Utility and Risk Preferences

Abstract

. Utility theory has been a primary method used for the analysis of decision making under uncertainty for the last 60 years. We describe the rationale and uses of the approach in the case of decisions involving money. Our focus is the question of which particular utility function should be used by a decision maker. Introduction Playing games of chance for money is an activity that has diverted people for at least 6 millennia, so it is reasonable to suppose that an interest in how one should think about maximizing wealth under uncertainty has existed at least as long. The starting point for all students of decision analysis is Expected Monetary Value (EMV) (Raiffa 1968). If there are i possible courses of action under consideration, and n possible outcomes x 1 , …, x n , and if p ij is the probability that action i leads to monetary outcome x j , then EMV suggests that one select the action i that maximizes ∑ j p ij x j . The justification for this criterion – and it's a good one – is that any other criterion, if used repeatedly, will assuredly (almost certainly) leave you less well off at the end. Though few people get to repeat the same gamble over and over again, EMV is still relevant in our lives because we often make decisions involving financial uncertainty, and using EMV to make them will almost certainly be the right criterion for choice.

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