Utility Theory Flashcards Preview

Decision Making > Utility Theory > Flashcards

Flashcards in Utility Theory Deck (14)
Loading flashcards...
1

Expected Utility

quantification of the DMs preferences towards an outcome under risk

2

Utility Curve

Utility is a function of reward U(r)
As the reward increases, the marginal utility gets smaller - Law of diminishing marginal return

3

Certain Monetary Equivalent

Guaranteed return that someone would accept now, rather than taking a chance on a higher, but uncertain, return in the future.

4

Types of Utility functions

Risk averse conditions
Risk taking conditions
Risk neutral conditions
Turning Point

5

Risk averse conditions (Utility function)

Concave
CME < EMV

6

Risk neutral conditions (Utility function)

Linear
CME = EMV

7

Risk Taking conditions (Utility function)

CME > EMV
Convex

8

Turning Point Condition (Utility function)

risk taking to a point then switch to risk averse
depends on the strategy you can afford

9

Prospect Theory

assumes that losses and gains are valued differently, and thus individuals make decisions based on perceived gains instead of perceived losses
Has a turning point

10

Insurance Problem

Insurance company and customer have varying opinions of risk
Creates a trading margin between the different CME values
Both CME < EMV

11

Von Neumann-Morganstern Axioms

Complete Ordering
Continuity
Independence
Unequal Probability
Compound Lottery

12

Complete Ordering Axiom

If r1 > r2
and r2 > r3
then r1 > r3

13

Continuity Axiom

for any gamble, there exists some probability such that the decision-maker is indifferent between the "best" and the "worst" outcome.

14

Independence Axiom

If a decision-maker is indifferent between two possible outcomes, then they will be indifferent between two lotteries which offer them with equal probabilities, if the lotteries are identical in every other way, i.e., the outcomes can be substituted
Allows the creation of simple lotteries from compounds
Given r1 and r2 are indifferent, you would then be indifferent between lottery with P(r1) and P(r3) and lottery with P(r2) and P(r3)