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 Outline Outline s Introduction s Preference s Properties of Utility Functions s Mean-Variance Analysis Utility Theory
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IEOR E4403 Advanced Engineering & Corporate Economics Introduction Introduction s What would you prefer: h $10 for certain or the opportunity of earning $25 with probability 50%? h $1,000,000 for certain or the opportunity of earning $2,500,000 with probability 50%? s Why does the answer change with the scale of the stakes? Utility Theory
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IEOR E4403 Advanced Engineering & Corporate Economics Introduction Introduction s Consider the following game: h 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 h What is the expected payoff? h What is the maximum amount that you would be willing to pay to play this game? Utility Theory
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IEOR E4403 Advanced Engineering & Corporate Economics Introduction Introduction s Why is it that rational people do not always act to maximize expected rewards? c One explanation is that many opportunities can only be taken once, so that we do not have a chance to observe the expected value c 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 Preference Preference s Answer of economists: h Economists explained this behavior by postulating that decision makers are risk averse h A risk averse individual will always prefer less risk h He/She may even pay a premium to reduce risk Utility Theory
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IEOR E4403 Advanced Engineering & Corporate Economics Preference Preference s Risk preference: Utility Theory
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IEOR E4403 Advanced Engineering & Corporate Economics Preference Preference s Two famous economists: Von Neumann and Morgenstern h They came up with a set of axioms of behavior that lead to the existence of a utility function h 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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This note was uploaded on 02/08/2012 for the course IEOR 4403 taught by Professor K during the Fall '09 term at Columbia.

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2011e4403lecture13 - IEOR E4403 Advanced Engineering &...

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