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• In some situations, there maybe factors that make decision making using expected value unacceptable. • This usually happens when

– the amount of loss is so big that it will not be acceptable even at low probability (e.g. insurance) – the amount of profit is so big that it will be sought even at low probability (e.g. lottery)

Utility Utility is a measure of the worth of an outcome to the decision maker. It reflects the decision maker’s attitude towards risk .

50 Î P(s3)=0.20 s3 = prices go down .• Consider the 3 decision alternatives d1 = make investment A d2 = make investment B d3 = do not invest • The states of nature are Î P(s1)=0.30 s1 = prices go up s2 = prices remain stable Î P(s1)=0.

000 -30.000 0 Prices stable s2 20.Payoff Table States of nature Decision d1 d2 d3 Prices up s1 30.000 0 .000 50.000 -20.000 0 Prices down s3 -50.

3(50.5(20. • In such a case. suppose that this company is in financial difficulty and the loss of 50.000 EV(d2) = 0.000) + 0.5(-20.000) + 0.Decision based on Expected Value EV(d1) = 0.3(30.5(0) + 0.000) = 1.000 EV(d3) = 0.000 • But. SELECT d1 with EV = 9.000) + 0. d1 is not desirable • To deal with this situation.3(0) + 0.000 would be detrimental to it.000) + 0.2(-30.000) = 9.2(-50.2(0) = 0 Therefore. we need to determine the utilities of the monetary values in the decision .

000) > U(-50.000) • Assign utilities to the other values as follows .Determining Utilities • Let U(M) = Utility of M [M=Monetary Amount] • Assign (arbitrarily) utility to the highest monetary value in payoff table Î U(50.000) = 0 Note: U(50.000) = 10 • Assign (arbitrarily) utility to the lowest monetary value in payoff table Î U(-50.

or a payoff of -50. or 2. DM has no preference between the two choices (equivalent) .000 with probability p. at what value does DM changes preference to the lottery? d. DM will prefer lottery c. If p is close to 1. DM will prefer the 30. participate in the following lottery DM get a payoff of 50. a guaranteed amount of 30.000 b. At this value of p.Assigning Utilities to Middle Values Consider the payoff of 30. If p is close to 0.000. As we increase p from 0.000: Decision maker is asked to select one of two choices: 1.000 with probability (1-p) a.

000 • Suppose the DM chooses p=0.000)+0.000) + (1-p)U(-50.000) as follows: U(30.05(-50.Assigning Utility to the Value 30.000 .95 the EV(lottery) is: EV(lottery) = 0.5 • Note that at p=0.95 (10) + 0.05 (0) = 9.000) = 45.000) = 0.95 • Now we can determine the U(30.95(50.000) = pU(50.

000.• DM is willing to accept a guaranteed amount of 30.000 • The difference between 45.000 is referred to as the risk premium. .000 and 30.000 risk premium to avoid the 5% chance of losing 50. • The DM is willing to pay 15.000 rather than risk anything more than 5% chance of a loss of 50.

000 with probability p.000) = pU(50. or a payoff of -50.000 • As before.90.Assigning Utility to the Value -20. participate in the lottery DM get a payoff of 50.000) as follows: U(-20.000. or 2. we ask DM if p=0.5 .000) = 0. • Suppose at this point p=0. would he choose lottery or an assured loss of 20. a guaranteed amount of -20.000 with probability (1-p) • For example.55 (10) + 0.000 (Îlottery) • We lower p until point of indifference is reached. DM is asked to select one of two choices: 1.45 (0) = 5.55 • Now we can determine the U(-20.000) + (1-p)U(-50.

000 with probability (1-p) • We find the probability p of indifference. we can determine the U(M) as follows: U(M) = pU(50. • DM is asked to select one of two choices: 1. • Then.000 with probability p.Assigning Utility in General • We follow the same procedure for all monetary values in the payoff table. or a payoff of -50. participate in the lottery DM get a payoff of 50.000) + (1-p)U(-50.p)(0) = 10p .000) = p (10) +(1. a guaranteed amount M. or 2.

0 9.90 0.000 0 -20.000 -50.0 0 .000 -30.5 5.000 Indifference Value of p NA 0.000 20.95 0.0 7.000 30.Utility of Payoff Values Monetary Value 50.75 0.5 4.55 0.40 NA Utility Value 10.5 9.

0 7.5 Prices down s3 0 4.5 Prices stable s2 9.5 .0 5.Utility Table States of nature Decision d1 d2 d3 Prices up s1 9.5 10 7.5 7.

5) + 0.50 .5(5.55 EU(d3) = 0.Decision based on Expected Utility EU(d1) = 0.3(9.5) = 7.5) + 0.50 Therefore.3(7.35 EU(d2) = 0.3(10) + 0. SELECT d3 [Do Not Invest] with EU = 7.5) + 0.2(0) = 7.0) = 6.2(4.5) + 0.5(7.0) + 0.5(9.2(7.

55 Expected Monetary Value 0 9.000 Investment A is rejected because the 20% of 50.50 Investment A Investment B 7.Ranking of Alternative with Expected Utility Rank of Alternative Expected Utility Do not Invest 7.000 -1.000 loss was too RISKY for the DM. DM. is a Risk Avoider .35 6. in this case.

Decision Maker is a Risk Taker • Suppose the DM was feeling comfortable about the financial status of his company • DM was seeking investments that may lead to high payoff and was willing to take risk • The DM will follow the same procedure for determination of utilities of the payoffs • But he will take the choice of the Lottery at lower probabilities .

000 20.000 NA 30.0 0 .10 NA Utility Value 10.25 0.0 5.0 4.000 0.40 0.0 2.000 -30.000 0 -20.000 -50.5 1.50 0.5 1.Utility of Payoff Values for a Risk Taker Monetary Indifference Value Value of p 50.15 0.

0 4.0 2.5 2.0 0 d2 d3 10 2.5 .5 1.5 1.Utility Table States of nature Prices Prices down Prices up stable Decision s3 s1 s2 d1 5.

0) + 0.5) + 0.50 EU(d2) = 0. SELECT d2 [Investment B] with EU = 3.95 .5) = 2.5(2.2(0) = 3.0) = 3.3(5.5) + 0.95 EU(d3) = 0.3(2.5(1.3(10) + 0.2(1.5(4.0) + 0.Decision based on Expected Utility EU(d1) = 0.2(2.50 Therefore.5) + 0.

50 2. .95 Investment A Do not Invest 3.000 0 • Investment B is selected even though EV is negative. • DM.Ranking of Alternative with Expected Utility Rank of Alternative Expected Utility Investment B 3. is a Risk Taker and willing to seek the opportunity of 50.000 payoff in Investment B. in this case.50 Expected Monetary Value -1000 9.

Utility Function for Risk Avoider 10 9 8 7 6 Utility 5 4 3 2 1 0 -50 -40 -30 -20 -10 0 Monetary Value (1000) 10 20 30 40 50 .

0 2.0 -60 -40 -20 0 Monetary Value 20 40 60 .0 1.0 Utility 6.0 8.Utility of a Risk Taker 11.0 0.0 3.0 7.0 9.0 5.0 10.0 4.

Risk Taker U tility. Risk Avoider U tility.Utility Function for Risk Avoider. and Risk Neutral 10 9 8 7 6 5 4 3 2 1 0 -50 -40 -30 -20 -10 0 Monetary Value (1000) 10 20 30 40 50 U tility. Risk N eutral . Risk Taker.

EV vs. • The range is where the payoffs (profit or loss) are not considered great. EV and EU will result in the same recommendation for a risk neutral DM. . EU • As can be seen from the graph above. • There is a range of monetary values where the DM is neutral Î the EV approach should be selected because EV & EU will be in agreement.

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