The Fabric of Felicity

Presented by: Rajan Thakur

Fin700
 Introduction
 Which risk should we take?
 Which risk should we hedge?
 What information is relevant?
 How confident do we hold our beliefs
about the future?
 And ultimately, how do we introduce
management into dealing with risk?
 What is essential to decision-
making? From preference to utility
 In the market, people respond to new
information on the basis of a clearly
defined preferences.
 Preference means liking one thing better
than another.
 How to measuring our preferences? With
the concept of Utility.
 The concept of Utility
 Daniel Bernoulli
 Jeremy Bentham
 William Stanley Jevons
Daniel Bernoulli
(29 January 1700 – Basel, 27 July 1782)

 Born in Groningen, Netherlands.

 Dutch-Swiss mathematician.
 He spent most of his career in
University of Basel.
 He is particularly remembered for his
applications of mathematics to mechanics,
especially fluid mechanics, and for his
pioneering work in probability and statistics.
 Bernoulli’s concept of Utility
 Daniel Bernoulli first introduced the utility as the
unit for measuring preferences—for calculating
how much we like one thing more than another.
 The amount that people are willing to pay for
desirable things differs from one person to
another.
 The more we have of something, the less we are
willing to pay to get more.
 Comment of Bernoulli’s work
 Bernoulli’s Utility concept provide definition,
quantification, and guides to rational
decisions in risk evaluation.
 Most later development of utility theory were
new discoveries rather than extensions of
Bernoulli’s original formulations.
 An impressive innovation, but with some
limitation due to its one-dimensional.
Jeremy Bentham
(15 February 1748–6 June 1832)

 Born in Spitalfields, London.

 English jurist, philosopher, and

legal and social reformer.

 He was a political radical, and a leading theorist
in Anglo-American philosophy of law.
 He is best known for his advocacy of
utilitarianism, for the concept of animal rights,
and his opposition to the idea of natural rights.
 Bentham’s concept of utility
 Major work: “The Principles of Morals and
Legislation. ” Published in 1789.
 The property in any object, whereby it tends to
produce benefit, advantage, pleasure, good, or
happiness…when the tendency it has to
augment the happiness of the community is
greater than any it has to diminish it.
 Focus on whether one opportunity was superior
to another.
Comment on Bentham’s work
 Actually, Bentham’s concept of utility was only a
talking about life in general.
 But it was attracted most of economists in
nineteenth century to use utility as a tool to
discover how prices result from interactive
decision by buyer and seller.
 His detour directly led to the law of supply and
demand.
 The possibility of loss was still not a
consideration in Bentham’s work.
William Stanley Jevons
(September 1, 1835 - August 13, 1882)

 Born in Liverpool, England.

 English economist and logician.
 Earned his B.A. and M.A. degrees at
University of London.
 Spent most of his life time as professor is
Owens College and University College, London.
 On the 13 August 1882 he was drowned whilst
bathing near Hastings. Only 45.
 Jevons’ improvement on Utility
Theory
 Masterwork: The Theory of Political Economy.
1871.
Main argument:
 Value depends entirely upon utility.
 Utility varies with the quantity of a commodity
already in one’s possession.
 The degree of utility of a commodity is some
continuous mathematical function of the quantity
of the commodity available
 Comment of Jevons’ work
 Made big efforts to introduce mathematics
into economics.
 Attract the attention of an indifferent public
to the field of economy.
 Did not explicitly distinguish between the
concepts of ordinal and cardinal utility.
 About economy fluctuation
 Jevons found that economy do fluctuate
over time.
 Jevons came up with a theory based on
the influence of sunspots on weather, of
weather on harvests, and of harvests on
prices, wages, and the level of
employment.
Modern version
Of
Utility Theory
 Definition
 In economics, utility is a measure of the relative
satisfaction from, or desirability of, consumption
of various goods and services.
 Given the measure, one may speak
meaningfully of increasing or decreasing utility,
and thereby explain economic behavior in terms
of attempts to increase one's utility.
 For illustrative purposes, changes in utility are
sometimes expressed in units called utils.
 Cardinal and Ordinal Utility
 Cardinal utility
The utility (roughly, satisfaction) gained from a particular
good or service can be measured and that the
magnitude of the measurement is meaningful.

 Ordinal utility
The utility of a particular good and service cannot be
measured using an objective scale, a consumer is
capable of ranking different alternatives available. Goods
are often considered in ‘bundles’ or ‘baskets’.
 Utility functions
 While preferences are the conventional foundation of
microeconomics, it is often convenient to represent
preferences with a utility function and reason indirectly
about preferences with utility functions.
 Let X be the consumption set, the set of all mutually-
exclusive packages the consumer could conceivably
consume.
 The consumer's utility function ranks each package in
the consumption set. If u(x) ≥ u(y), then the consumer
strictly prefers x to y or is indifferent between them.
 Example of utility function
 Suppose a consumer's consumption:
set is X = {nothing, 1 apple, 1 orange, 1 apple and 1
orange, 2 apples, 2 oranges}

 Utility function
u(nothing) = 0 u (1 apple) = 1
u (1 orange)= 2 u (2 apples) = 2
u (2 oranges) = 3 u (1 apple and 1 orange) = 4

 Conclusion:This consumer prefers 1 orange to 1 apple,

but prefers one of each to 2 oranges.
 Some assumptions of utility
functions
In order to simplify calculations, various
assumptions have been made of utility functions.
 CES (constant elasticity of substitution, or
isoelastic) utility
 Exponential utility
 Quasilinear utility
 Homothetic utility
 Expected utility
 Definition:
The "betting preferences" of people with regard to uncertain
outcomes can be described by a mathematical relation which
takes into account the size of a payout , the probability of
occurrence, risk aversion, and the different utility of the same
payout to people with different assets or personal
preferences.

 The expected utility theory deals with the analysis of choices

among risky projects with (possibly multidimensional)
outcomes.

 The expected utility model was first proposed by

Nicholas Bernoulli in 1713 and solved by Daniel Bernoulli in
1738 as the St. Petersburg paradox.
 Inadequacy of expected value
 A very simple economic theory is that outcomes with a higher
expected value are always preferred.

 For example, the expected value of getting a $100 payment

with a 1 in 80 chance is $1.25. Given the choice between this
gamble and a guaranteed payment of $1, by this simple
theory, people should choose the $100 gamble.

 A key insight is that people do not consider real assets and

"expected" assets to be equivalent. In the example, no one
will ever end up with a payment of $1.25; real payments are
made only in the amounts of $0, $1, and $100.
 Conclusion
 Theory of how people make decisions and
choices had been detached in our everyday life,
especially in the investment market.
 With the concept of utility, we can precisely
determine different people’s risk preference.
 Once risk preference is determined, expected
return can be calculated and investment can be
finally made.
Any Questions?
Thanks !!☺