29-03-2014

Decision Analysis
Utility theory

Luis C. Dias / FEUC

Expected value criterion vs. pessimistic

Regra do valor esperado vs. Regra pessimista

Alternative a1 Gamble a2 No gamble Prob.

Scenario 1 -100 0 0,50

Scenario 2 110 0 0,50

EV 5 0

LC Dias / FEUC

29-03-2014

Expected value criterion vs. pessimistic

Regra do valor esperado vs. Regra pessimista

Alternative a1 No insurance a2 Insurance Prob.

Car is lost Nothing happens -60 000 -800 0,01 0 -800 0,99

EV -600 -800

Clients perspective

EV criterion: a paradox
Critrio do valor esperado: um paradoxo
How much you you pay to play this game?
Quanto pagava para jogar o seguinte jogo? Flip coin until heads appears. Lanar moeda ao ar at sair cara. If heads appears at the n-th attempt you win 2n .
Se sair cara n-sima tentativa recebe-se 2n .

Example
1st H 2 , 1st T, 2nd H 4 , 1st T, 2nd T, 3rd H 8 , 1st T, 2nd T, 3rd T, 4th H 16 , etc.

EV(game) = 1/2 * 2 + 1/4 * 4 + 1/8 * 8 + .... = infinite (St. Petersburg paradox, Bernoulli)

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Expected Value criterion

Regra do valor esperado EV rule Regra do valor esperado
Decisions are repetitive Decises repetitivas Risk neutrality Neutralidade face ao risco Value of the consequence increases linearly Valor da
consequncia aumenta linearmente

Expected Utility theory

Teoria da Utilidade Esperada
Purpose Propsito:
To incorporate subjective risk attitudes
Incorporar a atitude subjetiva face ao risco

To address any kind of consequences (including qualitative scales and multi-attribute)

Trabalhar com quaisquer tipos de consequncias (incluindo qualitativas e multiatributo)

Expected Utility (EU) as a decision criterion

A utilidade esperada como um critrio de deciso: a P b (a preferred to b) EU(a) > EU(b) a I b (a indifferent to b) EU(a) = EU(b)

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Expected Utility theory

UE=0,5*u(300)+0,5*u(0) L1 0 300

UE=0,8*u(1 hour, race car) + 0,2*u(15 minutes, heli)

1 hour race car L3 15 minutes heli

Expected Utility theory: RLT(p)

RLT(p): Reference Lottery Ticket
Bilhete de lotaria de referncia Best consequence: utility = 1
Melhor consequncia: utilidade = 1

Worst consequence: utility = 0

Pior consequncia: utilidade = 0

New currency: RLT(p) is worth p utiles

Nova moeda: RLT(p) vale p utiles

u(RLT(p)) = p

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Expected Utility theory : example

Would you play this game?
L1 1000 0.40 200 0

1000 = RLT(1.0) = 1 utile -1000 = RLT(0.0) = 0 utiles Suppose that for you (subjective assessment):
0 I RLT(p1) p1 = 0.6 200 I RLT(p2) p2 = 0.8

-1000

1000 -1000 RLT(p)

Expected Utility theory : example

1000 L1 0.40 200 0 -1000 1 utile L1 0.40 0.8 utiles 0.6 utiles UE(L1)=0.668 0 utiles
0.12*1+0.40*0.8+0.38*0.6+0.10*0=0.668

1000 0.40 -1000 1000 -1000 1000 -1000 1000 -1000 1000

L1

-1000 L1 = RLT(0.668) better than RLT(0.6) = 0

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Expected Utility theory : Axioms

Nonambiguity (conectivity): given two options the decision maker either prefers one or is indifferent between them. No-ambiguidade (ou da conectividade): perante duas aes, o
decisor ou prefere uma, ou prefere a outra, ou conclui que so indiferentes.

Transitivity: the relations of Preference (P) and Indifference (I) are transitive: Transitividade: As relaes de
preferncia (P) e de indiferena (I) so transitivas:

a,b,cA, a I b b I c a I c, a,b,cA, a P b b P c a P c, because u(a) u(b) u(b) u(c) u(a) u(c)

Expected Utility theory : Axioms

Continuity: it is always possible to solve indifference equations, either varying a consequence or a probability:
Continuidade: sempre possvel formular equaes de indiferena, variando uma consequncia ou uma probabilidade.

a,b,c : a P b b P c, p[0,1] : L I b; a,c : a P c p[0,1], b: L I b. a L c

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Expected Utility theory : Axioms

Substitution: it is possible to find the relation between consequences b and c from the comparison between L(a,b,p) and L(a,c,p), and vice-versa: Substituio: Pode-se descobrir a
forma como o decisor compara b e c a partir da sua comparao das lotarias L(a,b,p) e L(a,c,p), e vice-versa:

b I c Lb I Lc, a, p[0,1] , b P c Lb P Lc, a, p[0,1] . a Lb b Lc c a

Expected Utility theory : Elicitation Eliciao

Indifference judgments :
a L b

c=?

a L b

p=?

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Expected Utility theory : Elicitation Eliciao

Adjusting a pre-specified curve: e.g. u(x) = - e-x/, where is the risk aversion constant, and are are normalization constants.
1 0,8 Uilidade 0,6 0,4 0,2 0 110 130 150 170 190 210 230 250 270 290 70 90

Potncia Consequncia

LC Dias / FEUC 2009

Utility functions (curves)

Funes (curvas) de utilidade

Risk neutrality Neutralidade face ao risco: UE(Lottery) = u(EV(Lottery))

Gains

Losses

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Utility functions (curves)

Funes (curvas) de utilidade Risk aversion Averso ao risco: UE(Lottery) < u(EV(Lottery))

Gains

Losses

Utility functions (curves)

Funes (curvas) de utilidade Risk propension Propenso para o risco: UE(Lottery) > u(EV(Lottery))

Gains

Losses

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Back to the insurance example (Mr. Silva)

Regresso ao exemplo do seguro (visto pelo Sr. Silva )
Alternative Car is lost a1
No insurance

Nothing happens

EV -600 -800

1,0 0,8 u( )

0.9984

-60 000 0 -800 0,01 -800 0,99

a2
Insurance

-800
0 -60000 -10000 0

Prob.

EU(a1) = 0,01u(-60000)+0,99u(0) = 0,010+0,991=0,99 EU(a2) = 0,01u(-800)+0,99u(-800) = u(-800) = 0,9984 a2 P a1

Megagiga is evaluating two potential alternative projects X and Y for a new factory. Both alternatives are flexible and can be modified if not successful initially. Project X yields a profit of 10 millions if it succeeds at the first attempt (0.75 probability). Otherwise, the company may either abandon the project (loss of 3 million) or change the project: if the modified version is successful (0.3 probability) profit will be 6 million; if unsuccessful, the loss will be 7 million. Project Y yields a profit of 15 millions if it succeeds at the first attempt (0.6 probability). Otherwise abandoning the project leads to a loss of 7 million, whereas changing the project can yield a 10 million profit (0.8 probability) or a 12 million loss, depending on the success of the modified version.
A empresa MegaGiga est a avaliar dois projectos alternativos X e Y para um nova fbrica. Os dois projectos so flexveis, podendo ser alterados se no forem logo bem sucedidos. O projecto X proporciona empresa um lucro de 10 milhes no caso de ser logo bem sucedido (probabilidade de 0,75). Se for mal sucedido, a empresa pode optar entre abandonar o projecto (prejuzo de 3 milhes) ou alterar o projecto: se a verso alterada for bem sucedida o lucro ser de 6 milhes (probabilidade de 0,3); se a verso alterada for mal sucedida existir um prejuzo de 7 milhes. O projecto Y proporciona empresa um lucro de 15 milhes se for logo bem sucedido (probabilidade de 0,6). Caso contrrio, abandonar o projecto implica um prejuzo de 7 milhes, enquanto alterar o projecto pode proporcionar um lucro de 10 milhes (probabilidade de 0,8) ou prejuzo de 12 milhes, dependendo do sucesso da verso modificada.
LC Dias / FEUC 2009

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Solution according to the EV criterion

Resoluo pela regra do valor esperado
6,75 10 -3 -7 11,24 11,24 15 5,6 -12 0 -7 -3 5,6 10 -3,1 6

Solution according to the EU criterion

Resoluo pela regra da utilidade esperada Elicitate utility function for money
Eliciar funo de utilidade do dinheiro u(x) 0.7 0.55 0.4 0.85 0.9 1.0

-12

-7 -3 0

6 10

15

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Solution according to the EU criterion

Resoluo pela regra da utilidade esperada
0.8125 u(10)=0.9 0.535 0.55 u( -7)=0.4 0.888 0.888 u(15)=1 0.72 u(-12)=0 u(0)=0.7 u(-7)=0.4 u(-3)=0.55 0.72 u(10)=0.9 u(6)=0.85

Maria, a financial manager, is asked to compare pairs of alternative investments. In each pair one alternative is a given amount, whereas the other alternative is a lottery with two possible results. For each pair of alternatives, Maria is asked to indicate probabilities such that the two alternatives would be indifferent to her. The results of this process are depicted below. Draw Marias utility function for money. What is her attitude towards risk?
A uma gestora financeira, a Maria, so apresentados, sequencialmente, pares de investimentos alternativos. Para cada par, a primeira alternativa uma determinada quantia, enquanto que a segunda alternativa consiste numa lotaria com dois resultados possveis. Para cada par de alternativas, pedido Maria para atribuir probabilidades de modo a que lhe seja indiferente a escolha de uma ou da outra alternativa. Os resultados deste processo foram abaixo indicados. . Represente a funo de utilidade da Maria para o dinheiro. Qual a sua atitude face ao risco?
Alternative 1 Certain amount: 100 20 60 120 160
LC Dias / FEUC 2009

Alternative 2 Result1 0 0 20 60 20 p1 .15 .60 .50 .45 .06 Result2 200 100 200 200 200 p2 .85 .40 .50 .55 .94

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Indifference equations
Outline an utility function for the range [-50, 50] suited to an individual that states that lotteries L1, L2 and L3 are indifferent to him.
5 5 5 5

0 .3 7
L1

-50
L2

0.3 7

50
L3

0 .5 0.5

-50 50

0 .6 2

25

0.6 2

-25

Do we follow utility theory?

Seguimos a teoria da utilidade?
An urn contains 30 red balls and 60 other balls that are either black or yellow. You can draw a ball. X vs. Y: your choice? W vs. Z: your choice?
red X 0 m Y black 1 m 1 m W 0 m Z 1 m black or yellow 0 m 1 m red or yellow

0 m

Ellsbergs paradox: the common answer of choosing X and Z violates utility theory.
Paradoxo de Ellsberg: escolher X e Z viola a teoria da utilidade

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Do we follow utility theory?

Seguimos a teoria da utilidade?
A vs. B: your choice?
A B 1 m 1 m 5 m 0 m

X vs. Y: your choice?

0 m X 5 m Y 0 m

1 m

Allaiss paradox: the common answer of choosing A and X violates utility theory.
Paradoxo de Allais: escolher A e X viola a teoria da utilidade

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