Expected Utility and Jensen S Inequality

Download as pptx, pdf, or txt
Download as pptx, pdf, or txt
You are on page 1of 30

Economic Rationality Qua Expected Utility Theory

The math behind it via Jensens inequality

x is a random variable with realizations x1 and x2, x1 < x2. u is the utility function. u is increasing and strictly concave. p = prob{x = x1}, 1 p = prob{x = x2} Model Setup

x is a random variable with realizations x1 and x2, x1 < x2. u is the utility function. u is increasing and strictly concave. p = prob{x = x1}, 1 p = prob{x = x2} Model Setup

x is a random variable with realizations x1 and x2, x1 < x2. u is the utility function. u is increasing and strictly concave. p = prob{x = x1}, 1 p = prob{x = x2} Model Setup

E(x) = px1 + (1-p)x2 E(u(x)) = pu(x1) + (1-p)u(x2)

Expectation of x and Expectation of u(x)

E(x) = px1 + (1-p)x2 E(u(x)) = pu(x1) + (1-p)u(x2)

Expectation of x and Expectation of u(x)

If u is strictly concave and 0 < p < 1, then u(E(x)) > E(u(x)).


Jensens Inequality Derivation for the two-point support case

If u is strictly concave and 0 < p < 1, then u(E(x)) > E(u(x)).


Jensens Inequality Derivation for the two-point support case

If u is strictly concave and 0 < p < 1, then u(E(x)) > E(u(x)).


Jensens Inequality Derivation for the two-point support case

Looking at it Graphically

Larger D: Base = x2 - x1 Height = u(x2) u(x1).

Smaller D: Base = E(x) - x1 Height = ?

Base and Height

Larger D: Base = x2 - x1 Height = u(x2) u(x1).

Smaller D: Base = E(x) - x1 Height = ?

Base and Height

Larger D: Base = x2 - x1 Height = u(x2) u(x1). Smaller D: Base = E(x) - x1 Height = ? E(x) - x1 = px1 + (1 p)x2 x1 = (1 p)(x2 x1).

A little bit of algebra

Larger D: Base = x2 - x1 Height = u(x2) u(x1). Smaller D: Base = (1 p)(x2 x1). Smaller D: Height = (1 p)[u(x2) u(x1)].

Conclusion

u(x1) + (1 p)[u(x2) u(x1)] = u(x1) - (1 p)u(x1) + (1 p)u(x2) = pu(x1) + (1 p)u(x2) = E(u(x))

More Algebra

u(x1) + (1 p)[u(x2) u(x1)] = u(x1) - (1 p)u(x1) + (1 p)u(x2) = pu(x1) + (1 p)u(x2) = E(u(x))

More Algebra

u(x1) + (1 p)[u(x2) u(x1)] = u(x1) - (1 p)u(x1) + (1 p)u(x2) = pu(x1) + (1 p)u(x2) = E(u(x))

More Algebra

Justification of Labeling

Constant Absolute Risk Aversion Constant Relative Risk Aversion Quadratic Utility

Three Functional Forms for u

Constant Absolute Risk Aversion Constant Relative Risk Aversion Quadratic Utility

Three Functional Forms for u

Constant Absolute Risk Aversion Constant Relative Risk Aversion Quadratic Utility

Three Functional Forms for u

u(x) = -ke-gx + c; k, g, and c constants; k, g > 0. u(x) = gke-gx > 0, u(x) = -g2ke-gx < 0. -u(x)/u(x) = g.

Constant Absolute Risk Aversion

u(x) = -ke-gx + c; k, g, and c constants; k, g > 0. u(x) = gke-gx > 0, u(x) = -g2ke-gx < 0. -u(x)/u(x) = g.

Constant Absolute Risk Aversion

u(x) = -ke-gx + c; k, g, and c constants; k, g > 0. u(x) = gke-gx > 0, u(x) = -g2ke-gx < 0. -u(x)/u(x) = g.

Constant Absolute Risk Aversion

u(x) = kxa + c; k, a, and c constants; k > 0, 0 < a < 1. u(x) = akxa-1 > 0, u(x) = a(a-1)kxa-2 < 0. -xu(x)/u(x) = 1 - a.

Constant Relative Risk Aversion

u(x) = kxa + c; k, a, and c constants; k > 0, 0 < a < 1. u(x) = akxa-1 > 0, u(x) = a(a-1)kxa-2 < 0. -xu(x)/u(x) = 1 - a.

Constant Relative Risk Aversion

u(x) = kxa + c; k, a, and c constants; k > 0, 0 < a < 1. u(x) = akxa-1 > 0, u(x) = a(a-1)kxa-2 < 0. -xu(x)/u(x) = 1 - a.

Constant Relative Risk Aversion

u(x) = -ax2 + bx + c; a, b, and c constants; a, b > 0. u(x) = -2ax + b > 0 if x < b/2a, u(x) = -2a < 0. E(u(x)) = -aE(x2) + bm + c = -a(s2 + m2) + bm + c.

Quadratic Utility

u(x) = -ax2 + bx + c; a, b, and c constants; a, b > 0. u(x) = -2ax + b > 0 if x < b/2a, u(x) = -2a < 0. E(u(x)) = -aE(x2) + bm + c = -a(s2 + m2) + bm + c.

Quadratic Utility

u(x) = -ax2 + bx + c; a, b, and c constants; a, b > 0. u(x) = -2ax + b > 0 if x < b/2a, u(x) = -2a < 0. E(u(x)) = -aE(x2) + bm + c = -a(s2 + m2) + bm + c.

Quadratic Utility

You might also like