FOR DECISION-MAKING: THE EVOLUTION OF THEORIES Expected Utility Expected utility rests on the expected utility hypothesis. This hypothesis is related with people’s preferences with regard to their choices that have uncertain outcomes. Three main pillars of expected utility are as follows: Outcomes, which are objects of non-instrumental preferences. States are the things outside the decision-maker’s control which influence the outcome of the decision. Acts are objects of the decision-makers instrumental preferences EXPECTED VALUE In the presence of risky outcomes, usually a decision- maker uses the expected value criterion for an investment option. The expected value (EV) is an anticipated value for a given investment. The EV is calculated by multiplying each of the possible outcomes by the likelihood each outcome will occur, and summing all of those values. By calculating expected values, investors can choose the scenario most likely to give them their desired outcome. UTILITY The value of each outcome, measured in terms of real numbers (mathematical form) is called a utility DEVELOPMENT OF EXPECTED UTILITY THEORY Thought of Expected Utility Theory was coined initially with the description given in terms of mathematical explanations given by Nicolas Bernoulli. In a letter to Nicolas Bernoulli, Gabriel Cramer explained that mathematicians estimate money in proportion to its quantity. RISK AVERSION AND EXPECTED MARGINAL UTILITY Risk aversion implies that the utility function of risk- averse investors is concave in nature and show diminishing marginal wealth utility. Risk-neutral individuals have linear utility functions, while risk-seeking individuals have convex utility functions. Hence the degree of risk aversion can be measured by the curvature of the utility function. It is further explained that concave expected utility theory explains risk-averse behavior for both small- stake gambles and large-stake gambles observed in everyday life. Expected Utility Theory & Loss Aversion The highlights of expected utility theory with reference to loss aversion are given as below: Investors are consistently deviated to one side only from the point of view of prediction of risk neutrality and these deviations are with risk aversion. There is no relevance with the loss aversion in the behavior of the investors. In expected utility theory there is no implication of calibration theory (comparison of measurement values). EXPECTED UTILITY THEORY
“Expected utility theory can be defined
as the theory of decision-making under risk based on a set of outcomes for preference ordering.” Expected Utility as a Basis for Decision-Making Expected Utility Theory (EUT) states that at the time of decision-making, the decision maker chooses among various risky or uncertain options by comparing their expected utilities with respect to his need. EXAMPLES You don’t know if it’s going to rain, and you have to decide whether to carry an umbrella. If you carry an umbrella, then there are 10 per cent chance you lose it, 70 per cent chance you carry it around needlessly, 20 per cent chance you use it. Expected Utility theory with Reference to lottery • A lottery [p1, p2, ..., pn] is a list of probabilities, where pi is the probability with the outcome i. • John Von Neumann and Oskar Morgenstern developed expected utility theory with reference to lottery as a financial instrument. Assumptions of utility function on lotteries 1. Completeness: which means that as per the preference of individual lotteries can be ranked. 2. Transitivity: which means that the preferences among different options are open. 3. Continuity: says that the upper and lower outline sets of a preference range over lotteries are closed. 4. Monotonicity: means that a gamble which gives a higher probability to a preferred outcome will be preferred to one which assigns a lower probability to a preferred outcome. 5. Substitution: the outcomes of different lotteries with same probability can be substituted by each other. Criticism of Expected Utility Theory Many experimental economists agree that concave expected-utility theory explains systematic, one-sided deviations from the predictions of risk-neutral models because of the belief that expected utility theory does not give right explanation of risk attitudes over modest stakes of investors in different asset classes. Also if the investors or subjects considered in experiments are risk- averse, then they are not expected-utility maximizes. In order to clarify the fundamental differences between expected utility theory and other decision theories, the distinction between expected utility theory and expected utility models need to be made. EXPECTED UTILITY MODELS
1. The expected utility of income and
Initial wealth model (EUI & IW) 2. The expected utility of income model (EUI) 3. The expected utility of terminal wealth (EUTW) THE EXPECTED UTILITY OF INCOME UTILITY AND INITIAL WEALTH (EUI&IW) MODEL This model assumes that the prizes are ordered pairs of amounts of initial wealth and income. Indifference curves for this model are parallel straight lines; therefore it is more or less an expected utility model. THE EXPECTED UTILITY OF INCOME (EUI) MODEL The expected utility of income (EUI) model is based on the assumption that the prizes are amounts of income. The EUI model is mostly used in the theory of auctions. THE EXPECTED UTILITY OF TOTAL WEALTH (EUTW) MODEL The expected utility of terminal wealth (EUTW) model is based on the assumption that the gains are amounts of terminal wealth. Terminal wealth is expected cash flow in future by applying mathematical formula It helps to explain some essential distinctions among various models to briefly review the familiar triangle-diagram representation of indifference curves for simple gambles