Uncertainty

Fair Gambles and Expected Utility

St. Petersburg Paradox

You are considering participation in a gamble. Suppose that a coin will be flipped until a
heads occurs. if you participate, you will be paid $ 2 n if the first heads occurs on flip n.
How much would you be willing to pay for the opportunity to participate?

Calculate the expected value (the probability weighted average) of your earnings:

1 1 1
2 4 8 ... 1 ...
2 4 8

The expected money payoff is infinite.

This means that the fair gamble price for participating is also infinite.

However, most people would not pay an infinite amount to participate (even if they
believed the prize would certainly be paid at the conclusion of the game).

How do we resolve this problem? One approach is to assume that individuals maximize
expected utility rather than expected monetary gain.

The amount one would be willing to pay to play the game would equate expected utility
of playing the game (including what you pay to play) with the certain utility you get by
not playing.

For some utility functions, expected utility associated with the gamble described above
will be bounded, even when expected wealth is not bounded.

Von Neumann-Morgenstern Utility

How might we represent utility numbers that are to be used in the calculation above?

Previously, we treated utility as a concept that had only an ordinal interpretation. Any
monotonic transformation of an individuals utility function was an equally good
representation of the individuals preferences. Unfortunately, that is not satisfactory if we
are to make decisions on the basis of expected utilities. Monotonic transformations can
change the answer to the question about how much one would be willing to pay to play
the game described above.

We really need a meaningful cardinal utility function.

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Von Neumann and Morgenstern have shown that under plausible assumptions, an
individual will act as if she had a cardinal utility function over dollar outcomes, U x .

We can construct the von Neuman-Morgenstern (VNM) utility function for a person as
follows:

1. Suppose the prizes in a lottery are x1 , x2 ,..., xn , arranged in order of worst prize to
best prize.

2. Assign utilities to the best and worst prizes as follows: u x1 0 and u xn 1 .

Actually, the scaling here is arbitrary.

3. Now consider some alternative xi . Ask, at what probability, i , would the

individual be indifferent to xi and a lottery that offers prizes xn (the best
outcome) and x1 (the worst outcome) with probabilities i and 1 i ? That
probability number is assumed to be the utility associated with outcome xi . That
is, U xi i (the probability of winning the best prize in that lottery).

a. Note: It seems plausible that in most situations an individual will

indifferent to a sure thing and some gamble, so long as the gamble has
sufficiently high chances or producing a desirable outcome.

4. We can assign utilities to all other outcomes in the same way.

Von Neumann and Morgenstern proved that, for utility functions constructed as above,
rational behavior (preferring better lotteries to worse) implies that consumers will
maximize expected utility.

The key assumptions (above and beyond assumptions that we have previously made) are
that:

1. Consumers can answer the question posed in item 3 above. For any xi , the
consumer can always state a probability, i , such that the consumer is indifferent
to xi and a lotter over xn and x1 and xn (with probabilities i and 1 i ).

2. Compound lotteries can be reduced to equivalent simple lotteries and that utility
from the compound lottery is the same as that from the equivalent simple lottery.

3. One can substitute a prize in a lottery with a prize yielding equal utility without
changing preferences regarding that lottery (a consumer will be indifferent to the
original lottery and the new one).

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 4. For two lotteries offering the same two prizes but with different probabilities, a
consumer prefers the lottery with the higher probability of the better prize.

Exactly what these assumptions mean is best illustrated as we sketch the logic of the von
Neuman-Morgenstern theorem.

A Sketch of the Von Neumann - Morgenstern Theorem

The theorem says that if a VNM cardinal utility function is constructed as described
above, and if the assumptions listed above are satisfied, then consumers evaluating risky
alternatives will make decisions by maximizing expected utility.

To follow the argument, please see the diagrams for the Expected Utility Theorem
(posted separately in iLearn for Chapter 7).

In the first diagram, x1 and xn are the best and worst feasible outcomes. You can think of
these as different levels of wealth. Outcomes x2 and x3 are two other possible outcomes.

Utilities for x2 and x3 are given by 2 and 3 . As a result of the way that VNM utilities
are constructed, we know that the consumer is indifferent to x2 and a lottery over x1 and
xn , where the associated probabilities are 1 2 and 2 . Similarly, the consumer is
indifferent to to x3 and a lottery over x1 and xn , where the associated probabilities are
1 3 and 3 .

Now consider lottery A, which offers x2 and x3 as prizes, with probabilities a and 1 a .
Notice that the expected utility of lottery A will be given by E U A a 2 1 a 3 .

In place of x2 and x3 , we wish to substitute prizes that give the same utility. We
substitute exactly the lotteries described in the preceding paragraph that yield equal
utilities. That is, in place of x2 , offer a prize that is a lottery between x1 and xn , where
the associated probabilities are 1 2 and 2 . And in place of x3 , offer a lottery over x1
and xn , where the associated probabilities are 1 3 and 3 .

As the diagram reveals, the compound lottery is equivalent to a simple lottery over x1
and xn , where the probabilities are a 1 2 1 a 1 3 for x1 and a 2 1 a 3
xn . This lottery offers the same utility as lottery A.

The second diagram goes through precisely the same steps for another lottery, lottery B.
Lottery B offers x4 and x5 as prizes, with probabilities b and 1 b . The expected utility
of lottery B will be given by E U B b 4 1 b 5 . By a an argument similar to

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that given before, Lottery B has the same utility as a lottery over x1 and xn , where the
probabilities are b 1 4 1 b 1 5 for x1 and b 4 1 b 5 xn .

Lotteries A and B have now been replaced with utility equivalent lotteries over x1 and
xn . The consumer will prefer A only if if it offers a higher prize for the better outcome,
xn . So A B if:

a 2 1 a 3 b 4 1 b 5

But notice that this says that A B if the expected utility of A exceeds the expected
utility of B since

E U A a 2 1 a 3

and

E U B b 4 1 b 5 .

So, given our assumptions, consumers must act in a way that is consistent with expected
utility maximization under the VNM utility function.

Risk Aversion

Risk Aversion and VN Utility

Generally, we believe that people like to avoid risk. If I were offered the chance to win or
lose 1 million AED based on the outcome of a coin flip, that would be a fair gamble. The
expected value of my monetary gain is exactly zero:

0.5 1, 000, 000 0.5 1, 000, 000 0

So, on average, I would neither win nor lose.

Note that the term expected value is a statistical one: the expected value of the gamble
is the probability-weighted average of the possible outcomes. It provides a measure of the
average outcome.

While the gamble described above is fair, I would turn it down in favor of the status
quo. This is what is meant by risk aversion.

Figure 7.1, copied below, provides useful intuition about risk aversion. An individuals
utility is shown to be a function of wealth, W. Initial wealth is W0 . Suppose the individual

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considers a fair gamble A, which offers outcomes W h and W h , each with
probability 1/ 2 . Expected utility of the gamble is given by:

1 1
EU A U W h W h
2 2

Notice that this expected utility is less than the utility the individual would get from
having W with certainty.

The diagram shows a second gamble in which the individual would gain or lose
twice as much, 2h. This gamble has lower expected utility than the first one.

Risk Aversion and Insurance

There is a certain wealth that would yield the same utility as the expected utility of the
gamble. That is shown as CE A in the diagram and is called the certainty equivalent of

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gamble A. Notice that CE A W0 . In other words, the individual would accept a reduction
in expected wealth from W0 to CE A in order to avoid the risky gamble A.

There is an insurance application here. Suppose an individual earns $60,000 per year.
However, there is a 50-50 chance that he will need heart surgery that would cost $20,000.
Net of health costs, this individual will either have income of $60,000 or $40,000 (with
the expected value of income equal to $50,000). Think of W0 $50, 000 with
h $10, 000 .

Perhaps CE A $48, 000 . This would imply that the individual would be willing to pay
$12,000 for health insurance that would cover his $20,000 surgery (In the event of
surgery, the insurance company pays the hospital). Regardless of his health outcome, he
will be left with wealth of $48,000).

The $12,000 that the consumer is willing to pay can be thought of as consisting of two
parts. $10,000 is the actuarially fair price of insurance; i.e., the fair-gamble price. The
additional $2,000 is a risk premium. This is what the consumer is willing to pay to avoid
risk.

Measuring Risk Aversion

Absolute Risk Aversion

You have probably noticed that the existence of risk aversion in the example above
depends of the shape of the utility function. In Figure 7.1, the U W function is concave
(the function is always below a tangent line to the function). This implies the second
derivative, U '' W is negative. This suggests the following measure of risk aversion,
referred to as absolute risk aversion:

U '' W
r W
U ' W

This will be a positive number. The division by U ' W makes the risk aversion number
invariant to the scale of the utility function (which is arbitrary).

As your text argues, for a given gamble, the risk premium (the amount one is
willing to pay to avoid a gamble) is approximately proportional to r W . Skip
this argument.

Example. Consider:

U ln W

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 U ' W 1

U '' W 2

W 2
r W 1 W 1
W

Now suppose the scale of the utility function is changed (the utility number is
doubled):

V 2ln W

V ' 2W 1

V '' 2W 2

2W 2
r W W 1
2W 1

Notice that the second derivatives differ, but the r W function does not change.

Relative Risk Aversion

For the utility function above, the individual gets less risk averse (in terms of absolute
risk aversion) as wealth increases. Basically, the threat of a $10,000 gain or loss is
perceived differently if one starts with wealth of $100,000 or $1,000,000. For the
wealthier person, the risk posed by this $10,000 gamble seems lower, and the measure
indicates less risk aversion.

However, it also makes sense to say that the rich person is not really more risk averse, he
is just richer.

This suggests that an alternative risk aversion measure, referred to as relative risk
aversion:

U '' W
rr W W Wr W
U ' W

Notice that this just scales up the absolute risk aversion measure by wealth.

For the example given earlier, with U ln W , rr W Wr W 1 , and the measure of

relative risk aversion does not vary with wealth.

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Here is some loose intuition. In the case example considered above, when wealth
increased 10-fold, we might argue that the (relative) risk faced by the wealthy individual
facing a given gamble was reduced by a factor of 10. In a sense, risk aversion, as
measured by r W , is also underestimated by a factor of 10. However, the relative
measure, rr W , by multiplying by W, corrects for this. Whenever W increases by a
factory of 10, rr W increases by a factor of 10, offsetting the reduction in r W .

Yet another way to look at this: Suppose one individual has wealth of $100,000 and
another has wealth 10 times as high, $1,000,000. Suppose each individual is willing to
pay 1% of wealth to avoid a gamble yielding plus or minus 10% of wealth. Then these
two individuals will have equal relative risk aversion.

Constant Absolute Risk Aversion Utility Function

U W e AW

U W
r W A
U W

Constant Relative Risk Aversion Utility Function

The CRRA utility function can be written as:

WR
U W for R 1 and R 0
R

U W ln W for R 0

U '' W
Note that rr W Wr W W 1 R
U ' W
rr W is the coefficient of relative risk aversion

Typical empirical values for rr W range from 1 to 4 (all indicating risk aversion), with
a typical value around 2. What does this mean? Suppose an individual will have wealth of
either 50,000 or 100,000 with probability 0.5. This risky wealth is then equivalent to
66,667 with certainty. This person would pay a risk premium of 8,333 to exchange the
risky wealth for its expected value of 75,000.