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THEORY

LOTTERIES!

Have previously considered preferences

over bundles of goods, will now expand

analysis to consider preferences over

lotteries (bundles of possible outcomes).

Begin with a Simple Lottery ͚L͛:

A list of ͚N͛ outcomes with probabilities

͚pn͛.

L=(p1,...,pn,...,pN)

Each pn is Non-negative, the sum of all

probabilities =1.

If we have more than one simple lottery

and want to compare, then it is possible,

e.g., comparison of a National Lottery and a

Tombola (Google it!).

The national lottery offers a prize of

10million or nothing; the Tombola offers

10k, 1k or nothing; we can still compare

them!

4 Outcomes:

1 ʹ 10 million

2 ʹ 10,000

3 ʹ 1, 000

4 ʹ 0

National Lottery = LN

LN = (0.0001, 0, 0, 0.9999)

Tombola = LT

LT = (0, 0.001, 0.001, 0.998)

LOTTERIES

Expanding on simple lotteries, we can

have situations where we have a lottery

to decide what lottery to participate in!

This is called a compound lottery:

͚K͛ simple lotteries, L1,...,LK.

Each simple lottery has a probability

of participation of ͚ɲk͛.

Each ɲk is NON-NEGATIVE and the

sum of all ɲk = 1.

Can now calculate the probabilities of

getting a single outcome (in the

previous, for example, outcome 1

occurred w/ probability 0 if you chose

the tombola and 0.0001 if you chose the

National Lottery; here, it is (0.5 x 0) +

(0.5 x 0.0001).

National Lottery = LN

LN = (0.0001, 0, 0, 0.9999)

Tombola = LT

LT = (0, 0.001, 0.001, 0.998)

Flip a coin to decide what

lottery to participate in ʹ

50% chance of either:

Compound Lottery:

(LN, LT; 0.5, 0.5)

Prob. of getting 1m:

(0.5x0.0001)+(0.5x0) =

0.00005.

So on and so forth for others.

LOTTERIES

To establish a preference relation between two lotteries (L and L͛), we need

to impose three restrictions, although the last is arguably the most

important:

Rationality, Continuity and Independence:

Rationality ʹ either one lottery is preferred to the other or both

(indifference). With three lotteries, if L > L͛, and L͛>L͛͛, then L> L͛͛ (see topic

1 slides).

Continuity ʹ A small change in probabilities does not affect the preference

ordering. This both rules out Lexicographic preferences (where one event is

always preferred or not preferred regardless of the probability associated

to it) and allows for the construction of a utility function representing the

preference relation.

Independence ʹ L is weakly preferred to L͛ (L >L͛) if and only if:

aL + (1-a)L͛ > aL͛ + (1-a)L͛͛

The preference relation is INDEPENDENT of the third lottery used. L͛͛ is

irrelevant because in a compound lottery, the consumer has either L/L͛, or L͛͛.

Thus his preferences over L and L͛ determine which of the two he would have in

a compound lottery.

LOTTERIES

We can represent preferences in lotteries using the von Neumann-

Morgenstern (v.N-M) expected utility function.

The v.N-M expected utility function arises if every simple lottery ͚L͛ has a

utility associated with each of its outcomes, such that:

U(L) = p1.u(1)+...+pN.u(N)

It is expected utility as the total utility of ͚L͛ is simply the expected

value of the utilities of the N outcomes associated with it.

When does the v.N-M expected utility function occur? I.e., when does a

utility function have an expected utility formthat makes it a v.N-M

expected utility function?

When the utility function is LINEAR ʹ when utility of the expected

value of a compound lottery is the same as the expected utility from

the compound lottery:

k

K

k

k

K

k

k k

L U L U

§ §

! !

! ¹

º

¸

©

ª

¨

1 1

o o

LOTTERIES

Proof of Linearity:

Need to show that BOTH

Linearity Ex. U

Ex. U Linearity

To do so, consider DEGENERATE

LOTTERIES (any lottery can be

written as a compound lottery

over degenerate lotteries):

A degenerate lottery Ln occurs

when outcome ͚n͛ occurs with

certainty in that lottery.

Ln = (0,...,1,...,0), Hence, the

overall lottery ͚L͛ can be

expressed as the sum of these

lotteries:

¯

=

N

n

n

L p L

Linearity Expected utility

utility! expected is Which

: linearity By

N

n n

n

N

n

N

n

n

u p L U

L U p L U

L p U L U

The last line derives from

the fact that U(Ln) is the

utility of state ͚n͛ because

Ln is a degenerate lottery).

Expected utility Linearity

!

: that Implies EU

Linearity

L U

u p

u p

p p

u p L U

k

N

k

K

n

k

n

N

k

N K

n

k

n k

K

k

n k n

N

n n

K

k k

@

!

!

!

!

§

§ §

§ §

§

§ §

E

E

E

E

E

LOTTERIES

Preference relations in v.N-M

expected utility functions are

preserved only by LINEAR

transformations:

U and U~ are both v.N-M

expected utility functions

representing the same

preference ordering iff:

0

~

"

!

F

K F L U L U

Proof:

? A

? A

k

K

k

K

k k

k

K

k

K

k k

K

k k

K

k k

L L

L

L

L L

~ ~

~

§ §

§

§

§ §

!

!

!

!

E E

K F E

K E F

K E F E

A linear

transformation of

U is therefore still

has an expected

utility form, as it is

linear.

'

~ ~

'

L L

L L

L L

L L

u

u

u

u

K F K F

F F

The preference

ordering is

therefore preserved

during a linear

transformation

LOTTERIES

The EXPECTED UTILITY THEOREM:

Most important result in choice under uncertainty, according to Mas-

Colell et al. Proof on next slide!

It states that:

If individual͛s preferences satisfy the continuity (such that they can be

represented by a utility function) and independence axioms, then his

preferences can be represented by a utility function with an expected

utility form.

Before we were considering the cases where a utility function could

have an expected utility form, now we have a direct relationship

between preferences and the expected utility form.

In an equation, the Expected Utility Theorem suggests that:

¯ ¯

> ÷

N N

u u L L ' ' H

~

LOTTERIES

5 Steps to the proof:

? A

' ' 1

: t e , 0,1 a L' L If

L L L L H H

H

o o

o

+

. J

o F o o F F

F o

> + +

Iff L 1 L L 1 L

: wor t the L and lottery be t the

be L and , 0,1 , Let

H

? A L L L

L L

L

1 ~

: where unique a is there L, any For

E E

E

Relation. Preference the

represents Function Utility The

L

Į L !

? A

Form Utility Expected the has

and linear is L U

L

@

!E

Step 1: Need to use the

Independence Axiom

? A

? A ' ~ ' 1 ' ' 1

' 1 1 ~

L L L L L

L L L L L

E E E E

E E E E

H

H

Step 2: Need to use step 1

´ ) ´ ) ´ ) . 1

´ ) ´ )

´ ) ´ ) . 1

´ ) . 1 ´ ) ´ ) . 1

´ ) ´ ) . 1 ´ )

´ ) ´ )

o f ,

o o f f

o o o o , ,

o o , o o ,

o o , ,

o o

o f , ,

o o , , f f

o

o f

> . >

+ + .

+ + + ÷

+ + +

+ + »

+ »

> > =

+ + = + »

, 0 Iff

1 1

1 1 1

1 1 1

1 1

1 Step 1

, 0 If ;

1 1 1

1

L L L L

L L L L L

L L L L

L L L

L L L

L L L L L

H

H

H

H

Can simplify

bottom line!

LOTTERIES

Step 3: Implied by the continuity

of preferences.

Step 4: Use steps 2 + 3

'

: 2 step Apply

1 1

3 step Apply '

'

' '

L U L U

L L L L

L L

L L

L L L L

u u

E E

E E E E H

H

Step 5: Use step 4

? A ' '

: show to Need

L U L U L L U F F F F !

L L U L L U L

L L U L L U L

L L L

L L

' 1 ' ~ '

1 ~

1 ~ : 4 St B

E E

Construct a compound lottery of L and L͛

Shown next slide due to complexity.

LOTTERIES

. J . J

. J _ a . J

D E Q U U

U U

''

U U U U

U U U U

. . ' 1 ' 1 U

' L' U

: 4) ( t fu cti utilit t c truct B t

' 1

1 ~

3! t R r

' 1 1 ' 1

~ ' 1

' 1 ' 1 1

~ ' 1

' '

' '

' '

' ' ' '

F F E F F

E

F F E

E E

F F F F

F F

F F

F F

! !

!

!

y

y

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