Von Neumann–Morgenstern utility theorem

In decision theory, the von Neumann–Morgenstern (VNM) utility theorem shows that, under certain
axioms of rational behavior, a decision-maker faced with risky (probabilistic) outcomes of different choices
will behave as if he or she is maximizing the expected value of some function defined over the potential
outcomes at some specified point in the future. This function is known as the von Neumann–Morgenstern
utility function. The theorem is the basis for expected utility theory.

In 1947, John von Neumann and Oskar Morgenstern proved that any individual whose preferences
satisfied four axioms has a utility function;[1] such an individual's preferences can be represented on an
interval scale and the individual will always prefer actions that maximize expected utility. That is, they
proved that an agent is (VNM-)rational if and only if there exists a real-valued function u defined by
possible outcomes such that every preference of the agent is characterized by maximizing the expected
value of u, which can then be defined as the agent's VNM-utility (it is unique up to adding a constant and
multiplying by a positive scalar). No claim is made that the agent has a "conscious desire" to maximize u,
only that u exists.

The expected utility hypothesis is that rationality can be modeled as maximizing an expected value, which
given the theorem, can be summarized as "rationality is VNM-rationality". However, the axioms
themselves have been critiqued on various grounds, resulting in the axioms being given further
justification.[2]

VNM-utility is a decision utility in that it is used to describe decision preferences. It is related but not
equivalent to so-called E-utilities[3] (experience utilities), notions of utility intended to measure happiness
such as that of Bentham's Greatest Happiness Principle.

Contents
Set-up
The axioms
The theorem
Proof sketch
Reaction
Consequences
Automatic consideration of risk aversion
Implications for the expected utility hypothesis
Implications for ethics and moral philosophy
Distinctness from other notions of utility
Limitations
Nested gambling
Incomparability between agents
Applicability to economics
References and further reading
Set-up
In the theorem, an individual agent is faced with options called lotteries. Given some mutually exclusive
outcomes, a lottery is a scenario where each outcome will happen with a given probability, all probabilities
summing to one. For example, for two outcomes A and B,

denotes a scenario where P(A) = 25% is the probability of A occurring and P(B) = 75% (and exactly one of
them will occur). More generally, for a lottery with many possible outcomes Ai, we write:

with the sum of the s equalling 1.

The outcomes in a lottery can themselves be lotteries between other outcomes, and the expanded
expression is considered an equivalent lottery: 0.5(0.5A + 0.5B) + 0.5C = 0.25A + 0.25B + 0.50C.

If lottery M is preferred over lottery L, we write , or equivalently, . If the agent is

indifferent between L and M, we write the indifference relation [4] If M is either preferred over or
viewed with indifference relative to L, we write

The axioms
The four axioms of VNM-rationality are then completeness, transitivity, continuity, and independence.

Completeness assumes that an individual has well defined preferences:

Axiom 1 (Completeness) For any lotteries L,M, exactly one of the following holds:

, , or

(either M is preferred, L is preferred, or the individual is indifferent[5]).

Transitivity assumes that preferences are consistent across any three options:

Axiom 2 (Transitivity) If and , then , and similarly for .

Continuity assumes that there is a "tipping point" between being better than and worse than a given middle
option:

Axiom 3 (Continuity): If , then there exists a probability such that

where the notation on the left side refers to a situation in which L is received with probability p and N is
received with probability (1–p).

Instead of continuity, an alternative axiom can be assumed that does not involve a precise equality, called
the Archimedean property.[4] It says that any separation in preference can be maintained under a
sufficiently small deviation in probabilities:
 Axiom 3′ (Archimedean property): If , then there exists a probability
such that

Only one of (3) or (3′) need to be assumed, and the other will be implied by the theorem.

Independence of irrelevant alternatives assumes that a preference holds independently of the possibility of
another outcome:

Axiom 4 (Independence): For any and ,

The independence axiom implies the axiom on reduction of compound lotteries:[6]

Axiom 4′ (Reduction of compound lotteries): For any lotteries and any

,

To see how Axiom 4 implies Axiom 4', set in the expression in Axiom 4, and
expand.

The theorem
For any VNM-rational agent (i.e. satisfying axioms 1–4), there exists a function u which assigns to each
outcome A a real number u(A) such that for any two lotteries,

where E(u(L)), or more briefly Eu(L) is given by

As such, u can be uniquely determined (up to adding a constant and multiplying by a positive scalar) by
preferences between simple lotteries, meaning those of the form pA + (1 − p)B having only two outcomes.
Conversely, any agent acting to maximize the expectation of a function u will obey axioms 1–4. Such a
function is called the agent's von Neumann–Morgenstern (VNM) utility.

Proof sketch

The proof is constructive: it shows how the desired function can be built. Here we outline the
construction process for the case in which the number of sure outcomes is finite.[7]: 1 32–134 

Suppose there are n sure outcomes, . Note that every sure outcome can be seen as a lottery: it is a
degenerate lottery in which the outcome is selected with probability 1. Hence, by the Completeness and
Transitivity axioms, it is possible to order the outcomes from worst to best:
We assume that at least one of the inequalities is strict (otherwise the utility function is trivial—a constant).
So . We use these two extreme outcomes—the worst and the best—as the scaling unit of our
utility function, and define:

and

For every probability , define a lottery that selects the best outcome with probability and the
worst outcome otherwise:

Note that and .

By the Continuity axiom, for every sure outcome , there is a probability such that:

and

For every , the utility function for outcome is defined as

so the utility of every lottery is the expectation of u:

To see why this utility function makes sense, consider a lottery , which selects outcome

with probability . But, by our assumption, the decision maker is indifferent between the sure outcome
and the lottery . So, by the Reduction axiom, he is indifferent between the lottery
and the following lottery:

The lottery is, in effect, a lottery in which the best outcome is won with probability , and the
worst outcome otherwise.

Hence, if , a rational decision maker would prefer the lottery over the lottery , because
it gives him a larger chance to win the best outcome.

Hence:
 if and only if

Reaction

Von Neumann and Morgenstern anticipated surprise at the strength of their conclusion. But according to
them, the reason their utility function works is that it is constructed precisely to fill the role of something
whose expectation is maximized:

"Many economists will feel that we are assuming far too much ... Have we not shown too
much? ... As far as we can see, our postulates [are] plausible ... We have practically defined
numerical utility as being that thing for which the calculus of mathematical expectations is
legitimate." – VNM 1953, § 3.1.1 p.16 and § 3.7.1 p. 28[1]

Thus, the content of the theorem is that the construction of u is possible, and they claim little about its
nature.

Consequences

Automatic consideration of risk aversion

It is often the case that a person, faced with real-world gambles with money, does not act to maximize the
expected value of their dollar assets. For example, a person who only possesses $1000 in savings may be
reluctant to risk it all for a 20% chance odds to win $10,000, even though

However, if the person is VNM-rational, such facts are automatically accounted for in their utility function
u. In this example, we could conclude that

where the dollar amounts here really represent outcomes (cf. "value"), the three possible situations the
individual could face. In particular, u can exhibit properties like u($1)+u($1) ≠ u($2) without contradicting
VNM-rationality at all. This leads to a quantitative theory of monetary risk aversion.

Implications for the expected utility hypothesis

In 1738, Daniel Bernoulli published a treatise[8] in which he posits that rational behavior can be described
as maximizing the expectation of a function u, which in particular need not be monetary-valued, thus
accounting for risk aversion. This is the expected utility hypothesis. As stated, the hypothesis may appear to
be a bold claim. The aim of the expected utility theorem is to provide "modest conditions" (i.e. axioms)
describing when the expected utility hypothesis holds, which can be evaluated directly and intuitively:

"The axioms should not be too numerous, their system is to be as simple and transparent as
possible, and each axiom should have an immediate intuitive meaning by which its
appropriateness may be judged directly. In a situation like ours this last requirement is
 particularly vital, in spite of its vagueness: we want to make an intuitive concept amenable to
mathematical treatment and to see as clearly as
possible what hypotheses this requires." – VNM
1953 § 3.5.2, p. 25[1]

As such, claims that the expected utility hypothesis does not characterize rationality must reject one of the
VNM axioms. A variety of generalized expected utility theories have arisen, most of which drop or relax
the independence axiom.

Implications for ethics and moral philosophy

Because the theorem assumes nothing about the nature of the possible outcomes of the gambles, they could
be morally significant events, for instance involving the life, death, sickness, or health of others. A von
Neumann–Morgenstern rational agent is capable of acting with great concern for such events, sacrificing
much personal wealth or well-being, and all of these actions will factor into the construction/definition of
the agent's VNM-utility function. In other words, both what is naturally perceived as "personal gain", and
what is naturally perceived as "altruism", are implicitly balanced in the VNM-utility function of a VNM-
rational individual. Therefore, the full range of agent-focussed to agent-neutral behaviors are possible with
various VNM-utility functions .

If the utility of is , a von Neumann–Morgenstern rational agent must be indifferent between and
. An agent-focused von Neumann–Morgenstern rational agent therefore cannot favor
more equal, or "fair", distributions of utility between its own possible future selves.

Distinctness from other notions of utility

Some utilitarian moral theories are concerned with quantities called the "total utility" and "average utility"
of collectives, and characterize morality in terms of favoring the utility or happiness of others with disregard
for one's own. These notions can be related to, but are distinct from, VNM-utility:

1) VNM-utility is a decision utility:[3] it is that according to which one decides, and thus by
definition cannot be something which one disregards.
2) VNM-utility is not canonically additive across multiple individuals (see Limitations), so
"total VNM-utility" and "average VNM-utility" are not immediately meaningful (some sort of
normalization assumption is required).

The term E-utility for "experience utility" has been coined[3] to refer to the types of "hedonistic" utility like
that of Bentham's greatest happiness principle. Since morality affects decisions, a VNM-rational agent's
morals will affect the definition of its own utility function (see above). Thus, the morality of a VNM-
rational agent can be characterized by correlation of the agent's VNM-utility with the VNM-utility, E-
utility, or "happiness" of others, among other means, but not by disregard for the agent's own VNM-utility,
a contradiction in terms.

Limitations

Nested gambling
Since if L and M are lotteries, then pL + (1 − p)M is simply "expanded out" and considered a lottery itself,
the VNM formalism ignores what may be experienced as "nested gambling". This is related to the Ellsberg
problem where people choose to avoid the perception of risks about risks. Von Neumann and Morgenstern
recognized this limitation:

"...concepts like a specific utility of gambling cannot be formulated free of contradiction on this
level. This may seem to be a paradoxical assertion. But anybody who has seriously tried to
axiomatize that elusive concept, will probably concur with it." – VNM 1953 § 3.7.1, p. 28.[1]

Incomparability between agents

Since for any two VNM-agents X and Y, their VNM-utility functions uX and uY are only determined up to
additive constants and multiplicative positive scalars, the theorem does not provide any canonical way to
compare the two. Hence expressions like uX(L) + uY(L) and uX(L) − uY(L) are not canonically defined, nor
are comparisons like uX(L) < uY(L) canonically true or false. In particular, the aforementioned "total VNM-
utility" and "average VNM-utility" of a population are not canonically meaningful without normalization
assumptions.

Applicability to economics

The expected utility hypothesis is shown to have limited predictive accuracy in a set of lab based empirical
experiments, such as the Allais paradox.
Which leads some people to interpret as evidence that

humans are not always rational, or

VNM-rationality is not an appropriate characterization of rationality, or
some combination of both, or
humans do behave VNM-rationally but the objective evaluation of u and the construction of u
are intractable problems.

References and further reading

1. Neumann, John von and Morgenstern, Oskar, Theory of Games and Economic Behavior.
Princeton, NJ. Princeton University Press, 1953.
2. Peterson, Chapter 8.
3. Kahneman; Wakker; Sarin (1997). "Back to Bentham? Explorations of Experienced Utility" (h
ttp://repub.eur.nl/pub/23011). Quarterly Journal of Economics. 112 (2): 375–406.
doi:10.1162/003355397555235 (https://doi.org/10.1162%2F003355397555235).
hdl:1765/23011 (https://hdl.handle.net/1765%2F23011).
4. Kreps, David M. Notes on the Theory of Choice. Westview Press (May 12, 1988), chapters 2
and 5.
5. Implicit in denoting indifference by equality are assertions like if then .
To make such relations explicit in the axioms, Kreps (1988) chapter 2 denotes indifference
by , so it may be surveyed in brief for intuitive meaning.
6. EconPort, "Von Neumann–Morgenstern Expected Utility Theory"
http://www.econport.org/content/handbook/decisions-uncertainty/basic/von.html
7. Keeney, Ralph L.; Raiffa, Howard (1993). Decisions with Multiple Objectives. ISBN 0-521-
44185-4.
 8. Specimen theoriae novae de mensura sortis or Exposition of a New Theory on the
Measurement of Risk

Nash, John F., Jr. (1950). "The Bargaining Problem". Econometrica. 18 (2): 155–162.
doi:10.2307/1907266 (https://doi.org/10.2307%2F1907266). JSTOR 1907266 (https://www.j
stor.org/stable/1907266). S2CID 153422092 (https://api.semanticscholar.org/CorpusID:1534
22092).
Anand, Paul. Foundations of Rational Choice Under Risk Oxford, Oxford University Press.
1993 reprinted 1995, 2002
Fishburn, Peter C. Utility Theory for Decision Making. Huntington, NY. Robert E. Krieger
Publishing Co. 1970. ISBN 978-0-471-26060-8
Sixto Rios (1998) Some problems and developments in decision science (http://www.mat.uc
m.es/serv/revmat/vol11-1/vol11-1g.html), Revista Matematica Complutense 11(1):113–41.
Peterson, Martin (2009). An Introduction to Decision Theory (Cambridge Introductions to
Philosophy). Cambridge: Cambridge University Press.

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