Expected Utility Theory

R K Amit
Department of Management Studies
IIT Madras

August 7, 2020

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1. Preferences and Utility

Let us consider a set of possible alternatives X ∈ RN

+ for a decision maker.

We use preferences as primitive—the decision maker uses her preferences to choose an ele-
ment (or elements) from X. The other approach is choice-based approach.

What is preference? It is her “attitude” towards the alternatives in X.

For any pair of x and y in X (∀x, y ∈ X), check only one box:
 I prefer x to y (x  y)
 I prefer y to x (y  x)
 I am indifferent (x ∼ y)

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Completeness in Strict Preferences A preference relation is complete if for any two alterna-
tives x, y ∈ X, either x  y; or y  x; or x ∼ y.

The completeness axiom suggests that the individual is capable of comparing any pair of
alternatives that we present to him.

Think of a binary relation “is the brother of”.

Weak preferences: For all the alternatives x, y ∈ X (x and y not necessarily distinct), is x at
least as preferred as y?
 Yes. x  y
 No. y  x

Checking both the boxes means that she is indifferent between x and y (x  y AND y  x
⇒ x ∼ y)

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Reflexivity A preference relation is reflexive if for any alternative x ∈ X, we have x  x.

Rationality A preference relation  is rational if it satisfies the following two properties:

• Completeness: ∀x, y ∈ X, either x  y; or y  x; or both x ∼ y.
• Transitivity: For any three alternatives x, y, z ∈ x, if x  y and y  z, then it must be
x  z.

Example:
P P
Consider an individual with preferences x  y ⇐⇒ n xi ≥ n yi . Is she rational?

Violations

Comparing elements that are too close to be distinguishable.

Framing Effects

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Utility Function

A function u : X → R is a utility function representing a preference relation  if, for every

pair of alternatives x, y ∈ X, x  y is equivalent to u(x) ≥ u(y).

Monotonocity A preference relation satisfies monotonocity if, for any two bundles x, y ∈ X,
where x 6= y
• xk ≥ yk , ∀k, implies x  y
• xk > yk , ∀k, implies x  y

Strong Monotonocity A preference relation satisfies strong monotonocity if, for any two
bundles x, y ∈ X, where x 6= y
• xk ≥ yk , ∀k, implies x  y

→ Monotonocity
Strong Monotonocity 8

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Continuous Preferences A preference relation defined on X is continuous if it is preserved
under limits. That is, for any sequence of pairs {(xn, y n)}∞
n=1 with x n
 y n
for all n and
limn→∞ xn = x and limn→∞ y n = y, the preference relation is maintained in the limit, x  y.

Example:

A bundle x = (x1, x2) is weakly preferred to another bundle y = (y1, y2) if and only if x1 > y1,
or if x1 = y1 and x2 > y2.

Let us consider a lexicographic preference relation xn = ( n1 , 0) and y n = (0, 1). Is it a contin-

uous preference?

Theorem ♣ If a rational preference relation satisfies monotonocity and continuity, then there
exists a utility function u(·) representing such preference relation.

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Indifference Set The indifference set of a bundle x ∈ X is the collection of all other bundles
y ∈ X, such that y ∼ x.
IND(x) = {y ∈ X : y ∼ x}

Example:

Show that if a preference relation is monotonic, its indifference curve must be downward
sloping.

Proof of Theorem ♣ Let us consider a bundle x 6= 0. By monotonocity, x  0. Let m ≡

max(x1, . . . , xN ). Let us define a bundle M ≡ (m, . . . , m). By monotonocity, M  x. By
continuity and monotonocity, there exists a bundle that is indifferent to x and lies on the main
diagonal. By monotonocity, this bundle is unique.

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 Let the bundle be (u(x), . . . , u(x)). It means x ∼
(u(x), . . . , u(x)). Similarly, y ∼ (u(y), . . . , u(y)).

By transitivity of the preference relation x  y if

and only if

x ∼ ((u(x), . . . , u(x))  (u(y), . . . , u(y)) ∼ y

By monotonocity, this is true if u(x) ≥ u(y).

It means x  y ⇔ u(x) ≥ u(y)

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2. Choice under Uncertainty

We have seen preferences and utility in deterministic settings. In most settings, we are sur-
rounded by uncertainty.

We represent the uncertainty in the form of lottery—list of potential outcomes and their asso-
ciated probability.

What are an individual’s preferences over the set of lotteries? What are the axioms needed to
represent those preferences by a utility function?

Simple and Compound Lotteries

Consider a set of outcomes (or consequences) C (in case of monetary payoffs, C = R).
#C = N . The probability associated with each outcome is pn, and is objective.

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Simple Lotteries

A simple lottery is a list L = (p1, . . . , pN )

P
pn ≥ 0 and n pn = 1.

Exercise

Graphically represent a simple lottery with two possible outcomes. Graphically represent a
simple lottery with three possible outcomes.

Compound Lotteries

A compound lottery is a lottery of lotteries (L1, . . . , LK ; α1, . . . , αK )

P
αk ≥ 0 and k αk = 1.

The decision maker is rational enough to reduce a compound lottery to a simple lottery, and
worry only about the consequences and their associated probabilities—-“consequentialism”.

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Exercise

Given a compound lottery (L1, L2, L3; 0.3, 0.3, 0.3). L1 = (1, 0). L2 = (0, 1). L3 = (0.5, 0.5).
Find the reduced lottery.

Preferences over Lotteries

Consider the set of all simple lotteries L.

Completeness: Either L  L0 or L0  L or both, ∀L, L0 ∈ L.

Transitivity: If L  L0 and L0  L00, then L  L00, ∀L, L0, L00 ∈ L.

Continuity: If L  L0, then there is a small neighborhood around L and L0, BL and BL0 , such
that ∀La ∈ BL and ∀Lb ∈ BL0 , we have La  Lb.

Independence Axiom (IA): ∀L, L0, L00 ∈ L and α ∈ (0, 1), L  L0 if and only if
αL + (1 − α)L00  αL0 + (1 − α)L00.

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Expected Utility Theory

Expected Utility The utility function U : L → R has the expected utility form if there is an
assignment of numbers (u1, . . . , uN ) such that ∀L ∈ L, we have
X
U (L) = pi × ui
n

The expected utility property is a cardinal property. It is preserved only under under increasing
linear transformations.

Suppose a decision maker’s preferences over L satisfies rationality, continuity, and the inde-
pendence axiom, then the preference relation admits a utility representation of the expected
utility form.

Violations of the IA: Allais’s Paradox

Is it possible to develop a utility theory that explains such paradoxes?

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3. Money Lotteries

We restrict our attention to lotteries over monetary outcomes C = R.

This allows us to describe money lotteries with CDF F (x) = prob {y ≤ x}.

For simplicity, we consider money lotteries to be distributed over C = R+.

The expected utility that the decision maker obtains from playing a money lottery F (x) is
Z
U (F ) = u(x)dF (x)
R+

Exercise

Consider a decision maker with a Bernoulli utility function u(x) = ax2 + bx. Show that
the mean and the variance of the money lottery F (x) are sufficient to determine the decision
maker’s expected utility of a lottery.

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Risk Aversion

Individual’s utility exhibits risk aversion if, for any money lottery F (x)
Z Z 
u(x)dF (x) ≤ u xdf (x)

This is also called Jensen’s Inequality. For a risk neutral, the relationship holds with equality;
and for risk seeking, the inequality is reversed.

Certainty Equivalent

The certainty equivalent of money lottery F (·) for an individual with utility function u(·),
c(F, u) is the amount of money for which the individual is indifferent between F (·) and ac-
cepting a certain amount of money c(F, u).
Z
u(c(F, u)) = u(x)dF (x)

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Arrow-Pratt Measures

Absolute Risk Aversion

u00(x)
rA(x) = − 0
u (x)

Exercise

Consider u(x) = − exp(−ax) where a > 0. Compute rA(x).

Relative Risk Aversion

u00(x)
rR(x) = −x 0
u (x)

Exercise

Consider u(x) = xb. Compute rR(x).

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