Studi Kebijakan

Dan Pembuatan
Keputusan

Lectured by B. Yuliarto Nugroho, PhD

© 2017 University of Indonesia Slide 1

 Utility and Decision Making

 The Meaning of Utility

 Developing Utilities for Monetary Payoffs
 Summary of Steps for Determining the Utility of
Money
 Risk Avoiders versus Risk Takers
 Expected Monetary Value versus Utility as an
Approach to Decision Making

Slide 2
 Meaning of Utility

 Utilities are used when the decision criteria must be

based on more than just expected monetary values.
 Utility is a measure of the total worth of a particular
outcome, reflecting the decision maker’s attitude
towards a collection of factors.
 Some of these factors may be profit, loss, and risk.
 This analysis is particularly appropriate in cases where
payoffs can assume extremely high or extremely low
values.

Slide 3
 Example: Adm Advisors

Adm Advisors have analyzed the profit potential

of five different investments. The probabilities of the
gains on $1000 are as follows:
Gain
Investment $0 $200 $500 $1000
A .9 0 0 .1
B 0 .8 .2 0
C .05 .9 0 .05
D 0 .8 .1 .1
E .6 0 .3 .1

One of Weiss’ investors informs Weiss that he is

indifferent between investments A, B, and C.

Slide 4
 Example: Adm Advisors

 Developing Utilities for Payoffs

Assign a utility of 10 to a $1000 gain and a utility of
0 to a gain of $0. Let x = the utility of a $200 gain and
y = the utility of a $500 gain. The expected utility on
investment A is then .9(0) + .1(10) = 1.
Since the investor is indifferent between investments
A and C, this must mean the expected utility of
investment C = the expected utility of investment A = 1.
But the expected utility of investment C = .05(0) +.90x +
.05(10). Since this must equal 1, solving for x, gives x =
5/9.

Slide 5
 Example: Adm Advisors

 Developing Utilities for Payoffs (continue)

Also since the investor is indifferent between A, B,
and C, the expected utility of investment B must be 1.
Thus, 0(0) + .8(5/9) + .2y + 0(10) = 1. Solving for y,
gives y = 25/9.
Thus the utility values for gains of 0, 200, 500, and
1000 are 0, 5/9, 25/9, and 10, respectively.

Slide 6
 Expected Utility Approach

 Once a utility function has been determined, the

optimal decision can be chosen using the expected
utility approach.
 Here, for each decision alternative, the utility
corresponding to each state of nature is multiplied by
the probability for that state of nature.
 The sum of these products for each decision alternative
represents the expected utility for that alternative.
 The decision alternative with the highest expected
utility is chosen.

Slide 7
 Risk Avoiders vs. Risk Takers

 A risk avoider will have a concave utility function

when utility is measured on the vertical axis and
monetary value is measured on the horizontal axis.
Individuals purchasing insurance exhibit risk
avoidance behavior.
 A risk taker, such as a gambler, pays a premium to
obtain risk. His/her utility function is convex. This
reflects the decision maker’s increasing marginal value
of money.
 A risk neutral decision maker has a linear utility
function. In this case, the expected value approach can
be used.

Slide 8
 Risk Avoiders vs. Risk Takers

 Most individuals are risk avoiders for some amounts of

money, risk neutral for other amounts of money, and
risk takers for still other amounts of money.
 This explains why the same individual will purchase
both insurance and also a lottery ticket.

Slide 9
 Example 1

Consider the following three-state, four-decision

problem with the following payoff table in dollars:
s1 s2 s3
d1 +100,000 +40,000 -60,000
d2 +50,000 +20,000 -30,000
d3 +20,000 +20,000 -10,000
d4 +40,000 +20,000 -60,000

The probabilities for the three states of nature are:

P(s1) = .1, P(s2) = .3, and P(s3) = .6.

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 Example 1

 Risk-Neutral Decision Maker

If the decision maker is risk neutral the expected
value approach is applicable.

EV(d1) = .1(100,000) + .3(40,000) + .6(-60,000) = -$14,000

EV(d2) = .1( 50,000) + .3(20,000) + .6(-30,000) = -$ 7,000
EV(d3) = .1( 20,000) + .3(20,000) + .6(-10,000) = +$ 2,000

Note the EV for d4 need not be calculated as decision d4

is dominated by decision d2.

The optimal decision is d3.

Slide 11
 Example 1

 Decision Makers with Different Utilities

Suppose two decision makers have the following
utility values:
Utility
Amount Decision Maker I Decision Maker II
$100,000 100 100
$50,000 94 58
$40,000 90 50
$20,000 80 35
-$10,000 60 18
-$30,000 40 10
-$60,000 0 0

Slide 12
 Example 1

 Graph of the Two Decision Makers’ Utility Curves

Utility
100
Decision Maker I
80

60

40 Decision Maker II
20

-60 -40 -20 0 20 40 60 80 100

Monetary Value (in $1000’s)
Slide 13
 Example 1

 Decision Maker I
• Decision Maker I has a concave utility function.
• He/she is a risk avoider.

 Decision Maker II
• Decision Maker II has convex utility function.
• He/she is a risk taker.

Slide 14
 Example 1

 Expected Utility: Decision Maker I

Expected
s1 s2 s3 Utility
d1 100 90 0 37.0
d2 94 80 40 57.4
d3 80 80 60 68.0
Probability .1 .3 .6

 Optimal Decision: Decision Maker I

The largest expected utility is 68.0. Note again that d4
is dominated by d2 and hence is not considered.

Decision Maker I should make decision d3.

Slide 15
 Example 1

 Expected Utility: Decision Maker II

Expected
s1 s2 s3 Utility
d1 100 50 0 25.0
d2 58 35 10 22.3
d3 35 35 18 24.8
Probability .1 .3 .6

 Optimal Decision: Decision Maker II

The largest expected utility is 25.0. Note again that d4 is
dominated by d2 and hence is not considered.

Decision Maker II should make decision d1.

Slide 16
 Example 2

Suppose the probabilities for the three states of

nature in Example 1 were changed to:
P(s1) = .5, P(s2) = .3, and P(s3) = .2.

• What is the optimal decision for a risk-neutral

decision maker?
• What is the optimal decision for Decision Maker I?
. . . for Decision Maker II?
• What is the value of this decision problem to
Decision Maker I? . . . to Decision Maker II?
• What conclusion can you draw?

Slide 17
 Example 2

 Risk-Neutral Decision Maker

EV(d1) = .5(100,000) + .3(40,000) + .2(-60,000) = 50,000

EV(d2) = .5( 50,000) + .3(20,000) + .2(-30,000) = 25,000
EV(d3) = .5( 20,000) + .3(20,000) + .2(-10,000) = 14,000

The risk-neutral optimal decision is d1.

Slide 18
 Example 2

 Expected Utility: Decision Maker I

EU(d1) = .5(100) + .3(90) + .2( 0) = 77.0

EU(d2) = .5( 94) + .3(80) + .2(40) = 79.0
EU(d3) = .5( 80) + .3(80) + .2(60) = 76.0

Decision Maker I’s optimal decision is d2.

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 Example 2

 Expected Utility: Decision Maker II

EU(d1) = .5(100) + .3(50) + .2( 0) = 65.0

EU(d2) = .5( 58) + .3(35) + .2(10) = 41.5
EU(d3) = .5( 35) + .3(35) + .2(18) = 31.6

Decision Maker II’s optimal decision is d1.

Slide 20
 Example 2

 Value of the Decision Problem: Decision Maker I

• Decision Maker I’s optimal expected utility is 79.

• He assigned a utility of 80 to +$20,000, and a utility
of 60 to -$10,000.
• Linearly interpolating in this range 1 point is worth
$30,000/20 = $1,500.
• Thus a utility of 79 is worth about $20,000 - 1,500 =
$18,500.

Slide 21
 Example 2

 Value of the Decision Problem: Decision Maker II

• Decision Maker II’s optimal expected utility is 65.

• He assigned a utility of 100 to $100,000, and a utility
of 58 to $50,000.
• In this range, 1 point is worth $50,000/42 = $1190.
• Thus a utility of 65 is worth about $50,000 + 7(1190)
= $58,330.

The decision problem is worth more to Decision

Maker II (since $58,330 > $18,500).

Slide 22
 The End
and
Thank you

Slide 23