UTILITY FUNCTION

TRANSFORMATIONS
If we transform the individual’s utility function with an
increasing transformation, are the preferences the same?

No, the risk aversion/attraction degree can be altered.

Is there any transformation that does not alter the
preferences?
Yes, linear transformations.

If an individual’s preferences over lotteries are represented

by 𝑢(𝑥 ) and we change it with a linear transformation:

𝑢̂(𝑥 ) = 𝑎. 𝑢(𝑥 ) + b when a > 0

Then, 𝑢̂(𝑥 ) and 𝑢(𝑥 ) represent the same preferences and,

therefore, two individuals with these utility functions, when
facing a lottery will choose the same alternative, and the
lottery’s EC and RP will be the same.
VALUE OF PERFECT INFORMATION
Would the individual be willing to know what state of
nature is going to occur?

When choosing between two options, the one with the

highest expected utility is always chosen, therefore, the
individual will pay as long as the utility paying for the
information is greater than the utility without paying for the
information.

What lottery does the individual face if they pay for the
information?

We see it with an example.

Example: Jorge has a car that needs to be repaired. The cost

of repair is uncertain: it is either 300 euros with probability
1/3, or 1.200 euros with probability 2/3. Alternatively, he
has been offered a used car at a price of 1.000 euros.
Jorge cannot do without a car as there is no public
transportation that he can use for his daily activity.
If Jorge’s utility function is 𝑈(𝑥 ) = 𝑥, should he repair the
car or replace it?
How much would the individual pay to know the state of
nature is going to happen?

They pay for the information if the expected utility of the

lottery with perfect information is greater than the
expected utility of the lottery without perfect information.

𝑬𝑼(𝒍𝑽𝑷𝑰 ) ≥ 𝑬𝑼(𝒍∗ )
Do the results change in the utility function is 𝑈(𝑥 ) =
√1200 + 𝑥?
EXERCISES
42. A consumer must choose between buying an apartment
in Madrid or a house in the suburb. Both choices would cost
him 120,000 euros. He is indifferent between the two
options, except for his expectation regarding revaluation. If
the housing prices keep on increasing (event E1), the price
of the apartment will reach 140,000 euros, while the price
of the house will reach 340,000 euros. The probability that
this will happen is 0,3. If the opposite thing (decrease in the
housing prices) happens (event E2), the price of the
apartment will be 70,000 euros and the price of the house
20,000. The preferences of the consumer are represented
by the utility function 𝑈(𝑥 ) = √𝑥, where 𝑥 is the wealth
expressed in euros. The consumer’s initial wealth is
140,000 euros.
a. Represent the decision problem and determine whether
the consumer should buy the house or the apartment.
b. Should he pay 20,000 euros in order to learn whether the
housing prices will decrease or increase?
45. A professional has an annual wage of 250,000 and his
income tax rate is 50%. He considers whether he should
declare his full income, declaring half of his income, or
declaring nothing at all. It is known that the probability of a
Hacienda inspection is 0,1. If the inspection detects that he
misdeclared his income, he will have to pay the amount of
the missing tax plus the same amount as a fee. His
preferences are represented by the Bernoulli utility
function 𝑈(𝑥 ) = 2√𝑥, where 𝑥 is his income.
a. Draw the decision tree that corresponds to this problem.
b. Suppose now that he decides not to declare anything and
that after doing so, he gets afraid of a possible inspection
and asks a friend to help him. In such a situation, he has to
pay m euros in order to be sure that he will not have any
problems with the inspection. How much is he willing to pay
for the service of his friend (m)?

c. Would your answer in part a. change if the utility function

was given by 𝑼(𝒙) = √𝒙? And if it was given by 𝑼(𝒙) =
𝟐𝒙?
d. Suppose now that Hacienda has already decided (before
the professional makes the declaration) the list of persons
that will be inspected. His friend offers to check whether
his name is on the list for 20.000 euros. Will the
professional accept? Draw the conditions for finding out
the maximum amount that the professional is willing to pay
for this information.