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    Expected Utility and Jensen S Inequality

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    ProfArvan
    The document discusses expected utility theory and Jensen's inequality. It presents a model where a random variable x has two possible values, x1 and x2, with probabilities p and 1-p, respectively. It shows that if the utility function u(x) is strictly concave, the expected utility E(u(x)) will be less than the utility of the expected value of x, or u(E(x)). This is known as Jensen's inequality. The document also provides examples of constant absolute risk aversion, constant relative risk aversion, and quadratic utility functions.

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    Expected Utility and Jensen S Inequality

    Uploaded by

    ProfArvan
    175 views30 pages
    The document discusses expected utility theory and Jensen's inequality. It presents a model where a random variable x has two possible values, x1 and x2, with probabilities p and 1-p, respectively. It shows that if the utility function u(x) is strictly concave, the expected utility E(u(x)) will be less than the utility of the expected value of x, or u(E(x)). This is known as Jensen's inequality. The document also provides examples of constant absolute risk aversion, constant relative risk aversion, and quadratic utility functions.

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    Th math behind expected utility theory.

    Original Title

    Expected Utility and Jensen s Inequality

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    The document discusses expected utility theory and Jensen's inequality. It presents a model where a random variable x has two possible values, x1 and x2, with probabilities p and 1-p, respectively. It shows that if the utility function u(x) is strictly concave, the expected utility E(u(x)) will be less than the utility of the expected value of x, or u(E(x)). This is known as Jensen's inequality. The document also provides examples of constant absolute risk aversion, constant relative risk aversion, and quadratic utility functions.

    Copyright:

    Attribution Non-Commercial (BY-NC)
    Download as PPTX, PDF, TXT or read online from Scribd
    Download as pptx, pdf, or txt
    175 views30 pages

    Expected Utility and Jensen S Inequality

    Uploaded by

    ProfArvan
    The document discusses expected utility theory and Jensen's inequality. It presents a model where a random variable x has two possible values, x1 and x2, with probabilities p and 1-p, respectively. It shows that if the utility function u(x) is strictly concave, the expected utility E(u(x)) will be less than the utility of the expected value of x, or u(E(x)). This is known as Jensen's inequality. The document also provides examples of constant absolute risk aversion, constant relative risk aversion, and quadratic utility functions.

    Copyright:

    Attribution Non-Commercial (BY-NC)
    Download as PPTX, PDF, TXT or read online from Scribd
    Download as pptx, pdf, or txt
    of 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

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