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2011e4403lecture13

# 2011e4403lecture13 - IEOR E4403 Advanced Engineering...

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0 Professor Sadighian Professor Sadighian Lecture 13 Utility Theory IEOR E4403 IEOR E4403 Advanced Engineering & Corporate Advanced Engineering & Corporate Economics Economics Fall 2011 Fall 2011

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IEOR E4403 Advanced Engineering & Corporate Economics Fall 2011,Prof. Sadighian & Kachani Outline Outline square4 Introduction square4 Preference square4 Properties of Utility Functions square4 Mean-Variance Analysis Utility Theory
IEOR E4403 Advanced Engineering & Corporate Economics Fall 2011,Prof. Sadighian & Kachani Introduction Introduction square4 What would you prefer: head2right \$10 for certain or the opportunity of earning \$25 with probability 50%? head2right \$1,000,000 for certain or the opportunity of earning \$2,500,000 with probability 50%? square4 Why does the answer change with the scale of the stakes? Utility Theory

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IEOR E4403 Advanced Engineering & Corporate Economics Fall 2011,Prof. Sadighian & Kachani Introduction Introduction square4 Consider the following game: head2right A fair coin is tossed until the first time a head occurs. If it takes n tosses to obtain the first head, the payoff to the player is \$2 n head2right What is the expected payoff? head2right What is the maximum amount that you would be willing to pay to play this game? Utility Theory
IEOR E4403 Advanced Engineering & Corporate Economics Fall 2011,Prof. Sadighian & Kachani Introduction Introduction square4 Why is it that rational people do not always act to maximize expected rewards? checkbld One explanation is that many opportunities can only be taken once, so that we do not have a chance to observe the expected value checkbld True. However, this does not explain why scale may reverse decisions as in the first example Utility Theory

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IEOR E4403 Advanced Engineering & Corporate Economics Fall 2011,Prof. Sadighian & Kachani Preference Preference square4 Answer of economists: head2right Economists explained this behavior by postulating that decision makers are risk averse head2right A risk averse individual will always prefer less risk head2right He/She may even pay a premium to reduce risk Utility Theory
IEOR E4403 Advanced Engineering & Corporate Economics Fall 2011,Prof. Sadighian & Kachani Preference Preference square4 Risk preference: Utility Theory

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IEOR E4403 Advanced Engineering & Corporate Economics Fall 2011,Prof. Sadighian & Kachani Preference Preference square4 Two famous economists: Von Neumann and Morgenstern head2right They came up with a set of axioms of behavior that lead to the existence of a utility function head2right Once the utility function is found, they claim that decision makers can make decisions based on maximizing expected utility Utility Theory
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2011e4403lecture13 - IEOR E4403 Advanced Engineering...

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