Introduction To Game Theory 1 - Decision Theory: Helena Perrone
Introduction To Game Theory 1 - Decision Theory: Helena Perrone
1 - Decision Theory
Helena Perrone
Introduction
Risk and Uncertainty
Decision Theory Introduction
Uncertainty
Example
Uncertainty
Example
Risk
Sun Rain
ice-cream shop 6 0
bookshop 2 2
Example
Strategic Interaction
Decision Theory
exploits the information given by probabilities and the information
about agentspreferences in order to make good decisions - choose
favorite lottery
Decision Theory Taking Decisions
1
Suppose the probability of cold weather is p = 2
Decision Theory Taking Decisions
Lotteries
Tree representation
Decision Theory Taking Decisions
Rational Behavior
An experiment
choose a lottery
Expected Value
I consider a game in which you pay a xed fee to play and then
you toss a coin repeatedly until it turns up heads
I you get $2 if the coin comes up heads in the 1st toss
I $4 if heads in the 2nd toss
I $8 if heads in the 3rd toss
I etc.
1 1 1 1
E (L) = (0) + (2) + (4) + ... + n +1 2n ... =
2 4 8 2
1
= (1 + 1 + 1 + 1 + ...) =
2
=
Expected Utility
m n
L L0 , pi u (xi ) > pi0 u xi0
i =1 i =1
Expected Utility von Neumann-Morgenstern utility function
Example
I Suppose an economic agent has preferences that can be
represented
p by the von Neuman-Morgenstern utility function
u (x ) = x.
I Which lottery will this agent choose?
E (L1 ) =
E (L2 ) =
Preference Representations
Expected Utility von Neumann-Morgenstern utility function
Proof.
L < L0
m
n n
pi u (xi ) pi0 u (xi0 )
i =1 i =1
m
n n
pi u (xi ) pi0 u (xi0 )
i =1 i =1
m
n n
pi v (xi ) pi0 v (xi0 )
i =1 i =1
Expected Utility The VNM: Application
I Check with u:
1
u (0) = 10 = 9.
0+1
! u isnt satisfactory.
Expected Utility The VNM: Application
I 10
But it doesnt satisfy the 2nd condition since v (10) = 11 . So
v is not satisfactory.
Expected Utility The VNM: Application
I 10
Construct a new w dividing v by 11 :
11 11x
w (x ) = v (x ) = .
10 10(x + 1)
The oil well L0 should be chosen if the investor is risk neutral. Yet,
you should check his attitude toward risk before giving any advice.
Expected Utility The Investor Example
u (60) = 0
u (200) = 1
I Now we assess the utility of the remaining consequences by
means of the reference lottery:
L = h, 1 j x1 , x2 i
remember: 0 1 ( is a probability)
Expected Utility Graphical Analysis
Risk Aversion
Attitude towards risk
E (L) = pg + (1 p )b = E (L )
risk averse/neutral/loving - based on the reaction when comparing
2 lotteries with the same expected value: a risky lottery L and an
actuarially equivalent degenerate lottery L
Attitude towards risk
Risk Aversion
Proof.
Attitude towards risk
U (L ) = u (pg + (1 p ) b ) >? pu (g ) + (1 b ) u (b )
Graph
Attitude towards risk
Risk Loving
Proof.
Homework
Graph
Attitude towards risk
Risk Neutral
Proof.
Homework
Graph
Attitude towards risk
Certainty Equivalent
Attitude towards risk Certainty Equivalent
Certainty Equivalent
u [C (L)] =p u (x ) + (1 p ) u (x 0 )
C (L) =u 1
[p u (x ) + (1 p ) u (x 0 )]
Attitude towards risk Certainty Equivalent
u [C (L)] =p u (x ) + (1 p ) u (x 0 )
C (L) =u 1
[p u (x ) + (1 p ) u (x 0 )]
Attitude towards risk Certainty Equivalent
Proof.
p u (x ) + (1 p ) u (x 0 ) < u p x + (1 p) x 0
or, equivalently
u 1
[pu (x ) + (1 p )u (x 0 )] < px + (1 p )x 0
Applications
Applications
Applications
Applications
2 questions:
______________________
) x = ____
I Assume the individual does not own the risky asset and is
considering whether to buy it
I compare two lotteries: not buying, L4 , and buying at a price
y , L3 .
U (L3 ) = _______________________
U (L4 ) = _______________________
Applications Buying and Selling Risky Assets
__________________________
) y = ____
2 - Insurance Contracts
Insurance: Notation
0 initial wealth
0 d loss
p probability of re
x d compensation in case of re
s price of a unit of insurance
sx insurance premium
Applications Insurance Contract
U (Ld ) = f (x ) = pu ( d sx + x ) + (1 p ) u ( sx )
Applications Insurance Contract
max f (x ) = p u ( d sx + x ) + (1 p ) u ( sx )
x
s.t. 0 x d
p (1 s ) u 0 ( d sx + x ) s (1 p ) u 0 ( sx ) = 0
Applications Insurance Contract
E (B0 ) = 0
E (B1 ) = 600
Insurance markets
30x
u (x ) =
x +4
where x represents the number of deer.
I It is easily veried that the second derivative is negative
I
d 2u 240
= <0
dx (x + 4)3
I so the utility function utility function is strictly concave,
meaning that both hunters are risk averse.
I When an individual goes hunting he gets 2 units of deer.
I From time to time (with probability 20%) a hunter gets ill and
cannot go hunting. In that case he gets nothing.
Applications Insurance Contract
3 - Optimal portfolio