DECISION MAKING WITH

UNCERTAINTY:
UTILITY THEORY

STQM6034 Decision and Game Analysis

Recall Decision Criteria in
Lecture 1

 Optimistic/maximax
 Conservative/maximin
Payoffs mostly
 Minimax regret
in monetary
 Hurwicz alpha
value
 Expected monetary value
 Expected opportunity loss

BUT MAY NOT be the MOST DESIRABLE decision

Desirable?
 Take into account OTHER factors
◦ Risk associated with outcomes
◦ Return trade-offs

 Case Example:
◦ To buy or not to buy a house insurance?
 Buy  does not provide a higher expected monetary
value
 Look at the protection and security provided with
buying the insurance

LOOK AT UTILITY
 DEFINITION

STQM6034 Decision and Game Analysis

Utility

 A measure of total worth of a decision that

reflects the attitude of a decision maker
towards profit, loss and risk.

 Also called a model.

 Given the same decision problem, different

decision makers will have different utility
regarding risk.
Utility Concept
 Von Neumann-Morgenstern

 Consider a situation where ri outcome is

accepted with probability pi that it will
happen

 The situation is known as lottery, L

(p1,r1;p2,r2;…. ;pn,rn)
 REPRESENTATION

STQM6034 Decision and Game Analysis

Decision tree representation
 Every branch represents one possible
outcome of L

 The number on a branch represents the

probability of the possible outcome
happening

 Note the difference between decision tree

for monetary decision problem and utility
decision problem
Example 1
 A situation (L) with 2 possible outcomes

P1
1 r1

L
P2
2 r2
Example 1a
Do not invest P1 = 0.25
1 RM 5,000

L
P2 = 0.75
Invest
2 RM 50,000

 Outcome is certain to be either RM5,000 or

RM50,000
Example 2
 A decision problem with 2 situations (L1 and
L2), L1 with 1 outcome and L2 with 2 possible
outcomes
L1
P1
a1 2 r1

P2
L2
1 r2
a21 4

3
a2
P3
a22 5 r3
Example 2a
L1
P1 = 1.00
Do not invest RM 5000
2

1 L2
P2 = 0.50
Profit 4 RM 20000

Invest
3

P3 = 0.50
Loss 5 - RM 8000
Example 2a
 Consider L1: Do not invest
◦ Outcome is certain to be RM5,000

 Consider L2: Invest

◦ Expected outcome is
0.50(RM20,000) + 0.50(-RM8,000) = RM6,000

 Interpretation:
◦ Although L2 gives a bigger expected outcome,
most decision makers prefer L1 since with L1 the
outcome is certain, unlike with L2 where there is a
50% chance of a loss.

 L1 is preferred for its lower uncertainty/risk.

 OBJECTIVE

STQM6034 Decision and Game Analysis

Objective

 To determine an approach where decision

maker can choose the best lottery/situation

 Von Neumann-Morgenstern gives a ‘rank’

to the lotteries.
Ranking the lotteries – some
terms
 Arrange the lotteries according to the
probabilities of getting the outcomes.

 L1pL2  decision maker prefers L1 to L2.

 L1 has a higher probability of getting
bigger/better outcome.

 L1iL2  decision maker is neutral

(indifferent) between L1dan L2.
 No difference between L1dan L2.
 LOTTERY
RANKING STEPS

STQM6034 Decision and Game Analysis

Ranking the lotteries – steps

1. Identify the BEST and the WORST

outcomes.

2. Set utility value of 1 to the best outcome,

i.e. U(best) = 1, and utility value of 0 to
the worst outcome, i.e. U(worst) = 0.
Steps continued
3. For the OTHER outcomes (i = 1,2,…,n), the
decision maker needs to determine a
probability value where he/she is
indifferent/neutral towards the 2 lotteries
below:
Pi
1 BEST
1.00
A OUTCOME
ri N
D
1 - Pi
2 WORST
OUTCOME
Steps continued
4. The decision maker then build a new
lottery Li’ where Li’iLi, and every Li’ will
involve the BEST and the WORST
outcomes.
NOTE for step 4:
 If a lottery Li has more than one outcome,
build a Compound Lottery Li’’ first. Then
obtain Li’.
 Li’’ is a Compound Lottery, when there is a
probability pi where the payoff for the
decision maker is to use other lottery Li
Steps continued
5. From each Li’ get the probability pi’ of
obtaining the BEST OUTCOME.

6. Arrange the probabilities pi’ (i=1,2,…,n) in

decreasing order, written as
p’(max)>…>p’(min).
The associated Li’s follow and ranked, written as
Li(max)’pLi(2ndmax)’p…pLi(min)’

7. Since Li’iLi then Li(max)pLi(2ndmax)p..pLi(min)

 Example:
A decision maker needs to decide on one of
the following situations/lottery.
0.20
1 RM1,000
1.00
L1 RM20,000 L3
2 0.80
-RM20,000
0.65
1 RM60,000

L2
1.00
0.35
2 RM0 L4 RM1,000
Example: Table form

Outcome Probability of getting

Lottery
(in RM) the outcome

L1 20,000 1.00

L2 60,000 0.65

0 0.35

L3 1,000 0.20

-20,000 0.80

L4 1,000 1.00
Example: Steps 1 & 2

Step 1:
BEST outcome = RM60,000
WORST outcome = -RM20,000

Step 2:
U(RM60,000) = 1
U(-RM20,000) = 0
 Step 3:
Outcome r1 = RM20,000
Assume decision maker is indifferent/neutral
between the two lotteries below at p1 =
0.90.

0.90
1 RM60,000
1.00 A
RM20,000 N
D
2
0.10
-RM20,000
 Step 3: continued
Outcome r2 = RM0
Assume decision maker is indifferent/neutral
between the two lotteries below at p2 =
0.37.

0.37
1 RM60,000
1.00 A
RM0 N
D
2
0.63
-RM20,000
 Step 3: continued
Outcome r3 = RM1,000
Assume decision maker is indifferent/neutral
between the two lotteries below at p3 =
0.60.

0.60
1 RM60,000
1.00 A
RM1,000 N
D
2
0.40
-RM20,000
 Step 3: Table form
Probabilities
Outcome ri
i Indifferent P(Worst
(in RM) P(Best outcome)
P(ri) Probability outcome)
P(RM60,000)
Pi P(-RM20,000)

1 20,000 1.00 0.90 0.90 0.10

2 1,000 1.00 0.60 0.60 0.40

3 0 1.00 0.37 0.37 0.63

Step 4: L1’
Build L1’ where L1’iL1
1.00
L1 RM20,000

0.90
1 RM60,000

L1 ’

2
0.10
-RM20,000
Step 4: L2’’
Build L2’ where L2’iL2

0.65
1 RM60,000

L2

2
0.35
RM0

Need to build compound lottery L2’’ first.

Branch one is the one with the best
outcome. Leave it first.
Find LRM0’ to cater for outcome RM0.
Step 4: L2’’ continued
Build LRM0’ where LRM0’iLRM0
1.00
LRM0 RM0

0.37
1 RM60,000

LRM0’

2
0.63
-RM20,000
Step 4: L2’’ continued
Include LRM0’ to build L2’’

0.65
1 RM60,000

L2’’ 0.37
3 RM60,000
2

0.35
4
0.63
-RM20,000
Step 4: L2’ continued
0.65
1 RM60,000

L2’’ 0.37
3 RM60,000
0.35 2

4
0.63
-RM20,000

Calculate total probability for RM60,000:

P(RM60,000) = P(RM60,000) on 1st branch +
P(RM60,000) in oval
P(RM60,000) = 0.65 + (0.35 x 0.37)
= 0.65 + 0.13 = 0.78
 Step 4: L2’ obtained
0.65
1 RM60,000

L2

2
0.35
RM0

0.78
1 RM60,000

L2 ’

2
0.22
-RM20,000
Step 4: L3’
0.20
Build L3’ where L3’iL3 1 RM1,000

L3
2 0.80
-RM20,000

Need to build compound lottery L3’’ first.

Branch two is the one with the worst
outcome. Leave it first.
Find LRM1,000’ to cater for outcome RM1,000.
But LRM1,000’ is L4’
Step 4: L4’ obtained
Build L4’ where L4’iL4
1.00
L4 RM1,000

0.60
1 RM60,000

L4 ’

2
0.40
-RM20,000
Step 4: L3’ continued
Include L4’ to build L3’’

0.60
0.20 3 RM60,000

L3’’

4
0.40
-RM20,000

2
0.80
-RM20,000

Calculate conditional probability for

RM60,000:
P(RM60,000) = 0.20 x 0.60 = 0.12
 Step 4: L3’ obtained
0.20
1 RM1,000

L3
2 0.80
-RM20,000

0.12
1 RM60,000

L3 ’

2
0.88
-RM20,000
Step 5: Table form

i 1 2 3 4

Li ’ L1 ’ L2 ’ L3 ’ L4 ’

Pi’ 0.90 0.78 0.12 0.60

Steps 6 & 7:
Pi’ 0.90 0.78 0.60 0.12

i 1 2 4 3

Li ’ L1 ’ L2 ’ L4 ’ L3 ’

Result L1’pL2’pL4’pL3’

Conclusion L1pL2pL4pL3
Expected Utility Criteria

 Considers the expected utility for each

decision alternative and then selects the one
that yields the highest expected utility

 A formal approach to rank lotteries

 EXPECTED UTILITY
CRITERIA

STQM6034 Decision and Game Analysis

Expected Utility Criteria
 Let u(ri) be the utility for payoff ri which is
the probability qi, that is getting the best
outcome where the decision maker is
indifferent/neutral towards the two lotteries

qi
1 BEST
1.00
A OUTCOME
ri N
D
1 – qi
2 WORST
OUTCOME
Expected Utility Criteria

 u(ri) for all payoffs ri is known as the

decision maker’s Utility Function

 Therefore, E(utility for L) is

n
E (Utility for L)   piu (ri )
i 1
 Expected Utility Criteria
 The Criteria

 L1pL2 ↔ E(utility for L1) > E(utility for L2)

 L2pL1 ↔ E(utility for L2) > E(utility for L1)

 L2iL1 ↔ E(utility for L2) = E(utility for L1)

 Example: Revisited
A decision maker needs to decide on one of
the following situations/lottery.
0.20
1 RM1,000
1.00
L1 RM20,000 L3
2 0.80
-RM20,000
0.65
1 RM60,000

L2
1.00
0.35
2 RM0 L4 RM1,000
Example revisited: table

Indifferent
Outcome ri
Probability qi
(in RM)
i.e. u(i)
20,000 0.90
1,000 0.60
0 0.37
Example Revisited: L1 and L2
1.00
L1 RM20,000

E(utility for L1) = 1(0.90) = 0.90

0.65
1 RM60,000

L2
0.35
2 RM0

E(utility for L2) = 0.65(1) + 0.35(0.37)

= 0.78
Example Revisited: L3 and L4
0.20
1 RM1,000

L3
2 0.80
-RM20,000

E(utility for L2) = 0.20(0.60) + 0.80(0)

= 0.12

1.00
L4 RM1,000

E(utility for L1) = 1(0.60) = 0.60

Result:

Li E(utility for Li) Rank Result

L1 0.90 1
L2 0.78 2 L1pL2pL4pL3
L3 0.12 4
L4 0.60 3
 UTILITY
FUNCTION

STQM6034 Decision and Game Analysis

Utility function : usage
Attitude towards risk
 Risk-averse
◦ Afraid of risk or sensitive to risk
◦ Seeks sure gains
◦ Example: purchasing insurance

 Risk-seeker
◦ Not afraid of risk
◦ Eager to enter into a gamble
◦ Example: investing in stock market

 Risk-neutral
◦ Does not care about risk
◦ Can ignore risk aspects of decision alternatives
 RISK PREMIUM

STQM6034 Decision and Game Analysis

Risk premium
 Risk premium:
The amount paid (in the sense of a lost
opportunity) by an individual to avoid risk.

 Common in:
◦ Insurance premiums
◦ Higher charge by contractors for risky works
◦ Higher fees paid by house owner to reputable
contractors
◦ Lower returns from less risky investments

 Normally risk-averse individual will pay ‘risk

premium’ to avoid uncertainty
Risk-averse: risk premium
Risk premium: sign & magnitude

 (risk premium < 0) ↔ willingness to take

the risk (risk-seeker)
◦ the larger is the risk premium, the more risk-
accepting the decision-maker.

 (risk premium > 0) ↔ would avoid taking

the risk (risk averse)

 (risk premium = 0) ↔ risk neutral

Risk premium: relate to lottery L
 Let RP be risk premium

 RP(L) < 0 ↔ risk-seeker

 RP(L) > 0 ↔ risk averse

 RP(L) = 0 ↔ risk neutral

Risk premium: calculation
 Risk premium of a lottery,
RP(L) = EV(L) – CE(L)
 where
◦ EV(L) is the expected value of the
lottery’s outcomes
◦ CE(L) is the certainty equivalent of a
lottery, i.e. the ‘guaranteed’ payoff at
which a decision maker is indifferent
between accepting the guaranteed
payoff and a higher but uncertain
payoff.
Certainty equivalent of lottery

a higher but
guaranteed payoff A uncertain payoff
N
D p1
1.00 1 r1
CE(L)

p2
2 r2
 RISK PREMIUM:
EXAMPLE 1

STQM6034 Decision and Game Analysis

Risk premium: Example 1
You have RM3000. Considering to invest in
a stock.
If invest:
If price goes up, will gain RM25K with
probability 0.5.
If price goes down, will lose RM15K with
probability 0.5.

If do not invest:
RM3K is saved.
Example 1
 So 2 indifferent lotteries are as follows:
CE
0.50
gain 1 RM25,000
1.00
RM3000
0.50
lose 2
-RM15,000

No risk
Example 1: RP(L) calculation
 CE(L) = RM3,000
 EV(L) = 0.50(RM25,000) + 0.50(-RM15,000)
= RM5,000

 So, RP(L) = EV(L) – CE(L) RISK-

AVERSE
= RM5,000 – RM3,000
= RM2,000

 RP(L) > 0  willing to “give up” RM2000 in

expected value in order to avoid risk inherent
in the decision problem
 RISK PREMIUM:
EXAMPLE 2

STQM6034 Decision and Game Analysis

Risk premium: Example 2
Qaisara has an apartment valued at
RM90,000, and a cash savings of RM100,000.
Her assets’ utility is formulated as U(x) = x1/2.
She has a reason to anticipate that the
probability of her house will be destroyed in fire
is 0.001.
Calculate the amount of insurance premium
that Qaisara has to pay to protect her house.
Example 2: solution
 Let x be annual insurance premium
 Qaisara’s 2 decision alternatives/lotteries are

L1: Buy Insurance L2: Do Not Buy

Insurance
1.00 0.001
RM100,000 - x
1 RM10,000
destroyed

0.999
2
RM100,000
safe
Example 2: utility function

L1pL2 if and only if

E(U for L1) > E(U for L2)

Then, p1U(r1) > p1U(r1) + p2U(r2)

Example 2: utility function
 Then p1U(r1) > p1U(r1) + p2U(r2)

1(U(RM100,000-x)) > 0.001(U(RM10,000)) +

0.999(U(RM100,000))

(RM100,000-x)1/2 > 0.001(RM10,000)1/2 +

0.999(RM100,000)1/2

(100,000-x) 1/2 > 316.01154

(100,000-x) > 99863.29
x < 136.71
Example 2: utility function
 Hence, attitude towards risk?
 Draw utility function U(x) = x1/2
 Find U(x)’’ to check for concavity or convexity
U(x)
12

10
U(x) = x1/2
U(x)’ = 1/2x-1/2
U(x)’’ = -1/4x-3/2
8

6
<0
4

RISK-
0
0 20 40 60 80 100 120 x AVERSE
Example 2: RP(L2) calculation
 EV(L2) = 0.001(RM10,000) + 0.999(RM100,000)
= RM99,910

 CE(L2) is unknown, but we know that

E(U for CE(L2)) = E(U for L2) U(CE) = E(U(L))

1(U for CE(L2)) = E(U for L2) Relation between
utility function
U(CE(L2)) = E(U for L2) and CE
Example 2: RP(L2) calculation
 E(U for L 2) = p1U(r1) + p 2 U(r 2)
= 0.001(U(RM10,000)) +
0.999(U(RM100,000))
= RM316.012

 U(CE(L 2)) = CE(L 2)1/2

 Therefore, CE(L 2)1/2= RM316.012

 CE(L 2) = RM99,863.29
Example 2: RP(L2) calculation
 So, RP(L 2) = EV(L 2) – CE(L 2)
= RM99,910.00 – RM99,863.29
= RM46.71

 RP(L 2) > 0  willing to “give up”/pay RM46.71

more than expected loss of RM90
(= RM100,000 – RM99,910) avoiding risk.

 Therefore, Qaisara pays the insurance

premium up to RM90 + RM46.71 = RM136.71
to protect her house.
 SELF-STUDY

STQM6034 Decision and Game Analysis

Please find more information on:
1. Utility function – graphs on attitudes
towards risk
2. Relationship among certainty equivalent,
expected value and risk premiums –
using utility function graph
3. Utility function assessment
4. Risk tolerance and exponential function
5. Risk tolerance and sensitivity analysis
6. GET MORE EXAMPLES AND EXERCISES