Sheena Joy Leones BTN1

Discussion Paper on Risk Attitudes: Expected Utility Theory and

Demand for Hedging
1. Utility theory is a preference-based approach that provides a rank ordering of
choices. Explain this statement.

Utility theory is an approach based on individual preferences and has the rank
ordering of choices. It is a way for economists to identify how consumer satisfaction affects
the goods and services they have consumed. With that, they could improve their study or
research about the behavior of an individual's choice of products. For instance, there are
bundles of various products, and each bundle has quality. The challenge now is that
customer's preferences would differ because of their desirability as well as in utility.

2. List and describe in your own words the four axioms/assumptions that lead \to the
existence of a utility function.

The first assumption in utility theory is completeness. It means that no matter how
many bundles are presented to people, they will always choose what they prefer. They will
compare the two bundles and rank them based on the satisfaction they will get from the
products. For instance, set a contains buffalo wing and set b contains burger and fries. I can
say that set A is good when compared to set B or set B is better than set A.

The “more-is-better” is the second assumption in utility theory. It is quite similar to

the completeness property of preferences. However, in this assumption, individuals prefer all
consumption bundle that contains more goods. For instance, set A compose of one week of
canned goods while set B consists of a half week of noodles. However, another set was
offered to the consumers in which contain two week of canned goods. Thus, individuals
would prefer one that has more commodities.

The third assumption is “mix-is-better.” In this assumption, a milk tea shop owner
could mix the product to another or not. For instance, a customer likes wintermelon milk tea
but also want ice cream. The customer will be torn between milk tea or ice cream. So, what
the owners will do is to mix the two products, and it will become wintermelon float.
Sheena Joy Leones BTN1

The fourth and last assumption is rationality. It is base on describing a relationship

between goods. If a consumer prefers good A to set B and prefers good B to good C then,
the consumer should prefer good A to good C. For instance, if a person prefers buffalo wing
(good A) to fillet mignon (good B), and prefers fillet mignon (good B) to beef wellington
(good C). Then, an individual should prefer buffalo wing (good A) to beef wellington (good
C).

3. What is “util” and what does it measure?

To presents hypothetical information about utility and consumer demand theory, util
is generally utilized by economists. It was established as the easy move to demonstrate and
discuss concepts such as marginal utility, total utility, and the law of diminishing marginal
utility. It is also a measure of satisfaction an individual gets from the consumption of the
commodities. Moreover, the util does show an actual unit of measurements such as inches or
pounds because the utility is not a measurable characteristic.