Explain the challenges expected utility theory faces in explaining (a) the St.

Petersburg paradox, (b)

the phenomenon of simultaneous gambling and insurance, and (c) the pattern of experimental
evidence known as the Common Ratio effect. Discuss whether or not it is possible to reconcile the
theory with each of these phenomena.
It is important when discussing the challenges to expected utility (EU) theory to first understand
what EU theory is. EU is the hypotheisis that an individual will make decisions based on their own
utility functions which in turn are derived from their own indididual preferences. Prferences could
then be categorised as risk averse (concave utility function), risk neutral (linear utilitiy function) or
risk loving (convex utility function). Using this understanding of preferences means we can easier
undersntad decisions made under risk, for instance those who are risk averse will prefer an outcome
with certainty over a gamble with a uncertain outcome. Thus when making such a decision under
uncertainty we will assume that an individual understands the probability of each outcome, however
is uncertain as to which one will occur.
EU theory is contradictory to Expected Value (EV) theory which instead models that decisions are
made based on the objective values in monetary terms related to a decision as aposed to the
subjective utility of them. Thus EU theory is concerned with maximising satisfaction, whereas EV
theory is concerned with maximising value. I
This essay will take our understanding of these two models to explain the challenges faced by EU
and EV theory today.
It is out of our definition of EV theory that the St Petersburg paradox arises, whereby the aradox
claims that an individual can gain an infinite level of value by playing a repeated game. We can
model this issue as follows, suppose we are flipping a coin with the probabilities p1=05 for heads
and p2=0.5 for tails. Essentially the price for guessing the correct side of the coin will be that the
initial stake is doubled, which means that if one adopted to the Martingale system and doubled their
stake after every loss then eventually they would win and make a gain equal to their initial
investment. Thus we can wirte the expected value of the game as follows:
1
12
13
= 2 + 4 + 8 + = 1 + 1 + 1 +
2
2
2
Thus it does seem that one could contuuously do this to win an infinite amount of money, however
it seems unlikely in that after enough losses someone would have stake large sums, i.e 1 million.
Thus the reasoning that a rational individual would actually stake 1 million pounds to geain an
infinitesimal increase in wealth creates the St Petersburg Pradox. EV theory claims that one would
decide to gamble if the EV(Game)>EV(Certaintly) which clearly is satisfied here as >
1 which is a fair gamble. Thus the reasoning that a rational individual would actually not
stake 1 million pounds to geain an infinitesimal increase in wealth defines the St Petersburg Paradox.
Bernoulli then proposes a fix to the paradox by explaining how indivuduals utility functions are in
fact logarithmic, and concave by nature. This would make indiviiduals risk averse by nature, leading
them to reject fair gambles. We can demonstrate this mathematically by assuming ones utility
function beieng u(x)=log(x) and the stake being arbritarily chosen as 1 million. Thus the expected
utility of the game can be written as:
1
12
13
[()] = log(2) + log(4) + log(8) + 0.6
2
2
2
We can then compare this with the expected utility of keeping the 1 million as:

(1 ) = log(1,000,000) = 13.8
Here we can see that 13.8>0.6 and we would reject the fair gamble in order to keep 1 million with
certainty. This then seems to fix the problems created by Srt Petersbyrg aradox. However for this
application of EU theory to work we have to hold one strong assumption, that utility fucntions are
converse and all individuals are neccersarily risk averse. If we assume risk loving with a ultilty
function of u(x)=x^2 or risk neutral u(x)=x, then if we followed our mathematical steps as before bith
situations would have expected utilities that tend towards infinity. This would then reinstate the
paradox. Therefore although EU theory can help to explain the paradox, the fact that it requires risk
aversion dampens the legitimacy of the fix.
Such a problem is also highlighted when we question whether or not individuals act in a risk averse
manner in reality. If people were by nature risk averse then nobody would ever gamble or buy
lottery tickets as the probabilities assigned to such lotteries relate to an unfair gamble; thus by
following EU theory decisions would be ade to reject such gambles. However in reality we can
witness people simultaneously buying insurance for their homes, cars etc, but also buying lottery
tickets, directly contradicting this assumption of people being risk averse. Freidman and Savage
offers an extension to basic EU theory in order to try and model this situation of simultaneous
gambling and insurance whereby they claim that utility fucntions can be both exponential and
logarithmic in different sections depending on whether one act in a risk averse or loving manner.
Such a situation can be shown graphically as in figure 1, whereby we assume that an individual has
an arbritary value of wealth, w, which is at the end of a concave section but at the start of a convex
section. If we now consider an indvidul who buys a lottery ticket to increase their wealth from w to
w+J then we can say that they are operating in the convesx part of their utility function. Here the
cost of the ticket would be 1, so the individual would reduce their wealth down to w-1 in order to
gamble on getting w+j.
If we consider a situation where the
individual is buying insurance then they
would buy insurance to reduce wealth to w1 in order to protect against a uninsured
cost thst would reduce wealth to w-L. Given
a risk averse inddividuals preferences to get
a certain outcome over an incertain one,
then we cn see that w-1 is preferable to w-j
and that the individual is operating in the
concave section off their utility function.
However complicating utility fucntions in
such a way sees a departure from mainstream theory, questioning whether or not the use of such
adaptions to EU theory is actually applicable in the real world.
Succh limitations to EU theory are also encountered in the common ratio effect. We can model this
effect by designing an experiment as follows.
If one is offered a choice between A[(1 million, prob 1)] and B[(5 million, prob 0.8), (0, 0.2)] as well as
C[(1 million, 0.05), (0, 0.95] and D[(5 million, 0.8), (0,0.2)] then experimental evidence concludes that
utility maximisers prefer A to B and D to C. formally this could eb shown as follows:
(1 ) > 0.8(5 ) + 0.2(0)
0.05(1 ) + 0.95(0) < 0.04(1 ) + 0.96(0)
The second equation here can be rewritten to give:

0.05(1) < 0.04(5) + 0.96(0)

= (1), 0.8(5) + 0.2(0)
Thus what we can see is that the evidence from the experiment is not consistant with standard EU
theory, as assuming preferences are linear in probability where AA is preferred to B then C should be
preferred to D.
Thus the common ratio effect shows that a general pattern occurs when the ratio of probabilities of
winning a price is the same or common, and that such patterns are not considered by EU theory. It
doesnt dispute the attitude to risk of a ndividual, but more a behavorioul characteristic tht occurs
when one notices the pattern, meaning that EU theory cannot be universally applied to all inividuls.
There we can conclude that the St Petersburg Paradox, Simultaneous gambling and insurance model,
and common ratio effect all in some way critique the use of standard EU theory. In the first 2 cases
we can apply adaptations to the shape of the EU curve in order to resolve the issues created,
however in doing so EU theory becomes mmore complex and less viable in terms of behavioural
economics. Such a problem is then picked up by the common rtio effect which exemplifies the fact
that as a predicitive tool, EU models are not iniversally applicable.