Decisions Under

Uncertainty
explicitly consider probability
again contrast normative (economic
theory) and descriptive models
examine expected value and
expected utility models
represent our own utility functions
try some numerical examples

Decisions Under
Uncertainty
Suppose I flip a coin. If it is heads,
you win $15. Tails, you lose $10.
Play?
What if you believe there is a 10%
chance that the coin is fixed?
How should we choose?
How would we know whether or not
to play the Massachusetts lottery?

Expected Value Principle

18th c. court mathematicians

EV =
p*V
play any gamble if EV > 0
choose so EV is maximized

Matrices and Trees

Payoff Matrix

Events
Heads
Tails

Play

15

-10

Dont Play

Acts

Events = mutually exclusive and exhaustive set of

States of Nature, e.g., snow/none
Outcomes = consequences (money, pleasure?)
Acts = choices, decisions taken
Independence Assumption: acts affect outcomes
but not events

Matrices and Trees,

continued
* Tree

C h o ic e

P la y

A c ts
E v e n ts
O u tc o m e s

D o n 't P l a y

H eads

T a ils

H eads

T a ils

+15

-1 0

Behavior Doesnt Match

EV
People find gambles attractive even
if the EV < 0, e.g., Mass Lottery
People find gambles unattractive even
if the EV > 0, e.g., subsidized insurance
St. Petersburg Paradox:
Flip a coin until heads comes up.
Payoff outcome is $2n (n= # flips).
What would you pay to play once?

Expected Utility
People act as if gaining more money has
diminishing returns as wealth increases
Bernouilli (1738):
EU =
p*U

U(W) = b * log(W)
U(gain X) = U(W+X) - U(W)
= b*log(W+X) - b*log(W) = b*log[(W+X)/W)]
people reject fair gambles (risk aversion), since
U(W) > .5*U(W+X) + .5*U(W-X)

Diminishing Returns

U(W+X)
U(W)
U(W-X)

W-X

W+X

Psychophysics of Wealth
Suppose your current level of total
monetary and non-monetary wealth
(your life situation score) is 1000
points. If I give you $10,000, what
would your life situation score be?
What if I give you $20,000?
What if I took away $10,000?

Psychophysics of Wealth

1000

W-X

W+X

W+2X

Psychophysics of Wealth,
cont.
U(W+2X)
U(W+X)
1000
U(W-X)

W-X

W+X

W+2X

Von Neumann - Morgenstern

Axioms
Completeness
either X > Y, Y > X, or X ~ Y
Transitivity
if X >~ Y and Y >~ Z, then X >~Z
Probability Mix I
if X > Y, then X > (p,X; 1-p,Y) > Y

More VNM Axioms

Substitutability
if X ~ Y, then (p,X; 1-p,Z) ~ (p,Y; 1-p,Z)
Probability Mix II
if X > Y > Z, there must be p such that
Y ~ (p,X; 1-p,Z)
Solvability of Complex Gambles

[p(q,X; 1-q,Y); 1-p,Z] ~ (pq,X; p-pq,Y; 1-p,Z)

Why Axioms?
If the axioms are satisfied, then there
exists a utility function U(X) such that the
ordering of lotteries by utilities is
equivalent to the ordering of preferences,
and U(X) is interval. It can have any
monotonic shape.
Then we can measure U(X)
- Certainty equivalent method
- Probability equivalent method

Certainty Equivalent
Method

What is X: X ~ (.5,$0; .5,$10,000) ?

i.e., what is your minimum selling price for a
ticket worth a 50% chance at $10,000?

This procedure identifies

U(X) = .5 * U(0) + .5 * U(10,000)
We are free to choose a scale for U,
usually U(0) = 0 and U(10,000) = 100,
thus U(X) must be 50 (we are really looking

at a segment of your utility curve above W)

Certainty Equivalent,
continued
What is Y such that: Y ~ (.5, $0; .5, X) ?
this defines U(Y) = 25
What is Z: Z ~ (.5,X; .5,$10,000) ?
by the axioms, U(Z) = 75
Now, plot a utility function with dollars
on the X-axis and utility on the Y-axis
Concave is diminishing marginal utility
or risk-aversion; convex is risk-seeking

Your Utility Curve

100
75
50
25
0

$0

$5,000

$10,000

Probability Equivalent

What is the p at which

(1-p,$0; p,$10,000) ~ (.5,$0; .5,$5,000) ?
this equates the two utilities, so
(1-p)*U(0)+p*U(10,000)=.5*U(0)+.5*U(5,000)

or, 0 + 100*p = 0 + .5*U(5,000)

therefore, U($5,000) = 200*p
Try $2,000 and $8,000, etc.
This plots another utility curve

Numerical Examples

assume U(X) =

30+X

what is the certainty equivalent or minimum

selling price X for (.33,$6; .67,$19) ?

U(X) = .33*U(6) + .67*U(19)

= .33 *
36 + .67*
49
= 2 + 4.67 = 6.67 utiles; but X in $ ?
U(X) = 6.67 =
30+X
X = $14.44 (note, EV is $14.67)

Numerical Examples,
continued
What is the certainty equivalent of playing
the same lottery twice? $28.88 ?
Outcomes are: (.11,$12; .44,$25; .44,$38)
U(XX)= .11*U(12) + .44*U(25) + .44*U(38)
= .11 42
+ .44 55
+ .44 68
= 7.68 utiles =
30+X
XX = 7.68*7.68 - 30 = $29.02

Numerical Examples,
continued

Whats the minimum bid for the simple

lottery? Is it the certainty equivalent (X)?
If you play, you get $6 or $19, but you have
already paid your bid $b; not play = U(0)
U(not play) = .33*U(6-b) + .67*U(19-b)
30 = .33 36-b + .67
49-b
9b*b + 1740b - 26,780 = 0
b = $14.33 (if U(X) is exponential, b=X)

Summary
Normative economic model has
changed over time (from EV to EU) to
better represent decision makers
preferences
As we will see, EU is still not a
complete descriptive theory
The EU model does provide a structure
and benchmark for analyzing decisions

More on Job Choice

Exercise
Most (but not all) trust the intuitive model,
and try to adjust the linear models to agree
Does using intuition first bias the model?
Weight ranges varied greatly
Weights may be hidden in attribute ratings
What would you do if this really mattered?
Modeling for learning, not for choice!