Chapter Three:

The Theory of Choice :

Utility Theory Given Uncertainty
Kawser Ahmed Shiblu
Lecturer
Department of Finance
Jagannath University.
Economics is the study of how people & societies choose to allocate
scarce resources and distribute wealth among one another and over
time. So we have to know the objects of choice & the method of choice.
In this chapter, we focus on the theory of how people make choices
when faced with uncertainty i.e. the method of choice. In later, we will
be familiar with the objects of choice faced by an investor.
Generally, in an economic society, prices provide a system of signals for
optimal allocation. But there are still other means or factor of
allocation. For example, the consumption behavior of the investors.
The theory of choice starts with the microeconomic price theory which
is the choice of various bundles of commodities at an instant in time.
Next come the utility theory of choice which is one-period
consumption/investment decision i.e. consume now or save (invest).
Finally comes the theory of investor choice which is the choice
between timeless risky alternatives.

Introduction
2 The Theory of Choice: Utility Theory Given Uncertainty
The theory of investor choice begins with five axioms or assumptions
about the behavior of individuals when faced with the task of ranking
risky alternatives. These assumptions are known as axioms of cardinal
utility.
These axioms provide the minimum set of conditions for consistent
and rational behavior.
Introduction
3 The Theory of Choice: Utility Theory Given Uncertainty
Oranges
Apples
C
1
C
0
Return
Risk -(1+r)
Price Theory Utility Theory of Choice
Theory of Investor Choice
Axiom 1: Comparability (completeness)
For the entire set S of uncertain alternatives, an individual can say for outcomes x,
y: (x>y) or (y>x) or (x~y)
Axiom 2: Transitivity (consistency)
If (x>y) and (y>z) then (x>z). And if (x~y) and (y~z) then (x~z).
Axiom 3: Strong independence
We construct a gamble where the individual has a probability of for receiving
outcome x and a probability of (1- ) of receiving mutually exclusive outcome z i.e.
we can write the gamble as G(x,z:). Again we can construct the second gamble
where the individual has a probability of for receiving outcome y and a
probability of (1- ) of receiving the same mutually exclusive outcome z i.e. we can
write the gamble as G(y,z:). Then, if (x~y) then G(x,z:) ~G(y,z:).
But this axiom is the hardest to accept. Lets see the example.
Let, Outcome x: winning left shoe, Outcome y: winning right shoe & Outcome z:
winning right shoe. 1
st
gamble: G(x,z:0.50) i.e. a left shoe or a right shoe. Again 2
nd

gamble: G(y,z:0.50) i.e. a right shoe or a right shoe.
We may indifferent between a left shoe (outcome x) & a right shoe (outcome y)
separately i.e. x~y. But this axiom states that we also indifferent between above
gambles. Is it correct???? No. So mutually exclusiveness of z is critical to the axiom.
Five Axioms of Choice under Uncertainty
4 The Theory of Choice: Utility Theory Given Uncertainty
Axiom 4: Measurability
If x>y>z then there is a unique probability , such that the individual will be
indifferent between y and a gamble between x with probability and z with
probability (1-) i.e. If x>y>z, then there exists a unique , such that y~G(x,z:).
Let, Outcome x: $ 16, Outcome y: $ 10 & Outcome z: $ 6. so x>y>z.
So for which unique probability of x, G(x,z:) will give $ 10 which is exactly equal to
y. The answer is 0.40. Check it. Let,15~G(20,12:), now =???
Axiom 5: Ranking
For alternatives x>y>z we can establish a gamble such that an individual is
indifferent between y and a gamble between x and z with certain probability
1
,
y~G(x,z:
1
). Also for x>u>z we can establish gamble such that u~G(x,z:
2
).
If x>y>z and x>u>z, then if y~G(x,z:
1
) and u~G(x,z:
2
), it follows that If
1
>
2
then
y>u, if
1
<
2
then y<u and if
1
=
2
then y~u.
Let, Outcome x: $ 16, Outcome z: $ 6; 16>Outcome y or u>6 i.e. x>y>z & x>u>z.
If
1
= 0.60 &
2
= 0.40 then y>u. Again if
1
= 0.40 &
2
= 0.60 then u>y.
These axioms lead to the following assumptions on human behavior:
I. Individuals always make completely rational decisions. For example, I prefer
iphone to Samsung and Samsung to Nokia but Nokia to iphone- is not rational.
II. People are able to make these rational decisions among thousands of alternatives.
Five Axioms of Choice under Uncertainty
5 The Theory of Choice: Utility Theory Given Uncertainty
Now the question arise:
How do individuals rank various combinations of risky alternatives? or
How can we establish a utility function that allows the assignment of a unit
measure (a number) to various alternatives so that we can rank them?
The answer leads us two properties of utility functions-
I. Utility function will be order preserving i.e. if utility of x is greater than that of y,
U(x)>U(y), then it can be said outcome x is really preferred to outcome y, x>y.
II. Expected utility can be used to rank combinations of risky alternatives i.e.
U[G(x,y: )]= *U(x) + (1-)*U(y)
Property-1: Utility function are order preserving.
Let, S= set of risky outcomes, a= highest possible outcome, b= lowest possible
outcome, x & y= intermediate outcomes where a>x>b & a>y>b
According to axioms 4 (measurability), for unique probability of x & y, we can
construct the following two gamble:
x~G(a,b:
x
) & y~G(a,b:
y
)
Again according to axioms 5 (ranking), we can say, If
x
>
y
then x>y, if
x
<
y
then
x<y and if
x
=
y
then x~y.
In this way, we can develop an order-preserving utility function.
Developing Utility Function
6 The Theory of Choice: Utility Theory Given Uncertainty
Property-2: Expected utility can be used to rank risky alternatives i.e.
U[G(x,y: )]= *U(x) + (1-)*U(y)
Lets, represent the previous gambles in decision tree:












Developing Utility Function
7 The Theory of Choice: Utility Theory Given Uncertainty
a
b
x ~

x

1-
x

a
b
y~

y

1-
y

x~G(a,b:
x
) y~G(a,b:
y
)
Now, consider a new choice of z and construct a gamble with respect to x & y i.e.
z~G(x,y:
z
). Now represent this gambles in decision tree:
Now if we construct the decision tree of the last gamble with respect to a & b, then the
gamble will be: z~G[a, b:
z
*
x
+ (1-
z
)*
y
Developing Utility Function
8 The Theory of Choice: Utility Theory Given Uncertainty
z ~

z

1-
z

a
b
x ~

x

1-
x

a
b
y ~

y

1-
y

z~G(x,y:
z
)
a
b
z ~
z~G(a,b:
z
*
x
+ (1-
z
)*
y
)
According to axioms 4 & 5, utilities of x & y can be represented by their
probabilities i.e. U
x
=
x
and U
y
=
y.
So the above gamble can be written as :
z~G[a, b:
z
* U
x
+ (1-
z
)* U
y
]

The unique probability of outcome z can be used as a measure of its utility
relative to a & b.
We can write:
U
z
=
z
* U
x
+ (1-
z
)* U
y

That is the utility of z is the probability of x times its utility plus the probability
of y times its utility. This is expected utility that represents a linear
combination of the utilities of outcomes.
In general,
E[U(w)]= *U(W)
Developing Utility Function
9 The Theory of Choice: Utility Theory Given Uncertainty
Given the axioms of rational investor behavior & knowing that all
investors always prefer more wealth to less, we can say that investors
always want to maximize their expected utility of wealth i.e. maximize
E[U(w)].
So all investors calculate the expected utility of wealth for all possible
alternative and choose the outcome that maximize their expected
utility of wealth.
Constructing a utility function
How we can construct the utility function? Let, loss of $1000 leads you
to utility of -10 utiles and you faced a gamble of sure 0 and a gamble
with probability 0.60 of winning $1000 and probability (1-0.60) of
losing $1000. what is the utility of winning $1000?
By repeating the problem for different payoffs, it is possible to develop
a utility function. But interpersonal comparison of utility function is
impossible. Because giving $1000 to two persons, we cant say who is
the happier.

Developing Utility Function
10 The Theory of Choice: Utility Theory Given Uncertainty
After developing utility function, now we give focus on determining the
risk tolerance level of an investor i.e. whether an investor is a risk
lover or risk neutral or risk averter. This will be done with the help of
risk premium.
Here, there are two assumptions:
I. More wealth is preferred to less &
II. Marginal utility of wealth is positive MU(W)>0.
Assume, we establish a gamble between two prospects a and b.
Probability of receiving a is , for b it is (1- ) & the gamble is G(a,b: ).
Now the question arise-
Will we prefer the actuarial value of the gamble (expected or average outcome) with
certainty or the gamble itself?
The person preferring the gamble -> risk lover.
The person preferring the actuarial value with certainty -> risk
averter.
The person who is indifferent between both -> risk neutral.
Establishing a Definition of Risk Aversion
11 The Theory of Choice: Utility Theory Given Uncertainty
Assume the gamble, where you get 30 EUR with
probability 20% and 5 EUR with probability 80%. The
expected (average) value is thus 10 EUR. Will you choose
the gamble or the value 10 EUR Under the following
assumptions-
I. Suppose that the utility function is U(W)=ln(W). Comment the answer.
II. Suppose that the utility function is U=0.04*W
2
. Comment the answer.
III. Suppose that the utility function is U=0.5*W. Comment the answer.
Establishing a Definition of Risk Aversion:
Class Practice
12 The Theory of Choice: Utility Theory Given Uncertainty
Lets see the answer under assumption-1.



As you receive more utility from the actuarial value of the gamble
obtained with certainty than from taking the gamble itself, you are a
risk averter.
Generally speaking, if utility of expected wealth is greater than the
expected utility of wealth, then the investor is risk averter.
The utility curve of this risk averter investor will be like as follow:
Establishing a Definition of Risk Aversion
13 The Theory of Choice: Utility Theory Given Uncertainty
Expected Case In case of Gamble
E(W) =0.8*5 + 0.2*30 = 10 E[U(W)] = 0.8* U(5) + 0.2 *U(30)
U[E(W)] = U(10) = ln 10 = 2.3 E[U(W)] = 0.8* 1.61 + 0.2 *3.4 = 1.97
Lets see the answer under assumption-2.



As you receive less utility from the actuarial value with certainty than
from taking the gamble itself, you are a risk lover.
Generally speaking, if utility of expected wealth is less than the
expected utility of wealth, then the investor is risk lover.
Lets see the answer under assumption-3.



As you receive equal utility from the actuarial value with certainty to
from taking the gamble itself, you are a risk neutral.
Generally speaking, if utility of expected wealth is equal to the
expected utility of wealth, then the investor is risk neutral.
Establishing a Definition of Risk Aversion
14 The Theory of Choice: Utility Theory Given Uncertainty
Expected Case In case of Gamble
E(W) =0.8*5 + 0.2*30 = 10 E[U(W)] = 0.8* U(5) + 0.2 *U(30)
U[E(W)] = U(10) = 0.04*10*10 = 4 E[U(W)] = 0.8*(0.04*5*5)+ 0.2 *(0.04*30*30)
E[U(W)] = 8
Expected Case In case of Gamble
E(W) =0.8*5 + 0.2*30 = 10 E[U(W)] = 0.8* U(5) + 0.2 *U(30)
U[E(W)] = U(10) = 0.50*10= 5 E[U(W)] = 0.8*0.50*5+ 0.2 *0.50*30
E[U(W)] = 5
We have to compare the actuarial value (average, expected) of the
gamble obtained with certainty and the gamble itself:
I. if U[E(W)]>E[U(W)] then we have risk aversion individual (concave utility function),
II. if U[E(W)]=E[U(W)] then we have risk neutral individual (linear utility function),
III. if U[E(W)]<E[U(W)] then we have risk seeking individual (convex utility function).
Three utility functions with positive marginal utility: (a) risk lover; (b)
risk neutral; (c) risk averter.







Establishing a Definition of Risk Aversion
15 The Theory of Choice: Utility Theory Given Uncertainty
Let us calculate the max amount of wealth a person would be willing to
give up in order to avoid the gamble, called risk premium i.e.
Difference between expected wealth given the gamble and the level of wealth the
individual would accept with certainty if the gamble were removed i.e. certainty
equivalent wealth. symbolically U[E(W)]-E[U(W)]
Let, we had utility function U(W)=ln(W) with current wealth level 10
EUR. Then we have the gamble G(5,30:80%) i.e. with probability 80%
of a decline to 5 EUR & probability 20% of increase wealth by EUR 20.
E[U(G)] = 1.97. From logarithmic function: 1.97 gives a wealth of EUR
7.17 (Certainty Equivalent). This is the value of the gamble.
If we accept the gamble & then the expected wealth is EUR 10
calculated as follows :
Current wealth adjusted for gain or loss Or Outcomes weighted by their probability
How much will we pay to avoid the gamble? We will be willing to pay
2.83 EUR (10- 7.17=2.83) = Markowitz risk premium. If we could buy
an insurance against the gamble for less than EUR 2.83, we will buy it.
The cost of gamble = current wealth minus Certainty Equivalent.
Establishing a Definition of Risk Aversion
16 The Theory of Choice: Utility Theory Given Uncertainty
Assume you are facing a gamble of 10% chance of
winning $10 and 90% chance of winning $100
with current wealth of $10. Compute the
following:
a) What is expected wealth?
b) What is Certainty equivalent wealth?
c) Calculate the risk premium?
d) Calculate the cost of gamble?
Establishing a Definition of Risk Aversion:
Class Practice
17 The Theory of Choice: Utility Theory Given Uncertainty
You have a logarithmic utility function U(W)=ln(W) and
your current level of wealth is $5000.
a) Suppose you are exposed to a situation that results in a 50/50 chance of
winning or losing $1000. if you can buy insurance that completely
removes the risk for a fee of $125, will you buy it or take the gamble?
b) Suppose you accept the gamble outlined in (a) and lose so that your
wealth is reduced to $4000. if you faced with the same gamble and have
the same offer of insurance as before, will you buy the insurance the
second time around?
Understanding ability testing
18 The Theory of Choice: Utility Theory Given Uncertainty
For a risk averse investors,
I. Risk premium is always positive but the cost of gamble can be
positive, negative or zero.
II. Their utility function are concave and increasing i.e.
a) they always prefer more to less (marginal utility of wealth is positive i.e.
MU(W)>0). symbolically U(w)>0
b) Their marginal utility of wealth decreases as they have more and more
wealth i.e. marginal utility of wealth is increasing at a decreasing rate or
(dMU(W)/dW<0). symbolically U(w)<0



Establishing a Definition of Risk Aversion
19 The Theory of Choice: Utility Theory Given Uncertainty
Pratt-Arrow measure of risk premium:
= 0.50*
2
*[-U(W)/ U(W)]
Here, since (0.50*
2
) is always positive so the sign of risk premium is
always determined by [-U(W)/ U(W)].
So risk aversion can be measured by the Pratt-Arrow absolute risk-
aversion, also known as the coefficient of absolute risk aversion (ARA),
defined as-
ARA=[-U(W)/ U(W)]
The actual dollar amount an individual will choose to hold in risky
assets, given a certain wealth level W is measuring above. For this
reason, the measure described above is referred to as a measure of
absolute risk-aversion.
To measure the percentage of wealth held in risky assets, for a given
wealth level W, we simply multiply ARA by the wealth W, to get the
Arrow-Pratt measure of relative risk-aversion or coefficient of relative
risk aversion (RRA) i.e.
RRA=W*[-U(W)/ U(W)]

Pratt-Arrow Risk Aversion Calculation
20 The Theory of Choice: Utility Theory Given Uncertainty
For following quadratic utility function: U(W)=aW-bW
2
. ARA & RRA
are as follows-
ARA= [2b/(a-2bw)] &
RRA= [2b/((a/W)-2b)]
The quadratic utility function exhibits increasing ARA and increasing
RRA. But these dont make sense!!! Why???
This problem of quadratic utility function is solved by Friend & Blume
by using power utility function U(W)=-W
-1
Thus marginal utility is U(W)=W
-2
and the change in marginal utility
with respect to the change in wealth is then U(W)=-2W
-3
. ARA & RRA
are as follows-
ARA= (2/W) &
RRA= 2
This result is consistent as this indicates-
marginal utility of wealth is positive, it decrease with increasing wealth,
the measure of ARA decreases with increasing wealth and
RRA is constant.




Pratt-Arrow Risk Aversion Calculation
21 The Theory of Choice: Utility Theory Given Uncertainty
An individual with logarithmic utility function U(W) = ln
(W) and a level of wealth of $20000 is exposed to two
different risks:
1. A 50/50 chance of winning or losing $10 and
2. An 80% chance of losing $1000 and a 20% chance of losing $10000.
What is the risk premium under both Pratt-Arrow and
Markowitz measure of risk premium for both of the above
situations? Given that, U(W)= W
-1

Key Points:
When risk is small and actuarially neutral then Pratt-Arrow
measure of risk premium is closely approximate to Markowitz
measure of risk premium.
But Markowitz measure of risk premium is superior for large or
asymmetric risks.
Pointing the problem with Pratt-Arrow
22 The Theory of Choice: Utility Theory Given Uncertainty
An asset is said to be stochastically dominant over another if an individual
receives greater wealth from it in every state of nature. This definition is
known as First-order stochastic dominance.
Mathematically, asset x, with cumulative probability distribution F
x
(W), will be
stochastically dominant over asset y, with cumulative probability distribution
G
y
(W), if
F
x
(W) G
y
(W) for all W
F
x
(W) < G
y
(W) for some W
Stochastic Dominance: First-order
23 The Theory of Choice: Utility Theory Given Uncertainty
In other words, cumulative
probability distribution for asset y
always lies to the left of the
cumulative probability distribution
for x.
The figure shows - cumulative
probability distribution for asset y
always lies to the left of the
cumulative probability distribution
for x.
An asset x to be stochastically dominant at second order asset y for all
risk averse investors, the accumulated area under the probability
distribution of y must be greater than the accumulated area for x i.e.

-
w
[G
y
(W)-F
x
(W) ] dW0 for all W
G
y
(W) F
x
(W) for some W
Stochastic Dominance: Second-order
24 The Theory of Choice: Utility Theory Given Uncertainty
Second order stochastic
dominance requires the
difference in the areas under
the cumulative density
function be positive i.e. the
sum of the differences
between two cumulative
density functions is always
greater than or equal to zero.
So, here cumulative density
function can cross.
Mean variance criteria give different decision which is fully depends on
the investors level of risk tolerance. Investor -1 choose combination of
A & B, Investor -2 choose B & Investor -3 choose A.
Note that, EPS of firm B is better in all state of nature.
A paradox:
Usefulness of Stochastic Dominance
25 The Theory of Choice: Utility Theory Given Uncertainty
State of nature Worst Bad Average Good Best
Prob. 0.2 0.2 0.2 0.2 0.2
EPS (Firm A) 3 4 5 6 7
EPS (Firm B) 3 5 7 9 11
Look the EPS distribution in the previous table, there firm B give
higher EPS in every state of nature, so firm B is dominant at first order.
If G
A
(W)-F
B
(W) 0 or F
B
(W)- G
A
(W) 0, then firm B is dominant at
second order. The above table represents the firm Bs dominance at
second order.
So we can say that mean-variance criteria cant not be give the exact
decision whereas stochastic dominance can.
A paradox:
Usefulness of Stochastic Dominance
26 The Theory of Choice: Utility Theory Given Uncertainty
EPS P(B) P(A) F(B) G(A) G(A) - F(B) G(A) - F(B)
3 0.20 0.20 0.20 0.20 0.00 0.00
4 0.00 0.20 0.20 0.40 0.20 0.20
5 0.20 0.20 0.40 0.60 0.20 0.40
6 0.00 0.20 0.40 0.80 0.40 0.80
7 0.20 0.20 0.60 1.00 0.40 1.20
8 0.00 0.00 0.60 1.00 0.40 1.60
9 0.20 0.00 0.80 1.00 0.20 1.80
10 0.00 0.00 0.80 1.00 0.20 2.00
11 0.20 0.00 1.00 1.00 0.00 2.00
Best of Luck!!!
The Theory of Choice: Utility Theory Given Uncertainty 27