UtilityTh - UTILITY THEORY Prof Preetam Basu IIM Calcutta...

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UTILITY THEORY Prof. Preetam Basu IIM Calcutta
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Heads (0.5) Tails (0.5) $100,000 $0 Utility Theory Accept Offer Reject Offer $40,000 EMV = $50,000 Decision Tree for a Lottery Ticket
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Utility Theory Monetary value is not always a true indicator of the overall value of the result of a decision. The overall value of a decision is called utility. A utility function for money is a way of transforming monetary values to an appropriate scale that reflects a decision maker’s preferences (e.g., aversion to risk). Assumption is that rational people make decisions to maximize their utility.
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Utility Theory Fundamental Property: Under the assumptions of utility theory, the decision maker’s utility function for money has the property that the decision maker is indifferent between two alternatives if the two alternatives have the same expected utility . The optimal decision (or series of decisions) is the one that maximizes the expected utility .
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Standard Gamble for Utility Assessment Best Outcome Utility = 1 Worst Outcome Utility = 0 Other Outcome Utility = ? ( p ) (1 – p ) Alternative 1 Alternative 2
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The Equivalent Lottery Method 1. Determine the largest potential payoff, M = Maximum . Assign U ( Maximum ) = 1. 2. Determine the smallest potential payoff, M = Minimum . Assign U ( Minimum ) = 0. 3. To determine the utility of another potential payoff M , consider the two alternatives: A 1 : Obtain a payoff of Maximum with probability p. Obtain a payoff of Minimum with probability 1– p. A 2 : Definitely obtain a payoff of M . Question to the decision maker: What value of p makes you indifferent?
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