2. Introduction
Expected utility theory was first proposed by Nicholas Bernoulli 1713
and solved by Daniel Bernoulli in 1738 and St. Petersburg Paradox.
It offers economical representation of truly rational behaviour under
uncertainty.
Expected utility theory is a normative approach which suggest how
should investors make a rational decision in an uncertain situation.
3. Introduction
Certainty of a particular outcome has increased irrespective of the
constant or the price of the bet, individual changed their preference
towards the event that were more certain.
But according to the prediction of Expected Utility theory, this
should not happen and individual were supposed to stick to their
preferences as the certainty increase not the price.
4. Equation of Expected Utility Theory
It Rains It does not Rain
Umbrella 15 15
No Umbrella 0 18
5. Assumptions
1. Investor is able to rank alternatives
2. An investor will prefer dominant investment
3. Investors ignore irrelevant alternatives
4. Investors consistently rank outcomes. If (A >B) or (B>C) then,
must be (A>C)
5. Investors ranking of alternatives are continuous.
6. Investors care about outcomes/payoff and probability with which
they are occur and not how they are presented.
6. Investment criteria under
Expected Utility Theory
Maximum Return Criteria (MRC): When there is no risk at all,
investor should choose the investment with highest rate of
return.
Maximum Expected Return Criteria (MERC): Investor
identifies the investment with the highest expected return
and thereby overcomes the problem of ranking.
7. Theories based on the concept of
Expected Utility Theory
Theories based on the concept of
Expected Utility Theory
Marginal Utility
Theory
Decision Theory
Subjective
Expected Utility
Theory
Von Veumann-
Morgenstern
Theory (VNMT)
Game Theory
8. Game Theory
Introduced after the 1944 publication of the monumental volume
“theory of game and economic behaviour” by Von Neumann and
the economist Oskar Morgenstern.
It is the formal study of conflicts and cooperation.
The concept of game theory provide a language to formulate,
structure, analyse and understand strategic scenarios.
9. Marginal Utility Theory
Marginal Utility Theory approach of consumer behaviour was
published by Gossen, W.S. Jevons of England, Leon Walras of
France and Carl Menger of Austria.
Marginal utility is the additional satisfaction a consumer gains from
consuming one more units of a good or service.
Positive marginal utility is when the consumption of an additional
item increases the total utility.
Negative marginal utility is when the consumption of an additional
item decreases the total utility.
10. Decision Theory
Decision Theory is a systematic procedure to identify the best
possible decision among the various available alternatives.
Decision Theory enables the decision maker to take the best
suitable decision by providing him the facilities to evaluate and
examine the decision as per the degree of certainty.
Decision Making
under Uncertainty
Decision Making
under Risk
Decision Making
under certainty
11. Subjective Expected Utility
Model (SEUT)
Also called as Bayesian decision theory.
The Subjective Expected Utility model provides the conceptual and
computational framework that is most often used to analyse
decisions under uncertainty.
Possible outcomes for the decision makers are represented by a set
of consequences, which could be such as health, happiness,
pleasant or unpleasant experiences and so on.
12. Von Neumann Morgenstern
Theory (VNMT)
Von Neumann Morgenstern utility function, an extension of the
theory of consumer preferences that incorporates a theory of
behaviour toward risk variance.
It shows that when a consumer is faced with a choice of items or
outcomes subject to various levels of chance, the optimal decision
will be the one that maximizes the expectation value of the utility
derived from the choice made.
