Expected Utility Theory

Economics 302 - Microeconomic Theory II: Strategic Behavior

Shih En Lu
Simon Fraser University
(with thanks to Anke Kessler)

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Topics

Introduction to choice under uncertainty

Expected utility theory

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Most Important Things to Learn

What is a lottery?

What is expected utility?

When can ones preferences over lotteries be represented by an

expected utility function?

Problems with expected utility theory

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Choice Under Uncertainty

You have learned about preferences and utility functions over sure
outcomes.
Recall: % means "is preferred to",
and
means "is as good as".

means "is strictly preferred to",

Denition: a utility function u represents preferences % if for any

outcomes A and B, u (A) u (B ) exactly when A % B.
Recall: This is only possible when preferences are rational (complete
and transitive). For example, not possible if A B C
A.
But life is full of uncertainty! You often have to decide between
choices that each lead to an uncertain outcome.
Todays goal: represent preferences over uncertain outcomes.
This is important for modeling strategic behaviour: how do you react
to others when their actions are uncertain?
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Example
You dont know if its going to rain, and you have to decide whether
to carry an umbrella.
If you carry an umbrella: 10% chance you lose it, 60% chance you
carry it around needlessly, 30% chance you use it
If you leave umbrella at home: 0.1% chance you lose it, 66.6% chance
you dont need it, 33.3% chance you get wet
What factors matter in your decision?
Your decision depends on the probability of each outcome, and on
how much you like/hate each outcome.
We will assume that these are the only relevant factors. But see
"Ellsberg Paradox" (slide 13) for an example where this is not true for
some people.

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Notation and Terminology

Suppose a situation has n possible and mutually exclusive outcomes,

labeled 1, 2, ..., n.
Example: Lose umbrella (1), carry it needlessly (2), use umbrella (3),
dont carry and dont need it (4), get wet (5)

A lottery [p1 , p2 , ..., pn ] is a list of probabilities, where pi is the

probability that outcome i occurs.
Example: Carrying the umbrella leads to lottery [0.1, 0.6, 0.3, 0, 0], not
carrying it leads to lottery [0.001, 0, 0, 0.666, 0.333].

Note: because p1 , p2 , ..., pn are the probabilities of all possible and

mutually exclusive outcomes, we must have p1 + p2 + ... + pn = 1.

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Expected Utility
Suppose outcome 1 gives you utility u1 , outcome 2 u2 , and so on.
What is your utility from lottery L = [p1 , p2 , ..., pn ]?
Natural answer: p1 u1 + p2 u2 + ... + pn un , which is the Ls (von
Neumann-Morgenstern) expected utility.
But even if the ui s represent your preferences over outcomes,
expected utility may not represent your preferences over lotteries.
Example: Fido prefers chicken (outcome 1) over pears (outcome 2)
over apples (outcome 3). Assigning u1 = 2, u2 = 1 and u3 = 0 would
represent its preferences over these sure outcomes.
But suppose Fido prefers [0.4, 0, 0.6] over [0, 1, 0]. With the above
utilities, does expected utility represent Fidos preferences over
lotteries?
So its important to assign the right utility to each outcome - not just
the order matters (ordinal utility), but size matters too (cardinal
utility).
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Axioms for Expected Utility (I)

Given preferences over lotteries, its not always possible to nd
utilities over outcomes u1 , u2 , ..., un such that expected utility
represents the said preferences over lotteries.
Just as you needed assumptions on preferences over outcomes to
build a utility function representing them, you need assumptions on
preferences over lotteries to build an expected utility function
representing them.
There are four required axioms. The rst two are the same as the
axioms needed on preferences over outcomes, but now applied to
lotteries:
1

Completeness: For any lotteries L and L0 , either L

L L0 .
Transitivity: If L % L0 and L0 % L00 , then L % L00 .

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Expected Utility Theory

L0 , L

L0 , or

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Compound Lottery
To state the next two axioms, we need more terminology.
Suppose there are two lotteries, L = [p1 , p2 , ..., pn ] and
L0 = [p10 , p20 , ..., pn0 ].
Suppose L occurs with probability , and L0 occurs with probability
1 .
Example: You ask your mom to put the umbrella in your bag, but she
might forget.

We eectively have a "lottery of lotteries," or a compound lottery,

and we denote it L + (1 )L0 .
The probabilities of outcomes 1, 2, ..., n associated with
L + (1 )L0 are:

[p1 + (1

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)p10 , p2 + (1

)p20 , ..., pn + (1

Expected Utility Theory

)pn0 ].

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Axioms for Expected Utility (II)

We can now state the third axiom of expected utility theory:
3. Continuity: If L % L0 % L00 , then there exists 2 [0, 1] such that
L0 L + (1 )L00 .

This seems like a sensible axiom, but its applicability is in doubt in

some extreme cases. Suppose L is winning $100.01, L0 is winning
$100, and L00 is dying...
Most microeconomic theorists nd the last axiom most problematic:
4. Independence: For any 2 (0, 1] and any lotteries L, L0 and L00 ,
L % L0 if and only if L + (1 )L00 % L0 + (1 )L00 .

In words: your preference over two lotteries isnt aected by mixing in

a third. See "Allais Paradox" (slides 14 and 15) for a situation where
this might not hold for some people.

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Expected Utility Theorem

Theorem
If preferences satisfy Axioms 1-4, then it is possible to assign a real
number (utility) ui to each outcome i = 1, 2, ..., n such that
L & L0 if and only if U (L)

U (L0 ),

where U ([p1 , p2 , ..., pn ]) = p1 u1 + p2 u2 + ... + pn un .

Due to John von Neumann and Oskar Morgenstern.
The theorem tells us that these ui s exist, but it doesnt tell us what
they are.
The proof of the theorem is beyond the scope of this course. Slides
16-18 sketch the argument.
The converse of this theorem (that if an expected utility
representation exists, Axioms 1-4 must hold) is not hard to show.
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Take Away Message

For the rest of this course, we will assume that the four axioms hold
so that agentspreferences admit an expected utility representation.
This is an intuitive assumption, but there are cases where it does not
match the real world.
Much of economics builds on expected utility theory, but economists
also study alternative hypotheses that may shed light on some
phenomena - search for prospect theory.
We will specically study lotteries over money later in the semester.
Preview: if your utility over monetary outcomes is concave in the
amount of money, then you are risk averse.

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Supplementary Material: Ellsberg Paradox

Theres an urn with 3 balls, one of which is red. The other two may
be both blue, both yellow, or one blue and one yellow.
You choose a colour, and a ball is drawn. If the ball has the colour
you chose, you win $10.
What colour do you choose?
If you strictly prefer red to both blue and yellow, then, assuming that
you only care about the probability of winning, you think red is more
likely than blue, and also more likely than yellow.
But then both Pr(BLUE ) and Pr(YELLOW ) are less than
Pr(RED ) = 13 .
This cant be the case since probabilities must add up to 1! This is
the Ellsberg Paradox.
Lesson: uncertainty about the uncertainty may matter, so people
might care about more than the ultimate probabilities and outcomes.
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Supplementary Material: Allais Paradox (I)

Outcomes: [win nothing, win $1,000,000, win $5,000,000].
Consider two choices:
1
2

A = [0.9, 0, 0.1] or B = [0.89, 0.11, 0]

A0 = [0.01, 0.89, 0.1] or B 0 = [0, 1, 0]

What would you choose in each case?

Some people would choose:
1

A over B (winning under A is only slightly less likely, but gives much
more money), and
B 0 over A0 ($1,000,000 is guaranteed by B 0 ; dont want to "get
greedy" and lose it).

These peoples preferences violate the independence axiom! The next

slide shows why.

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Supplementary Material: Allais Paradox (II)

By the formula for compound lotteries, we can write:
1 , 0, 10 ] + 0.89[1, 0, 0]
A = 0.11[ 11
11
B = 0.11[0, 1, 0] + 0.89[1, 0, 0]
1 , 0, 10 ] + 0.89[0, 1, 0]
A0 = 0.11[ 11
11
0
B = 0.11[0, 1, 0] + 0.89[0, 1, 0]

If A B, then
1
0.11[ 11
, 0, 10
11 ] + 0.89[1, 0, 0]

0.11[0, 1, 0] + 0.89[1, 0, 0].

1 , 0, 10 ]
If the independence axiom applies, this means [ 11
11

If A0 B 0 , then
1
0.11[ 11
, 0, 10
11 ] + 0.89[0, 1, 0]

[0, 1, 0]

0.11[0, 1, 0] + 0.89[0, 1, 0].

1 , 0, 10 ]
If the independence axiom applies, this means [ 11
11

[0, 1, 0]

We have a contradiction! So the independence axiom cannot apply.

This is the Allais paradox.
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Supplementary Material: Sketch of the Expected Utility

Theorems Proof
This section is only for those curious about the proof.
We only need to show that
U ( L + (1

)L0 ) = U (L) + (1

)U (L0 )

Once we have the above, we get an expected utility representation,

since for any lottery L = [p1 , p2 , ..., pn ], we can write:
U (L) = U (p1 [1, 0, ..., 0] + p2 [0, 1, 0, ..., 0] + ... + pn [0, ..., 0, 1])

= p1 U ([1, 0, ..., 0]) + p2 U ([0, 1, 0, ..., 0]) + ... + pn ([0, ..., 0, 1])
= p1 u1 + p2 u2 + ... + pn un .
By the continuity axiom, given any lottery L, the agent is indierent
between L and some mixing of the best lottery L and the worst lottery
L (which can be shown to exist by completeness, transitivity and
independence).
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Supplementary Material: Sketch of the Expected Utility

Theorems Proof (II)

L L + (1

Suppose L

L )L, and L0

L 0 L + (1

L 0 )L.

Then by the independence axiom (applied twice),

L + (1

)L0

( L L + (1

L )L) + (1

)L0

( L L + (1

L )L) + (1

)(L 0 L + (1

( L + (1 )L 0 )L
+( (1 L ) + (1 )(1

L 0 )L)

L 0 ))L.

This is the crucial step: we have now related all three lotteries that
were interested in (L, L0 and L + (1 )L0 ) to the best and worst
lotteries.

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Supplementary Material: Sketch of the Expected Utility

Theorems Proof (III)
Now lets assign U (L) = 1 and U (L) = 0. (This just linearly scales
the utility function and simplies the algebra.)
If U is to have expected utility form, then we must have
U (L) = U ( L L + (1 L )L) = L U (L) + (1 L )U (L) = L .
Similarly, U (L0 ) = L 0 , and U ( L + (1
You can check that U ( L + (1
indeed holds, so we are done.

)L0 ) = L + (1

)L0 ) = U (L) + (1

) L 0 .

)U (L0 )

In a nutshell: Continuity lets us associate every lottery to a mixture of

the best and the worst lottery, and independence ensures that these
associations are consistent with expected utility - without
independence, L + (1 )L0 might correspond to some other mix of
L and L, in which case we wouldnt get
U ( L + (1 )L0 ) = U (L) + (1 )U (L0 ).
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