UNIT 2:

EXPECTED VALUE PRINCIPLE $CONCEPT OF UTILITY FUNCTION

EXPECTED VALUE PRINCIPLE

Basic definition of some terms

1. Probability is the percentage chance that something will occur. For example, there is a 50 percent
chance that a tossed coin will come up heads. We say that the probability of getting the outcome “heads” is
½.
• There are some few things you need to know about probability

i. All probability of events must lie between 0 and 1

ii. If an outcome is certain to occur, it has probability 1.
iii. If an outcome is certain not to occur, it has probability 0.
iv. If we add together the probabilities for all the possible outcomes, the total must equal 1.
2. Expected value is the sum of the probability of an event times the gain/loss if that event occurs.
• The expected value of a situation with financial risk is a measure of how much you would expect
to win (or lose) on average if the situation were to be replayed a large number of times.
You can calculate expected value as follows:
• For each outcome, multiply the probability of that outcome by the amount you will receive.
• Add together these amounts over all the possible outcomes.
• For example, suppose you are offered the following proposal. Roll a six-sided die. If it
comes up with 1 or 2, you get $90. If it comes up 3, 4, 5, or 6, you get $30. The expected
value is
• (1/3) × $90 + (2/3) × $30 = $50.
On average you expect to get $50 on this proposal.
APPLICATION OF EXPECTED VALUE IN INSURANCE
• Insurance has long been considered a major pillar in risk management as it allows the transfer of risks to the
insurer under the payment of a fee (the premium).
• A useful guideline for anyone buying insurance is to compare the expected value of the possible payoffs with
the price charged for the insurance cover.
• The difference between these two numbers is (in effect) the cost of achieving the risk reduction and is the most
relevant number in comparing alternative insurance products.
• Firms which sell insurance can also use the expected value principle to assess the impact on their cost base of
repositioning their product in the marketplace
• Risk-averse people will pay to avoid risk. This is the basis of insurance.
RISK ATTITUDE OF INDIVIDUALS

• Insurance is designed to protect against serious financial reversals that results from random
events intruding on the plans of individuals.
• However, many individual might be indifferent whether to buy insurance or not. It all
depends on individual attitude towards risk.
• People have three alternative views of risk –

i. risk aversion,
ii. risk neutrality, and
iii. risk loving.
• Example: A person is given the choice between two scenarios: one with a guaranteed payoff, and one with a risky
payoff with same average value. In the former scenario, the person receives $50. In the uncertain scenario, a coin
is flipped to decide whether the person receives $100 or nothing. The expected payoff for both scenarios is $50,
meaning that an individual who was insensitive to risk would not care whether they took the guaranteed payment
or the gamble. However, individuals may have different risk attitudes.A person is said to be:
i. risk averse (or risk avoiding) - if they would accept a certain payment (certainty equivalent) of less than $50
(for example, $40), rather than taking the gamble(Kamari) and possibly receiving nothing.
ii. risk neutral – if they are indifferent between the bet and a certain $50 payment
iii. risk loving (or risk seeking) – if they would accept the bet even when the guaranteed payment is more than
$50 (for example, $60)
1.Risk averse
 These are unwilling to take risks or wanting to avoid risks as much as possible:
 The risk averse person prefer certain income over risky income and, most important to
insurance, are willing to pay to avoid risk.
 These are prime candidates for insurance. They pay a premium, which gives them a
lesser amount of guaranteed, certain income, but in so doing they do not face the risk of a
larger loss of income.
2. Risk loving/Risk Takers prefer risky income over certain income and.
 Risk Takers are individuals or investors who see opportunity in the market volatility and
risk a great deal in expectation of a high rate of return.
 They have an inclination towards high-risk investments with a great potential of return as
well as a loss at the same time.

3. Risk neutral are indifferent between the two.

• Example1.
• Suppose a house has a value of worth $100,000 There is a very small probability of 1%
that a house can catch fire, and if that will happen then the total loss will be ($100,000)
There is a very high probability of 99% that the house will not catch fire, and if the event
wont happen then you will retain the value of ($ 100,000). What is the expected value?
 Event Probability Value
fire 1% -10,000 (total loss)
No fire 99% 0( no loss at ll)

The expected value= (0.01*(-10000))+(0.99*0)= -$100

• The expected value of this policy is −$100. Now ask the individual how much she would pay to avoid this policy.

i. Someone who is risk-neutral would be willing to pay only $100.

ii. Someone who is risk-averse would be willing to pay more than $100.
The more risk-averse an individual, the more the person would be willing to pay.
THUS; The fact that risk-averse people will pay to shed risk is the basis of insurance
EXAMPLE 2:Suppose a life Insurance company sells$ 29000 one year life insurance policy
to 23Year old female for $220. The probability that the female survives the year is
0.99989.Compute and interpret the expected value of this policy to the insurance company
Example
• A 40-year old man in Tanzania has a 0.242% risk of dying during the next year. An
insurance company charges $275 for a life insurance policy that pays a $100,000 death
benefit. What is the expected value of the person buying insurance?
• The expected Value

Event Death value

death 0.00242 100,000( death benefit)
No Death 0.99758 0 (no benefit)

• The expected value =(0.00242*100,000) +(0.99758*0)=242-275=-$33

• Solution
Event probability Value
Death 0.00242 100,000- 241.3345
275=99725
Survive 0.99758 -275 -274.3345

The expected Value= -$33

Interpretation: On average the individual is expected to loose $33 per year.

UTILITY THEORY

What is utility?
• Utility is the level of satisfaction a person derives from consuming a good or service.
• When the product or service is useful to the consumer’s needs or wants, they can achieve
a certain level of utility from consuming it.
• Utility can also refers to something being beneficial, useful, or profitable (in Context of
insurance this will be the definition)
Utility theory
• Consider the following scenarios

i. Students choose to study because they want to pass their exams.

ii. We eat something because we're hungry.
iii. We sleep to give our bodies some rest.
iv. We insure because…………………
• Utility is involved in everything we do and we get satisfaction from consuming or using goods or services. This is
what utility theory is concerned with: explaining individuals’ choices and measuring the satisfaction level from
consuming a good or service.
• The level of satisfaction is measured in units called ‘utils.
Total utility and marginal utility
• There are two different types of utility:

1.Marginal utility (MU)

• Marginal utility is the satisfaction that a person receives from consuming an additional unit of the
same good or service
EXAMPLE: If John is drinking his first glass of water and gets 10 units of satisfaction, the marginal
utility he derives from the first glass is 10 units. He then has a second glass of water and gets 8 units
of satisfaction. The marginal utility he derives from the second glass is 8 units. With the third glass, he
gets only 7 units of satisfaction. Thus, the marginal utility he derives from the third glass is 7 units.
Total utility (TU)
• Total utility is the aggregate satisfaction a person receives from the consumption of all the
units of the same good or service.
• Total utility is derived from adding every marginal utility from each additional unit.
• Continuing with our previous example, where John derived 10, 8, and 7 units of utility
from the glasses of water, the total utility that John would derive is 10 + 8 + 7 = 25 units.
• The equation for total utility (TU) is:
• As the table shows, the marginal utility decreases with the addition of further units,
whereas the total utility increases until a certain point. At that point, which is 5 glasses of
water, the total utility reaches its maximum and starts declining.
We can conclude the following relationship between MU and TU:
• As the number of units increases, MU decreases, and TU increases.
• When TU reaches its maximum level, MU is 0. At that unit, the marginal utility is 0.
• MU starts to get negative and TU starts decreasing.
Number of chocolates Marginal utility Total utility
consumed
0 0 0
1 8 8
2 6 14
3 5 19
4 4 23
5 3 26
6 2 28
7 1 29
8 0 29
9 -4 25
The law of diminishing marginal utility
• The Law of diminishing marginal utility states that the level of satisfaction for an
individual diminishes as the use of the same product increases. Eventually, the consumer
either looks for an alternative or stops consuming the product.
• According to the law of diminishing marginal utility, the consumption of the first unit
gives the consumer maximum utility. Then, the level of satisfaction starts reducing as the
units increase. The consumer starts getting negative utility after a particular unit of
consumption, which may vary from consumer to consumer.
Example: Suppose Alan is very hungry and decides to eat a burger. The first burger satisfies
his hunger. However, he is still hungry, so he buys another burger. This further satisfies his
hunger. However, not as much as the first burger. He goes on to have a third burger to fill
the little hunger he still has and gets fully satisfied. Any further burger will not satisfy
Alan's hunger and might be a bit too much for him to eat. It may make him feel too full and
may also result in him feeling sick. Thus, the fourth burger may not give any satisfaction to
Alan and instead give him a negative utility.
Utility maximization
• Utility maximization means that a consumer will try to get the highest level of satisfaction
for consuming something they paid for. The utility may be different for every individual and
cannot be stated as a single total unit.
EXAMPLE: Imagine you are paying a tutor to help you with maths five days per week.
However, the tutor isn't available at least two or three times per week as initially agreed.
Would you be happy with that? Would you be satisfied with the tutor and willing to pay the
same price? The answer is generally no. If someone is paying for five days a week tuition fee,
they will expect to receive the tutoring hours they paid for. This is utility maximization.
• However, even though consumers wish to have the maximum utility from the consumption of a
product or service, sometimes they may have to make other choices due to constraints. Let's
explore them:
1.Limited income
• Even though someone may fancy having the best of all products because it gives them the
highest satisfaction, limited income may stop them from buying it.
• Richard wishes to have a Ferrari car. However, his income just covers his basic needs of food,
clothing, shelter, and a comparatively cheaper car. He has no budget for a Ferrari. In his case,
limited income stops him from having the car that will satisfy him the most.
2. A given set of prices
• Some individuals like some products or services more than others. However, they may opt
for a substitute or a similar product due to the set of prices. Although they will get the
maximum utility from consuming the high-priced goods, they may not be willing to pay the
given set of prices. Thus, they will look for alternatives.
Many people like classic non used cloth (Turkey Brand). However, some decide not to buy
them because they have a high price. They may opt for cheaper available alternatives like a
chines brand . (Why should I purchase a high priced cloth while there are some cheap ones?)
 The importance of margin when making choices
• Economists say that most choices are made at the margin.
• The margin is the current state at which an individual is making choices.
• Margin helps the consumers decide how much they will gain or lose with the extra unit
of a good or service. Hence, the consumer’s buying decision is on the margin.
Expected Utility Theory
• In real life, businesses have a lot of uncertainty when dealing with consumers and what is most beneficial to them.
• Expected utility theory is used to try to make the best decision possible when the outcome is uncertain.
• Probabilities are assigned to the various outcomes of a decision.
• The decision-maker also assigns a utility (estimated value) to each of these outcomes. The more important the
outcome is, the higher the assigned utility will be.
• To calculate the expected utility, the probability is multiplied by the utility for each outcome, and all the totals are
added together. NOTE: When
comparing different choices, the one that provides the most expected utility is considered to be the best choice.
Expected Utility Equation
• Expected utility is calculated by adding (probability x utility) for each outcome. Consider
a scenario with three outcomes. Each outcome has a specific probability and specific
utility:
UTILITY FUNCTION

Utility function, can be described as a function which measures the value, or utility, that an
individual (or institution) attaches to the monetary amount x.
• Instead of saying: iPhone7 ≻Galaxy8, we say U(iPhone7)>U(Galaxy8)
• Instead of saying: (2 Beers,3 Pizzas)≻(1 Beers,4 Pizzas), we say U(2,3)>U(1,4)

That is, like preference relations, utility is an ordinal (i.e. ordering) concept.
If, for example,
 Then bundle x is strictly preferred to bundle y. But we cannot say: " x is preferred three
times as much as is y ".
Basic attribute of a utility function
1.Utility function in an increasing function (
• Simply put, an individual whose utility function is u prefers amount y to amount z
provided that y > z, that is the individual prefers more money to less!
• The fact that means that there is non-satiation, i.e. an individual never becomes
completely satisfied and will always prefer more to less.
2. Utility function is a concave Function () (Decreasing marginal utility. )
• Simply put as the individual’s wealth increases, the individual places less value on a fixed increase
in wealth.
 Take an example of the beggar and the millionaire, A beggar will value a 100/= much more than a
millionaire. 10000/= may double the wealth of the beggar where as a millionaire would never
notice the loss of 10000/=.
 we can see that as wealth increases, each additional 100 has a lower perceived value. This is not
surprising and is known as decreasing marginal utility, that is
(
Types of utility function
• It is possible to construct a utility function by assigning different values to different levels
of wealth. For example, an individual might set , and so on. Clearly it is more practical to
assign values through a suitable mathematical function.
• Therefore, we now consider some mathematical functions which may be regarded as
having suitable forms to be utility functions.
1.Exponential
• A utility function of the form where , is called an exponential utility function.
2. Quadratic
A utility function of the form and β > 0,is called a quadratic utility function. The use of this
type of utility function is restricted by the constraint ), which is required to ensure that u’(x)
> 0.
3.Logarithmic
• A utility function of the form 0 and β > 0, is called a logarithmic utility function. As u(x)
is defined only for positive values of x, this utility function is unsuitable for use in
situations where outcomes could lead to negative wealth.
4. Fractional power
A utility function of the form and 1, is called a fractional power utility function. As with a
logarithmic utility function, u(x) is defined only for positive x, and so its applications are
limited in the same way as for a logarithmic utility function.
The expected utility criterion
• Decision making using a utility function is based on the expected utility criterion.
• This criterion says that a decision maker should calculate the expected utility of resulting
wealth under each course of action, then select the course of action that gives the greatest
value for expected utility of resulting wealth.
• If two courses of action yield the same expected utility of resulting wealth, then the
decision maker has no preference between these two courses of action.
• To illustrate this concept, let us consider an investor with utility function u who is
choosing between two investments which will lead to random net gains of
andrespectively. Suppose that the investor has current wealth W, so that the result of
investing in Investment i is Then, under the expected utility criterion, the investor would
choose Investment 1 over Investment 2 if and only if

• Further, the investor would be indifferent between the two investments if

• Example: Suppose a house has a value of worth $100,000 There is a very small probability of
1% that a house can catch fire, and if that will happen then the total loss will be ($100,000)
There is a very high probability of 99% that the house will not catch fire, and if the event wont
happen then you will retain the value of ($ 100,000) Suppose the utility function is given by
U(w)=ln(w+100)
i. If no insurance arrangement is made then what is the the expected utility will be;
ii. Suppose the how owner takes an insurance and the premium to be charged is $1200 what
will be the expected utility?
iii. What is the conclusion with respect to the calculated expected utility?
CASE1:E(u(w))=
P(w=100,00)=0.99 and p(w=0)=0.01
E(u(w))=0.99Xln(100,100) + 0.01ln(100)=11.44
• Thus the expected utility if the home owner will not take an insurance cover = 11.44

CASE2:The worth of the homeowner would have been reduced from $ 100,000 to $98800 due to premium paid. Thus
there is certain 100% that the wealth of homeowner will remain to be $98800 if loss occurs or don’t occur Then the
Expected utility in this case is given by
• E(u(w))=1Xln(98,900)=11.5

CONCLUSION: Thus the expected utility obtained by effecting insurance is higher than of not effecting an insurance.
With this scenario a home owner should take insurance
APPLICATION IN INSURANCE
• Most people are risk averters and therefore they buy insurance to avoid risk.
• Now an important question is how much money or premium a risk-averse individual will
pay to the insurance company to avoid risk and uncertainty facing him.
• The theory of utility explains why risk adverse are willing to pay a premium larger than
the net premium, that is, the mathematical expectation of the insured loss.
• The Result of Jensen’s inequality can be used to proof the above concept
Jensen’s inequality
Definition : Jensen’s inequality shows that For any random variable X and any function u that is strictly concave,
that is u
Please note: Jensen’s inequality tells us that, if the utility is concave, the expected utility is less than the utility of
the expected value.
• We can use Jensen’s inequality to obtain results relating to appropriate premium levels for insurance cover,
from the viewpoint of both an individual and an insurer.
• Consider first an individual whose wealth is W. Suppose that the individual can obtain complete insurance
protection against a random loss, X. Then the maximum premium that the individual is prepared to pay for this
protection is P, where
The utility equilibrium equation is…………….(i)
• This follows by the expected utility criterion and the fact that u(x) > 0, so that for any premium ¯P < P,

By Jensen’s inequality,

• As is an increasing function, it follows that P ≥ E [X].

• This result simply states that the maximum premium that the individual is prepared to pay is at least equal
to the expected loss.
• By Jensen’s inequality,
• E [u(W − X)] ≤ u (E [W − X]) = u (W − E [X]) ,
• u(W − P) ≤ u (W − E [X]) .
• As u is an increasing function, it follows that P ≥ E [X].
• This result simply states that the maximum premium that the individual is prepared to pay
is at least equal to the expected loss.
• A similar line of argument applies from an insurer’s viewpoint. Suppose that an insurer
whose utility function is v and whose wealth is W is asked by an individual to provide
complete insurance protection against a random loss, X. From the insurer’s viewpoint, the
minimum acceptable premium for this protection is , where the equilibrium is given by
• v(W) = E [v(W + − X)] ……….(i)
• This follows from the expected utility criterion, noting that the insurer is choosing
between offering and not offering insurance. Also, as v is an increasing function, for any
premium
• Applying Jensen’s inequality to the right-hand side of equation (i) we have

and as is an increasing function, ≥ E [X]. Thus, the insurer requires a premium that is at
least equal to the expected loss, and so an insurance contract is feasible when P ≥ .e
• Example 3 An insurer is considering offering complete insurance cover against a
random loss, X, where E[X] = V[X] = 100 and Pr(X > 0) = 1.The insurer adopts the utility
function for decision making purposes. Calculate the minimum premium that the insurer
would accept for this insurance cover when the insurer’s wealth, W, is (a) 100, (b) 200
and (c) 300.
• Solution
Example 2: A risk averse customer, whose utility is given by U(x) = ln x and wealth is TZS
50M is faced with a potential loss of TZS 10M with a probability of pL = 0.1. What is the
maximum premium he would be willing to pay to protect himself against this loss?