Slides by

John
Loucks
St. Edward’s
University

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 Chapter 13, Part B: Decision Analysis

 The Meaning of Utility

 Utility and Decision Analysis
 Utility Functions

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 Example: Swofford, Inc.

For the upcoming year, Swofford has three real estate

investment alternatives, and future real estate prices are
uncertain. The possible investment payoffs are below.
States of Nature
PAYOFF TABLE Real Estate Prices:
Go Up Remain Same Go Down
Decision Alternative s1 s2 s3

Make Investment A, d1 30,000 20,000 -50,000

Make Investment B, d2 50,000 -20,000 -30,000
Do Not Invest, d3 0 0 0
Probability .3 .5 .2

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 Example: Swofford, Inc.

 Expected Value (EV) Approach

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

EV(d1) = .3(30,000) + .5( 20,000) + .2(-50,000) = $9,000

EV(d2) = .3(50,000) + .5(-20,000) + .2(-30,000) = -$1,000
EV(d3) = .3( 0 ) + .5( 0 ) + .2( 0 )= $0

Considering no other factors, the optimal decision

appears to d1 with an expected monetary value of
$9,000……. but is it?

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 Example: Swofford, Inc.

 Other considerations:
• Swofford’s current financial position is weak.
• The firm’s president believes that, if the next
investment results in a substantial loss, Swofford’s
future will be in jeopardy.
• Quite possibly, the president would select d2 or d3
to avoid the possibility of incurring a $50,000 loss.
• A reasonable conclusion is that, if a loss of even
$30,000 could drive Swofford out of business, the
president would select d3, believing that both
investments A and B are too risky for Swofford’s
current financial position.

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 The 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.

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 Steps for Determining the Utility of Money

Step 1:
Develop a payoff table using monetary values.
Step 2:
Identify the best and worst payoff values and assign
each a utility value, with U(best payoff) > U(worst payoff).
Step 3:
Define the lottery. The best payoff is obtained with
probability p; the worst is obtained with probability (1 – p).

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 Example: Swofford, Inc.

Step 1: Develop payoff table.

Monetary payoff table on earlier slide.
Step 2: Assign utility values to best and worst payoffs.
Utility of $50,000 = U(50,000) =   0
Utility of   $50,000 = U(50,000) = 10

Step 3: Define the lottery.

Swofford obtains a payoff of $50,000 with
probability p and a payoff of $50,000 with
probability (1  p).

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 Steps for Determining the Utility of Money

Step 4:
For every other monetary value M in the payoff table:
4a: Determine the value of p such that the decision
maker is indifferent between a guaranteed
payoff of M and the lottery defined in step 3.
4b: Calculate the utility of M:
U(M) = pU(best payoff) + (1 – p)U(worst payoff)

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 Example: Swofford, Inc.

Establishing the utility for the payoff of $30,000:

Step 4a: Determine the value of p.

Let us assume that when p = 0.95, Swofford’s

president is indifferent between the guaranteed
payoff of $30,000 and the lottery.

Step 4b: Calculate the utility of M.

U(30,000) = pU(50,000) + (1  p)U(50,000)

= 0.95(10) + (0.05)(0)
= 9.5

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 Steps for Determining the Utility of Money

Step 5:
Convert the payoff table from monetary values to utility
values.
Step 6:
Apply the expected utility approach to the utility table
developed in step 5, and select the decision alternative
with the highest expected utility.

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 Example: Swofford, Inc.

Step 5: Convert payoff table to utility values.

UTILITY TABLE States of Nature

Real Estate Prices:
Go Up Remain Same Go Down
Decision Alternative s1 s2 s3

Make Investment A, d1 9.5 9.0 0

Make Investment B, d2 10.0 5.5 4.0
Do Not Invest, d3 7.5 7.5 7.5
Probability .3 .5 .2

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 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.

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 Example: Swofford, Inc.

Step 6: Apply the expected utility approach.

The expected utility for each of the decision
alternatives in the Swofford problem is:

EV(d1) = .3( 9.5) + .5(9.0) + .2( 0 ) = 7.35

EV(d2) = .3(10.0) + .5(5.5) + .2(4.0) = 6.55
EV(d3) = .3( 7.5) + .5(7.5) + .2(7.5) = 7.50

Considering the utility associated with each possible

payoff, the optimal decision is d3 with an expected
utility of 7.50.

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 Example: Swofford, Inc.

 Comparison of EU and EV Results

Decision Expected Expected

Alternative Utility Value
Do Not Invest 7.50 0
Investment A 7.35 9,000
Investment B 6.55 -1,000

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 Risk Avoiders Versus 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.

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 Risk Avoiders Versus 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.

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 Utility Example 1

Consider the following three-state, three-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

The probabilities for the three states of nature are:

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

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 Utility 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

The optimal decision is d3.

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 Utility Example 1

 Decision Makers with Different Utilities

Suppose two decision makers have the following
utility values:
Utility 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

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 Utility 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)
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 Utility 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.

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 Utility Example 1

 Expected Utility: Decision Maker I

Expected
Optimal s1 s2 s3 Utility Largest
decision expected
d1 100 90 0 37.0
is d3 utility
d2 94 80 40 57.4
d3 80 80 60 68.0
Probability .1 .3 .6

Note: d4 is dominated by d2 and hence is not considered

Decision Maker I should make decision d3.

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 Utility Example 1

 Expected Utility: Decision Maker II

Expected
Optimal s1 s2 s3 Utility
decision
d1 100 50 0 25.0
is d1
d2 58 35 10 22.3 Largest
expected
d3 35 35 18 24.8 utility
Probability .1 .3 .6

Note: d4 is dominated by d2 and hence is not considered.

Decision Maker II should make decision d1.

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 Utility 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?

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 Utility 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.

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 Utility 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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 Utility 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.

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 Utility 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.

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 Utility 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).

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Expected Monetary Value Versus Expected Utility

 Expected monetary value and expected utility will

always lead to identical recommendations if the
decision maker is risk neutral.
 This result is generally true if the decision maker is
almost risk neutral over the range of payoffs in the
problem.

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 Expected Monetary Value Versus Expected Utility

Generally, when the payoffs fall into a “reasonable”


range, decision makers express preferences that
Expected
agreeMonetary Value Versus
with the expected monetaryExpected Utility
value approach.
 Payoffs fall into a “reasonable” range when the best is
not too good and the worst is not too bad.
 If the decision maker does not feel the payoffs are
reasonable, a utility analysis should be considered.

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 End of Chapter 13, Part B

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