Introduction to Game Theory

1 - Decision Theory
Helena Perrone
Universitat Pompeu Fabra
January 9, 2012
Decision Theory Introduction
I
Until now, consumers and rms knew the exact
consequences/outcomes of their actions
Example a monopolist knows exactly its prot if it xes price at a
certain level
I
But usually theres UNCERTAINTY about the payos from
choices
Example
- A farmer chooses to cultivate either apples or oranges
- when he makes the decision, hes uncertain about the prots that hell
obtain
- best choice depends on rain conditions, future world prices, plagues...
I
Gap between actions and consequences - Decision Theory
shows us how to deal with this gap
Decision Theory Introduction
Another Example
I
youll open a shop in a very touristic town
I
you can open an ice-cream parlor or a bookshop specialized in
travel guides and maps
I
prots are uncertain: they depend on a variable that you
dont control
Table: Actions, States, Consequences

1

2
ice-cream 6 0
bookshop 2 2
Decision Theory Introduction
I
Suppose is the weather: if its sunny, youll sell a lot of
ice-cream; if it rains, youll sell nothing
I
the prot from the bookshop doesnt depend on the weather
I
the realizations of the variable follows a probability
distribution
Sun Rain
ice-cream shop 6 0
bookshop 2 2
Fundamental problem of Decision Theory: how to use the
information on possible payos and probabilities to choose between
risky alternatives
Decision Theory Introduction
Economist Jargon
I
lottery - situation involving uncertain outcomes:
I
cultivating apples is a lottery
I
cultivating oranges is another lottery
I
opening an ice-cream parlor is another one
I
state of nature - the variable that we dont control ; it can
take dierent values:
I
SUN is a state of nature
I
RAIN is a state of nature
Decision Theory Taking Decisions
A formal approach to taking decisions
I
set of actions A = a
1
, a
2
, ..., a
l

I
set of possible realizations of the state of nature
=
1
,
2
, ...,
m

I
set of consequences (outcomes) C = c
11
, c
12
, ..., c
lm

Table: Example with l = 2 and m = 3

1

2

3
a
1
c
11
c
12
c
13
a
2
c
21
c
22
c
23
Decision Theory Taking Decisions
I
realizations of follow a probability distribution
I
it can take m dierent values
1
,
2
, ...,
m

I
with probabilities p = p
1,
p
2
, ..., p
m
where p
i
> 0 and
m

i =1
p
i
= 1
I
lotteries L
j
= p
1
, ..., p
m
[ x
1
, ..., x
m

in a risky situation, we dont know what will happen but we know

what could happen (the dierent values of the state of nature) and
its likelihoods (the probabilities)
Example: we dont know what the weather will be but we know it
can be sunny or rainy and we know the probabilities
Decision Theory Taking Decisions
Decision Theory
exploits the information given by probabilities and the information
about agents preferences in order to make good decisions - choose
favorite lottery
Decision Theory Taking Decisions
The farmers example
Table: The farmers decision
Cold Warm
tangerines 0 100
apples 20 100
oranges -10 140
cherries 40 40
Suppose the probability of cold weather is p =
1
2
Decision Theory Taking Decisions
set of actions A = _______
set of possible realizations of state of nature = _____
probabilities p = _____
set of consequences C = ________________
Decision Theory Taking Decisions
lotteries:
L
t
= _____________________
L
a
= _____________________
L
o
= _____________________
L
c
= _____________________
Tree representation
What should the farmer choose?
Decision Theory Taking Decisions
Rational Behavior
I
an individual is rational if he has well dened objectives
(preferences) and makes decisions according to them
I
its convenient to work with numerical indicators of
preferences (utilities) so that rational behavior can be
expressed as a maximizing behavior
I
how to assign utility numbers to lotteries that represent
individual preferences so we can choose the best/preferred
lottery?
Expected Value
the expected value of a lottery?
I
if $$$ is the only objective of the decision maker, then the
expected value of the lotteries (i.e., the expected prots)
could be a good utility function (i.e., a good representation of
the decision makers preferences)
I
the expected value of L
j
= p
1
, ..., p
m
[ x
1
, ..., x
m
is the sum
of all its possible consequences weighted by its respective
probabilities:
E(L
j
) =
m

i =1
p
i
c
ji
Expected Value
Back to the farmers example
Expected Value of the farmers lotteries:
E(L
t
) = ________________
E(L
a
) = _______________
E(L
p
) = _______________
E(L
c
) = _______________
If the farmer is an "expected value maximizer", then his preference
ranking is ______________________
Spoiler : an expected value maximizer is also called risk neutral
Expected Value
I
do real people use expected value to choose between lotteries?
I
is expected value a good criterion to choose between lotteries?
Expected Value
An experiment
choose a lottery
Expected Value
E(L) = 11000 > 10000 = E(L
/
)
I
so expected utility maximizers would choose lottery L
I
but if people dislike risk (risk averse), theyll probably choose
L
/
I
the expected value doesnt seem to be a good criterion for
people that dislike risk
I
there is considerable empirical evidence that many people are
not expected utility maximizers and therefore the expected
value is not an appropriate utility representation of their
preferences over risky alternatives
Expected Value
The Saint Petersburg Paradox
I
consider a game in which you pay a xed fee to play and then
you toss a coin repeatedly until it turns up heads
I
you get $2 if the coin comes up heads in the 1
st
toss
I
$4 if heads in the 2nd toss
I
$8 if heads in the 3rd toss
I
etc
I
how much would you pay to play?
Expected Value
Expected Value of the game
E (L) =
1
2
(2) +
1
2
(4) +
1
2
(8) +
1
2
(16) ... =
= 1 + 1 + 1 + 1 + ... =
=
Expected Utility
Expected Utility Theory
I
individuals dont care only about the monetary values of the
lotteries
I
in general expected value, isnt a correct representation of
preferences
I
If preferences over risky alternatives satisfy certain consistency
conditions, then there exists a utility function u dened on
consequences such that for all L = p
1
, ..., p
m
[ x
1
, ..., x
m
and
L
/
= p
/
1
, ..., p
/
m
[ x
/
1
, ..., x
/
n

L ~ L
/
=
m

i =1
p
i
u (x
i
) >
n

i =1
p
/
i
u

x
/
i

Expected Utility von Neumann-Morgenstern utility function

The von Neumann-Morgenstern utility function
I
utility function u dened on consequences
I
allows the construction of a utility function U dened on
lotteries
I
U - the expected utility - is linear with respect to
probabilities and is given by
U (L) =
m

i =1
p
i
u (x
i
)
Economic agents will choose the lottery with highest expected
utility
Expected Utility von Neumann-Morgenstern utility function
NOTE the expected value is a special case of the von
Neumann-Morgenstern utility function
Indeed, if u (x
i
) = x
i
, then expected utility equals expected value
U (L) =
m

i =1
p
i
u (x
i
) =
m

i =1
p
i
x
i
= E (L)
Expected Utility von Neumann-Morgenstern utility function
Example
I
Suppose an economic agent has preferences that can be
represented by the von Neuman-Morgenstern utility function
u (x) =
_
x.
I
Which lottery will this agent choose?
Calculate and compare expected utilities:
U (L
1
) =
U (L
2
) =
Hell choose lottery ____
Expected Utility von Neumann-Morgenstern utility function
What if expected utility maximizer?
E (L
1
) =
E (L
2
) =
He would have chosen lottery ____
Expected Utility von Neumann-Morgenstern utility function
Preference representations are not unique
I
if u represents preferences < and v (x) = u (x) + with
> 0 then v represents the same preferences
Note: a function of the form f (x) = x + , with > 0, is called
a positive ane transformation
Expected Utility von Neumann-Morgenstern utility function
Proof.
L < L
/

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

i =1
p
/
i
u(x
/
i
)

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

i =1
p
/
i
u(x
/
i
)

i =1
p
i
v(x
i
) _
n

i =1
p
/
i
v(x
/
i
)
Expected Utility The VNM: Application
Application: freedom to choose the origin and unit of
measure
Suppose we have a function u representing some preferences:
u(x) = 10
1
x+1
. Wed like to have a utility representation such
that w(0) = 0 and w(10) = 1.
I
Check with u:
u(0) = 10
1
0 + 1
= 9.
u isnt satisfactory.
Expected Utility The VNM: Application
I
Construct v subtracting 9 from u:
v(x) = u(x) 9 = 1
1
x + 1
=
x
x + 1
.
I
The new function represents the same preferences and
satises our 1st condition since v(0) =
0
0+1
= 0
I
But it doesnt satisfy the 2nd condition since v(10) =
10
11
. So
v is not satisfactory.
Expected Utility The VNM: Application
I
Construct a new w dividing v by
10
11
:
w(x) =
11
10
v(x) =
11x
10(x + 1)
.
I
The function obtained is satisfactory since
w(0) =
0
10(0+1)
= 0 and w(10) =
1110
10(10+1)
= 1
Expected Utility The Investor Example
Utility Theory: the Investor Example
An investor has to choose between two risky projects. You are a
consultant. Yo have information about the prot levels in four
dierent scenarios. You obtain an estimation of the probabilities of
every outcome:
Retail store Oil well
Probability Wealth Probability Wealth
0,021 200 0,830 200
0,410 160 0,005 160
0,559 130 0,001 130
0,010 60 0,164 60
Expected Utility The Investor Example
Should the expected prots be used?
We have to choose between two lotteries
whose expected values (expected prots) are
E(L) = 0, 021 200 + 0, 41 160 + 0, 559 130 + 0, 01 60 = 143, 07
E(L
/
) = 0, 83 200 + 0, 005 160 + 0, 001 130 + 0, 164 60 = 176, 77
The oil well L
/
should be chosen if the investor is risk neutral. Yet,
you should check his attitude toward risk before giving any advice.
Expected Utility The Investor Example
I
The set of consequences is X = 60, 130, 160, 200.
I
We have to assign a utility number to each outcome.
I
Fix the utility of the best and worst consequences (can we do
this?):
u(60) = 0
u(200) = 1
I
Now we assess the utility of the remaining consequences by
means of the reference lottery:
that has the best and worse outcomes as possible consequences.
Expected Utility The Investor Example
Assessing the utility of 160e
I
Ask your client: what is the probability p that makes 160e
with certainty indierent to the reference lottery?
I
Suppose that the answer is p = 0.95
I
In that case, we know that both lotteries are indierent so L
and L
p
must have the same expected utility, that is
u(160) = 0, 05u(60) + 0, 95u(200) = 0, 05 0 + 0, 95 1 = 0, 95
and from here we get that the utility of 160e is 0,95
Of course, dierent people could have dierent preferences.
Utility is subjective.
Expected Utility The Investor Example
Assessing the utility of 120e
I
Now we ask what is the probability p that makes 120e with
certainty indierent to the reference lottery.
I
Suppose that the answer is p = 0.85
I
In that case we know that both lotteries are indierent so L
and L
p
must have the same expected utility, that is
u(120) = 0, 15u(60) + 0, 85u(200) = 0, 05 0 + 0, 85 1 = 0, 85
and from here we get that the utility of 120e is 0,85
Expected Utility The Investor Example
The estimated VNM utility function
Euros 60 120 160 200
Utility 0 0.85 0.95 1
Expected Utility The Investor Example
The optimal investment decision
The best investment opportunity is the one with higher expected
utility. Using the utility function obtained we can compute the
expected utilities of both lotteries
U(L) = 0, 021u(200) + 0, 41u(160) + +0, 559u(130) = 0, 88565
U(L
/
) = 0, 83u(200) + 0, 005u(160) + 0, 001u(130) = 0, 8356
, The retail store investment is better than the oil well.
Expected Utility The Investor Example
Summary of decision making recipe
1. Identify set of actions, states of nature, and outcomes (no
model can exactly reproduce the real world, so we need to
make simplifying assumptions to reduce the problem to whats
really important)
2. uncover preferences over outcomes and translate them into
utilities
3. assess probabilities of each state of nature
4. calculate expected utilities of each action and choose the
action that maximizes expected utility
Expected Utility Graphical Analysis
Expected Utility in a Graph
L = , 1 [ x
1
, x
2

remember: 0 _ _ 1 ( is a probability)
Expected Utility Example of a graphical analysis
Example of a graphical analysis
Initial Wealth and Investment
I
an investment project can yield a prot of 40 if things go well
and a loss of 20 if things go wrong
I
a long experience with projects of this type show that they fail
one out three times
I
initial wealth of the investor = 30
I
utility function is
Should he invest?
Expected Utility Example of a graphical analysis
I
compare 2 lotteries: invest (L) and not invest (H)
I
remember to add the initial wealth to the outcomes of each
lottery (level of nal wealth may be important to investor)
Expected Utility Example of a graphical analysis
Investor should _____________
Expected Utility Example of a graphical analysis
Homework same preferences, richer investor = 60
Attitude towards risk
Actuarially Equivalent Lotteries
I
two lotteries are actuarially equivalent if they have the same
expected value
I
given a lottery L, dene L
+
as the degenerate lottery that
gives with certainty (probability 1) the expected value of L
E(L) = pg + (1 p)b = E(L
+
)
risk averse/neutral/loving - based on the reaction when comparing
2 lotteries with the same expected value: a risky lottery L and an
actuarially equivalent degenerate lottery L
+
Attitude towards risk
Math Parentheses: Concave and Convex Functions
Attitude towards risk
Risk Aversion
I
a decision maker is said to be risk averse if he always prefers
the certain lottery L
+
instead of the actuarially equivalent
uncertain lottery L
I
the decision maker is risk averse if and only if his utility u is
strictly concave
Proof.
Attitude towards risk
Compare the expected utilities of L and L
+
U (L
+
) = u (pg + (1 p) b) >
?
pu (g) + (1 b) u (b)
Graph
Attitude towards risk
Risk Loving
I
a decision maker is said to be risk loving if he always prefers
the uncertain lottery L instead of the actuarially equivalent
certain lottery L
+
I
the decision maker is risk loving if and only if his von
Neumann-Morgenstern utility u is strictly convex
Proof.
Homework
Graph
Attitude towards risk
Risk Neutral
I
a decision maker is said to be risk neutral if hes always
indierent between the uncertain lottery L and the actuarially
equivalent certain lottery L
+
I
the decision maker is risk neutral if and only if his von
Neumann-Morgenstern utility u is linear
Proof.
Homework
Graph
Attitude towards risk
Summary of Attitudes towards Risk
risk aversion = L
+
~ L = u strictly concave
risk neutrality = L
+
~ L = u linear
risk loving = L ~ L
+
= u strictly convex
If u is dierentiable, then concavity/convexity depends on the sign
of the second derivative:
u
//
(x) < 0 = risk _____
u
//
(x) = 0 = risk _____
u
//
(x) > 0 = risk _____
Attitude towards risk Certainty Equivalent
Certainty Equivalent
The certainty equivalent of a lottery L is the amount of money
C(L) such that the agent is indierent between having C(L) and
participating in L.
u[C(L)] =p u(x) + (1 p) u(x
/
)
C(L) =u
1
[p u(x) + (1 p) u(x
/
)]
Attitude towards risk Certainty Equivalent
Graphical Representation of the Certainty Equivalent
u[C(L)] =p u(x) + (1 p) u(x
/
)
C(L) =u
1
[p u(x) + (1 p) u(x
/
)]
Attitude towards risk Certainty Equivalent
Certainty Equivalent and Risk Aversion
The relation between the certainty equivalent and the expected
value of a lottery characterizes the attitude towards risk
Risk averse = C(L) < E(L) for all L
Risk loving = C(L) > E(L) for all L
Risk neutral = C(L) = E(L) for all L
Proof.
p u(x) + (1 p) u(x
/
) < u

p x + (1 p) x
/

or, equivalently
u
1
[pu(x) + (1 p)u(x
/
)] < px + (1 p)x
/