aversion in
the behavior of the investors.
In expected utility theory there is no implication
of calibration theory (comparison of
measurement values).
 EX P EC TED U TILITY TH EO RY

Expected utility theory can be

defined as the theory of
decision-making under risk
based on a set of outcomes
for preference ordering.
 Expected U tility as a B asis for D ecision-
M aking

Expected Utility Theory (EUT) states

that at the time of decision-making, the
decision maker chooses among various
risky or uncertain options by
comparing their expected utilities
with respect to his need.
 EXAMPLES
You dont know if its going to rain,
and you have to decide whether to
carry an umbrella.
If you carry an umbrella,
then there are 10 per cent chance
you lose it,
70 per cent chance you carry it
around needlessly,
20 per cent chance you use it.
 Expected U tility theory w ith R eference to
lottery

A lottery [p1, p2, ..., pn] is a list of

probabilities, where pi is the
probability with the outcome i.
John Von Neumann and Oskar
Morgenstern developed expected
utility theory with reference to
lottery as a financial instrument.
 Assumptions of utility function on lotteries
1. Completeness: which means that as per the
preference of individual lotteries can be ranked.
2. Transitivity: which means that the preferences
among different options are open.
3. Continuity: says that the upper and lower outline
sets of a preference range over lotteries are
closed.
4. Monotonicity: means that a gamble which gives
a higher probability to a preferred outcome will be
preferred to one which assigns a lower probability
to a preferred outcome.
5. Substitution: the outcomes of different lotteries
with same probability can be substituted by each
other.
 Criticism of Expected U tility Theory
Many experimental economists agree that concave
expected-utility theory explains systematic, one-
sided deviations from the predictions of risk-neutral
models because of the belief that expected utility
theory does not give right explanation of risk
attitudes over modest stakes of investors in
different asset classes. Also if the investors or
subjects considered in experiments are risk-averse,
then they are not expected-utility maximizes.
In order to clarify the fundamental differences
between expected utility theory and other decision
theories, the distinction between expected utility
theory and expected utility models need to be
made.
EX P EC TED U TILITY M O D ELS

1. The expected utility of income

and Initial wealth model (EUI
& IW)
2. The expected utility of income
model (EUI)
3. The expected utility of
terminal wealth (EUTW)
 TH E EX PECTED U TILITY O F
IN C O M E U TILITY A N D IN ITIA L
W EA LTH (EU I& IW ) M O D EL
This model assumes that the prizes are
ordered pairs of amounts of initial wealth
and income.
Indifference curves for this model are
parallel straight lines; therefore it is more
or less an expected utility model.
 TH E EX PECTED U TILITY O F IN CO M E (EU I)
M O D EL

The expected utility of income (EUI)

model is based on the assumption that
the prizes are amounts of income.
The EUI model is mostly used in the
theory of auctions.
 TH E EX PECTED U TILITY O F TO TA L
W EA LTH (EU TW ) M O D EL
The expected utility of terminal wealth
(EUTW) model is based on the assumption
that the gains are amounts of terminal
wealth.
Terminal wealth is expected cash flow in
future by applying mathematical formula
It helps to explain some essential
distinctions among various models to
briefly review the familiar triangle-diagram
representation of indifference curves for
simple gambles