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Expected Utility Maximization

The document summarizes the expected utility theory of von Neumann and Morgenstern. It introduces the concept of a utility function over wealth that represents preferences over risky outcomes. It describes how utility is unique only up to a positive linear transformation. It defines risk aversion and risk indifference based on the properties of the utility function. It outlines the axiomatic basis of expected utility theory based on axioms like completeness, transitivity, continuity and substitution.

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47 views14 pages

Expected Utility Maximization

The document summarizes the expected utility theory of von Neumann and Morgenstern. It introduces the concept of a utility function over wealth that represents preferences over risky outcomes. It describes how utility is unique only up to a positive linear transformation. It defines risk aversion and risk indifference based on the properties of the utility function. It outlines the axiomatic basis of expected utility theory based on axioms like completeness, transitivity, continuity and substitution.

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অঙ্কন দাস
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© © All Rights Reserved
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Financial Economics Expected Utility Maximization

Von Neumann and Morgenstern


Expected Utility Maximization
Define a utility function so choice under uncertainty maximizes
the expected utility of wealth,

E [u (w)] .
We assume positive marginal utility.

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Financial Economics Expected Utility Maximization

Utility Unique Only up to


Positive Linear Transformation
For
v (w) = a + bu (w) , b > 0,
then
E [v (w)] = a + bE [u (w)] ,
so the two utility functions are equivalent.

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Financial Economics Expected Utility Maximization

Risk Indifference
Risk indifference means that the individual chooses the gamble
to maximize expected wealth

E (w) .

The individual is risk indifferent if and only if the utility


function is linear,

u (w) = a + bw, b > 0,

so
E [u (w)] = a + bE (w) .
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Financial Economics Expected Utility Maximization

Risk Aversion
The individual is risk averse if he will trade off less risk for a
reduced expected value. The individual is risk averse if and
only if the utility function is concave.

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Financial Economics Expected Utility Maximization

Figure 1: Risk Aversion


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Financial Economics Expected Utility Maximization

Axiomatic Basis
If the choice under uncertainty satisfies certain reasonable
axioms, then one can construct a utility function that explains
the choice (von Neumann and Morgenstern [1]).
Axioms:

• Completeness;

• Transitivity;

• Continuity;

• Substitution.
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Financial Economics Expected Utility Maximization

Completeness
For any two gambles A and B, the individual either prefers one
to the other or is indifferent between them: either A  B,
B  A, or A ∼ B.

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Financial Economics Expected Utility Maximization

Transitivity
A  B and B  C implies A  C.

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Financial Economics Expected Utility Maximization

Continuity
Notation: p ◦ A + (1 − p) ◦ B means to receive A with
probability p and B with probability 1 − p.
Continuity: if A  B  C, then there exists some probability p
such that
B ∼ p ◦ A + (1 − p) ◦ C.

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Financial Economics Expected Utility Maximization

Substitution
The substitution of indifferent gambles has no effect on the
preference ordering:

p ◦ A + (1 − p) ◦ C ∼ p ◦ B + (1 − p) ◦ C
if A ∼ B.

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Financial Economics Expected Utility Maximization

Example of Substitution
A: $5 with probability 1.
B: $10 with probability 1.
C: $4 with probability 12 , $7 with probability 12 .
If A ∼ C, then the individual is indifferent between:
$5 with probability p, $10 with probability 1 − p.
$4 with probability 12 p, $7 with probability 12 p, $10 with
probability 1 − p.

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Financial Economics Expected Utility Maximization

Definition of Utility
Let A denote the best outcome, and let Z denote the worst
outcome. For a gamble B, define its utility u (B) as the
probability such that

B ∼ p ◦ A + (1 − p) ◦ Z.

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Financial Economics Expected Utility Maximization

Proof of Expected Utility Property


To show:

u [p ◦ B + (1 − p) ◦ C] = pu (B) + (1 − p) u (C) .

Proof:

p ◦ B + (1 − p) ◦ C ∼ p ◦ [u (B) ◦ A + (1 − u (B)) ◦ Z]
+ (1 − p) ◦ [u (C) ◦ A + (1 − u (C)) ◦ Z]
∼ [pu (B) + (1 − p) u (C)] ◦ A
+ {p [1 − u (B)] + (1 − p) [1 − u (C)]} ◦ Z.

The latter has utility pu (B) + (1 − p) u (C).


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Financial Economics Expected Utility Maximization

References
[1] J. von Neumann and O. Morgenstern. Theory of Games
and Economic Behavior. Princeton University Press,
Princeton, NJ, third edition, 1953. QA269V65 1953
(originally 1944).

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