ADVANCED MICROECONOMIC

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
! !
!
!


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y

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