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Chapter 14 Utility Axioms,Paradoxes and Implications

Chapter 14 Utility Axioms,Paradoxes and Implications. Wang YU. Axioms. These axioms are the foundations of utility theory because that people who behave according to the axioms should make choices consistent with the maximization of expected utility.

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Chapter 14 Utility Axioms,Paradoxes and Implications

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  1. Chapter 14Utility Axioms,Paradoxes and Implications Wang YU

  2. Axioms • These axioms are the foundations of utility theory because that people who behave according to the axioms should make choices consistent with the maximization of expected utility. • People don’t always behave according to theses axioms.

  3. 1. Ordering and transitivity* (Loop) 2. Reduction of compound uncertain events 3. Continuity 4. Substitutability* 5. Monotone 6. Invariance 7. Finiteness Conclusion: Axioms are just assumptions. Based on these assumptions, we can introduce “ordinal” utilities. Axioms

  4. Paradoxes • 1. Framing effects: Where do you put the status quo? Peoples tend to be risk-averse in dealing with gains but risk-seeking in deciding about losses. Axiom 6: Invariance. Both the probabilities, paid offs and frames of the problems should be taken into consideration.

  5. Paradoxes Cont’d • 2. Certainty Effect • People tend to place too much weight on certainty outcome relative to uncertain outcomes. Allais Paradox • We should behave according to sure-thing principles.

  6. Implications • Utility assessment: • Basic Idea: Hold three of Gain, Loss, Probability and CE fixed and find the remaining one. • CE: with gain, more risk-averse With loss, more risk-seeking • PE: Certain forms of probability distortion • New method to assess utility are needed.

  7. Implications Cont’d • 1. Reference set and status quo: sunk cost and viewpoint to modeling a decision problem. • 2. Mania for certainty. ( protest for nuclear power plant).

  8. Conclusion • Decision analysis is a constructive mean to help the decision maker to gain insight from analysis and get consistent decisions. • 1. Utility and personal preferences assessment. • 2. Modeling the problem. • Systematically and consistently.

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