Chapter 4 The Theory of Choice Utility Theory Gven Uncertainty4章选择效用理论给出不确定度理论.docxVIP

PAGE  PAGE 17 The Theory of Choice: Utility Theory Given Uncertainty (CWS – Chapter 3) In this chapter, we explore the theory of how individuals choose among risky investments. In Topic 1, we looked at an individual’s investment and consumption decisions across time (e.g., t = 0 and t = 1) under the assumption of certainty. Here we look at a single point of time, but where individuals are faced with a choice of return versus risk. In general, traditional finance models assume individuals (1) are rational, (2) prefer more to less (i.e., investments with a higher expected payoff or expected return), and (3) prefer less risk (i.e., less dispersion). Consider the following examples: Example 1: Asset A: -$1,000 (50% chance), $1,005 (50% chance) Asset B: -$1,001 (50% chance), $1,004 (50% chance) Example 2: Asset A: -$1,000 (50% chance), $1,005 (50% chance) Asset C: -$1,010 (50% chance), $1,015 (50% chance) Example 3: Asset A: -$1,000 (50% chance), $1,005 (50% chance) Asset D: -$2 (99.99999% chance), $15,000,000 (0.00001% chance) What are the logical choices in the first two examples? What about the last example? Why might an individual prefer Asset D? Assuming individuals prefer investments (gambles) like Asset D, how should they gamble in a lottery (or casino)? Consumer Choice under Uncertainty - Axioms Acknowledging that individuals sometimes act “irrationally,” or derive utility from things other than monetary payoffs of an investment, let’s still go forward to develop a theory of rational consumer choice under uncertainty. To do so, we need to make some assumptions about human behavior. Notation: The symbol means “preferred,” the symbol ~ means “indifferent,” and means “weakly preferred.” The axioms of cardinal utility Axiom 1: Comparability. Given a set of two uncertain outcomes, individuals can say that they prefer one outcome to the other, or that they are indifferent between the two outcomes. Notation: between two possible outcomes x and y, an investor