Risk attitude and utility analysis

The Decision-analysis Process

Recognise problem

Set objectives
Formulate model
Understand problem
Observe & Determine options
Monitor

Evaluate options
Analyse and
Select options solve model

Test solutions Implement

Learning outcomes

• limitations of expected value

• why ‘q lotteries’ or utility help overcome
limitations of EMV
• construct a utility function
• attitude to risk & the shape of a utility
curve
• use utility analysis to make decisions
• utility of non-monetary outcomes
Problems with Expected Value
 0.3 -100

530
A 0.7 +800

B 0.5 +600

450
0.5 +300
 £ 5M
0.5
Lottery A

0.5
£5M

£ 20M
0.5

Lottery B

0.5
0
 £2
H

T
£ -1

Entry fee £0.10

 £ 1000
H

T
£-500

Entry fee £100

 £2
H
Entry fee £0.10

T
£ -1

£ 1000
H
Entry fee £50
T
£-500
 Coin toss game
First H First toss £20= £1

First H Second toss £21=£2

First H Third toss £22=£4

First H Fourth toss £23=£8

. . .

. . .

First H Kth toss £2k=£2k-1

How much would you bid to play this game 1000 times?
‘Utility’
When outcomes are uncertain,
taking a gamble depends both on
the level of ‘uncertainty’
(probability) and the ‘value of
the outcome’ (payoff).
Imagine this choice:
A: £5k guaranteed cash, or
B: A lottery with a 50/50 chance of getting £10k or nothing?

£5k Which option would

A you choose?
Certain

0.5 £10k
B
Lottery

0.5 0 An EMV maximiser

should be indifferent
between A & B. Yet
EMV(A)= £ 5k most people would
prefer A…
EMV(B)=
(0.5  £ 10k) + (0.5  £0) = £ 5k
 Limitation of EMV
<Limitation 1>: EMV cannot cater non-monetary objectives, such as,
reputation, and environmental issues.
<Limitation 2>: The decision can only be made sufficiently often for
the expected value to be obtained in the long run.
<Limitation 3>: The decision maker’s risk attitude is neutral.
Example:
X
Experience
losses ‘Small’ ‘Large’ EMV (£m)
profits profits
Strategy probability probability
(£m) (£m)

0.4 x 120 + 0.6 x -50

A 0.4 120 0.6 -50
= 18

0.7 x 20 + 0.3 x 10 =
B 0.7 20 0.3 10
17
The decision is
made only once! •Many organisations prefer profit stability.
•Large organisations might choose A as they
could easily bear -£50m.
 Limitation of EMV-continue…
<Limitation 4>: The decision maker does not always have a
linear value function for money.
Heads £2m
Example:
Lottery EMV:(0.5 x £2m+0.5 x £1m=£1.5m)
A
Tails £1m

Heads £6m
B
Lottery EMV:(0.5 x £6m+0.5 x £0=£3m)
Tails
£0
Which lottery would
you choose? Certain gain of £1m (lottery A) is sufficient to
change your lifestyle considerably.
‘Expected’ gain of £3m (lottery B) would
not be judged to have twice the impact on
your current lifestyle of an expected gain of
£1.5m (lottery A)
 Exercise
(a)SVM plc is attempting to expand through buying one of its
rivals. They have four main rivals (A,B,C and D) in their
industry and it would cost SVM a similar amount to
purchase any one of these companies. The Finance Director
estimates that SVM’s profits (£M) over the next two years,
should they purchase one of these rivals, will depend upon
the level of interest rates in the economy over this period, as
follows:
Interest Rates
Low Medium High

No purchase 4 4 1
SVM’s Purchase A 10 2 -2
acquisition Purchase B 5 4 1
strategy Purchase C 3 6 0
Purchase D 2 2 6
 Exercise
Explain to what extent the information contained in the
payoff matrix may be inadequate for making a rational
decision.
Profit expected next year
Demand in Economy
High Medium Low

A 6 5 3
Potential
-2 8 7
products B
C 3 1 8

What information do you need to choose a product?

 Limitations of Expected Monetary Value
<Limitation 1>: EMV cannot cater non-monetary
objectives, such as, reputation, and environmental
issues.

<Limitation 2>: The decision can only be made

sufficiently often for the expected value to be obtained
in the long run.

<Limitation 3>: The decision maker’s risk attitude is

neutral.

<Limitation 4>: The decision maker does not always

have a linear value function for money.
Overcoming problems of EV:
A “New” Currency
Q lottery ticket
 Q lottery ticket

I promise to pay the bearer:

£x with a probability of q
or £y with a probability of 1-q,

where £x >£y
 ‘q lottery ticket’ (q LT)
to overcome limitations of EMV
Important Concept:
A ‘q lottery ticket’ gives the holder a probability of ‘q’
of receiving a fixed prize of £x
and
a probability of ‘1-q’ of receiving a fixed prize of £y
(where x > y)

q £x
x>y
1-q
£y
 ‘q lottery ticket’
A decision between C & D strategies, each of which may
result in different value ‘q lottery tickets’ (‘q’ LT), can
be made without suffering any of the limitations
imposed by the EMV criterion as follows:
•The overall probability
0.2 £ x of getting £x from C:
0.4 0.2LT 0.4*0.2+0.6*0.4=0.32
0.8 £ y
0.4 £ x •The overall probability
C 0.4LT of getting £y from C:
0.6
0.6 £ y 0.4*0.8+0.6*0.6=0.68
0.5 £ x
0.7 0.5LT
D 0.5 £ y
0.4 £ x
0.3 0.4LT
0.6 £ y
 ‘q lottery ticket’
A decision between C & D strategies, each of which may
result in different value ‘q lottery tickets’ (‘q’ LT), can
be made without suffering any of the limitations
imposed by the EMV criterion as follows:

•The overall probability

0.5 £ x
0.7 0.5LT of getting £x from D:
D 0.5 £ y 0.7*0.5+0.3*0.4=0.47
0.4 £ x •The overall probability
0.3 0.4LT
0.6 £ y of getting £y from C:
0.7*0.5+0.3*0.6=0.53
 ‘q lottery ticket’
0.32 £x

= 0.32 LT As £x > £y, D is

C preferable to C
0.68 £y (D gives a higher
£x probability of
0.47
receiving £x)
D = 0.47 LT

0.53
£y
The choice between a 0.32 LT and a 0.47LT is directly equivalent to
the original choice between C & D. This implies that, irrespective of
the decision-maker’s attitude to risk, and irrespective of whether the
decision is made just once or many times, the rational choice is D, as
the strategy gives a higher probability of achieving ‘prize’ £x
(compared with lower ‘prize’ £y). This is why q LT method
overcomes the limitations of the EMV criterion.
 Exercise: Einstein’s Chair
Einstein’s chair was on display in a museum and many visitors
would touch the chair or sit on it to have their photo taken-
perhaps hoping that some of Einstein’s genius would rub off on
them! Museum staff were concerned, because the chair was being
damaged by this constant touching and sitting.

They tried many things to stop visitors touching or sitting on the

chair- but none worked.

Identify at least three strategies

that you would recommend?
 Construct utility function
Principle: make decisions involving uncertainty into choices between
q LTs by converting pay-off(e.g., money, reputation, time) the
decision-maker feels is important in making the decision (ie based
on their objective) into equivalent q LT values.
Experience
losses
‘Small’ ‘Large’ EMV (£m)
profits profits
Strategy probability probability
(£m) (£m)

0.4 x 120 + 0.6 x -50

A 0.4 120 0.6 -50
= 18

0.7 x 20 + 0.3 x 10 =
B 0.7 20 0.3 10
17

£120m (x)
q

1-q
-£50m (y)
 Construct utility function
(‘q’ indifference curve)
q or utility Hint: To convert £ into qLT

0.5
0.4

£m
-50 0 10 20 120
Construct utility function: exercise

Because it is about how a

decision maker feels,
therefore, before constructing
a UF, a mind exercise is
necessary……
 Mind exercise
q= 1 q= 0
£120m for certain -£50m for certain

q £120m q £120m

1-q 1-q
-£50m -£50m

q= q= depends, say 0.5

depends, say 0.4

£10m for certain £20m for certain

q £120m q £120m

1-q 1-q
-£50m -£50m
 Use utility function
(‘q’ indifference curve) to make decisions
Example ‘Small’
profits
‘Large’
profits
X
EU (£m)

Strategy probability probability

(£m) (£m)

120 -50 0.4 * (1) + 0.6 * (0)

A 0.4 0.6
(1LT) (0LT) = 0.4

20 10 0.7 * (0.5) + 0.3 *

B 0.7 0.3
(0.5LT) (0.4LT) (0.4) = 0.47
This is not to calculate EMV anymore, because….

0.4 £120m (1LT) 0.7 0.5 £120m (1)

£20m (0.5LT)
0.5 £-50m (0)
A B
0.4 £120m (1)
0.6 0.3 £10m (0.4LT)
-£50m (0LT) 0.6 £-50m (0)
0.4 £120m (1LT)

Strategy A
0.6
-£50m (0LT)

0.47 £120m (1LT)

Strategy B
0.53
-£50m (0LT)

Should they adopt A or B

 Exercise
You are asked by SVM to draw their utility curve to help them
decide which strategy to adopt.
What would be the various stages in the process and
what specific questions would you need to ask to draw this curve?
Interest Rates
Low 0.3 Medium 0.5 High 0.2

No purchase 4 4 1
SVM’s Purchase A 10 2 -2
acquisition Purchase B 5 4 1
strategy Purchase C 3 6 0
Purchase D 2 2 6
 Method used to draw utility curve
• Method we used: probability equivalence method

• Alternative method: certainty equivalence method

• Alternative questions:

(a) How much would you pay to enter lottery?

(b) How much would you sell this lottery for?

• Use of several methods: sensitivity

 Different shapes of utility curve
Utility curve for risk neutral decision-maker

EMV represents their preferences

1

Utility
0.5 0. 5 £2000

0.5
£0

0
Money (£)
£1000 £2000
 Different shapes of utility curve
Utility curve for risk averse decision-maker

a sum of money for certain < EMV (Gamble)

1

Utility
0. 5 £2000
0.5

0.5
£0

0
£300 £1,000 £2000
Money (£)
 Different shapes of utility curve
Utility curve for risk preferring decision-maker

a sum of money for certain > EMV (Gamble)

1
0. 5 £2000

0.5
Utility £0
0.5

0
£1,000 1,700 2,000
Money (£)
 Different shapes of utility curve
In practice, many individuals are risk-preferring over certain
ranges of values of money and risk-averse for others. For
example, they currently have assets of £w, then they will be
risk-preferring, but if their current assets are £v then they will
be risk-averse.
1
Utility curve for mix risk
preferring decision-maker

Utility

0 w v Money (£)
 Risk Sensitivity Theory

• Risk averse in states of low need

• Risk preferring in states of high need

• Based on idea that decision makers are ‘satisficers’

driven by need to satisfy a goal
 Exercise

Complete exercises 3.1, 3.2 and 3.3 in the course notes (in
the ‘Risk attitude and utility’ section
 Use of utility in practice

Number of tons CO2 captured (m):

0.5 0.4 0.1 EV

Price of tree plants
High Med Low
A 10 20 0 13

B 12 12 12 12

C 10 5 35 10.5

In which location should the government decide

to plant trees (A, B or C)?
Let’s imagine that asking the Government officials a series
of questions related to the q lottery, we determine the
following Utility curve (or ‘q’’ indifference curve) for
converting number of tons of CO2 captured to utility.

Utility q
35
1

0.75 1-q
0
0.60

0.50

0.3

0
5 10 12 20 35 Tons of CO2(m)
 Use of utility in practice
q
35

1-q 0.5 0.4 0.1 EU

0
Price of tree plants
High Med Low
A 0.5 0.75 0 0.55

B 0.6 0.6 0.6 0.6

C 0.5 0.3 1.0 0.47

The result: A greener world which accounts for
risk attitude and non-monetary objectives
Utility for non-monetary aspects: The job interview
Demand for computer
services
High Low
A

B 1

C 0

Should we choose candidate A, B or C?

q B, or B,low
high

1-q C,
low
 Exercise
FA are currently contemplating the development of new fund
raising initiatives and they have identified a number of
professional fund raising companies (PFRC) they could employ
to assist in this process. The Trustees believe that the funds
they will raise over the next three years will depend upon the
PFRC they employ and various factors associated with the
level of economic activity in the country.
The maximum and minimum funds they contemplate they
will be able to raise as a result of choosing one of these PFRCs
ranges from $0m to $10m.
 Explain the advantages of developing a group utility function
for the Trustees

Outline the process which could be employed to construct

such a utility function.

The Board of Trustees’ utility(U) function for this decision

is estimated to be:

for 0 ≤ funds < $4m

for 4 ≤ funds < $6m

for funds between $6m and $10m the utility function is less
clearly defined, but
U($6m)=0.75, U($7m)=0.9, U($8m)=0.95 and U($10m)=1
Determine the Trustee Board’s attitude to risk for the three
funding categories ($0-$3.99m, $4-$5.99m, $6-10m) and
explain how you have made this judgement.
The Trustee Board narrows the choice of PFRCs to two: A and
B. The potential funding profiles arising from employing A or
B are estimated to be as follows:
PFRC A PFRC B
Funds($m) Probability Funds($m) Probability
2 0.2 0 0.3
4 0.6 8 0.6
6 0.2 10 0.1

Determine which PFRC the charity should partner

 Exercise
A decision maker, Victor Chandler (VC) is seeking to make
carbon emissions savings (CES), measured in (‘000) tons. A
consultant asks VC a series of questions. For each of these
questions VC must choose between receiving a fixed amount of
CES or selecting a ball at random from an opaque jar which
contains 100 balls, ‘B’ of which are blue and ‘100-B’ of which are
red. If VC chooses the uncertain alternative and pulls out a blue
ball they will be given CES (‘000) of 50 and if they pull out a red
ball they will gain no CES. The fixed CES and the number of blue
balls in the opaque jar are varied in order to discern the point at
which VC is indifferent between receiving the fixed amount of
money and selecting at random a ball from the opaque jar. The
number of blue balls in the opaque jar and the fixed amounts of
CES (‘000) for which VC is indifferent were as follows:
 Fixed amount of Number of blue
CES (‘000 tons) balls in jar (B) q
q
5 10 0.1
50
18 30 0.3
22 50 0.5 1-q
40 80 0.8 0
Draw the VC’s utility curve for carbon emission savings (CES ‘000) between 0
and 40, assuming that the VC’s attitude to risk for all CES (‘000) less than 5
is similar to his risk attitude for 5, his risk attitude for CES > 5 but ≤ 18 is
similar to his risk attitude for 18, his risk attitude for CES > 18 but ≤ 22 is
similar to his risk attitude for 22, and his risk attitude for CES> 22 but ≤ 40
is the same as his risk attitude for 40.

VC is indifferent between receiving 5 for

0.1
50 certain or the gamble (with EV=5)

So….VC risk neutral for CES ≤ 5

0.9
0
VC risk neutral for CES ≤ 5
VC risk preferring for CES > 5, ≤18
VC risk averse for CES > 18, ≤22
VC risk neutral for CES > 22, ≤40
Utility
1

0.80

0.50

0.3

0.1
0
5 18 22 40 CES