Behavioral finance FAQ / Glossary (Utility)

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Dates of related message(s) in the
Behavioral-Finance group (*):

Year/month, d: developed / discussed,
i: incidental

Utility (in economics and finance)

 



00/7i,8i,9i,10i - 01/1i,3i,4i,7d,11i -
02/4i,5i,8i,12i - 03/2i,5d - 08/11i
+ see value expected utility, utility
maximization, risk premium,
risk
aversion, preferences, ophelimity
+ bfdef + bfdecis

Pure souls, like you and me, and also economists,

define and reckon utility as

how much a satisfaction is worth in hard currencies.

Definition:

Utility is a personal measure of satisfaction (see needs,
preferences)brought in an economic transaction / exchange.

In economics and finance, utility (compared to price) is
supposed to be the main parameter to make decisions
such as to buy, to sell, to produce, to work, to save, to invest...

Utility is the personal monetary value that
somebody attributes,
more or less consciously, to a specific
goods, asset, service, situation or action.

It allows to compare it to other ones (and 
      their prices: market price, price proposal, listed price...)
     so as to make a choice.

Criteria and forms

 Is utility always ...useful


It is tricky, and not always relevant in economic reasoning, to determine to
what extent this personal satisfaction criterion is or not fully rational (*).

Another aspect is that potential personal satisfactions are "under
constraint"
, as bounded by

* the person's financial means

* and judicial rules and social acceptance.

(*) Utility in that sense does not need to be ...useful, for us or for
      anybody.

What are commonly seen, for good or bad reasons, as perverse
preferences / satisfactions are also realities, they cannot be
ignored in economic reasoning.

A scientific approach must include all cases without implying a
moral judgment about vice or virtue.

Pareto preferred to call it ophelimity, see that word).

The same as utility correspond to some pleasant feeling,
disutility (negative utility) is related to an unpleasant one.

Disutility is for example linked to a fear, or due to a loss (see "prospect
theory").

NB. Utility can also be collective (social utility, common
good).

But social utility is quite difficult to assess as it supposes to have
ian dea of what is good for other people (see "ethics").

Utility maximization and economic choice

Always choosing smartly? Hmm, why should we?


Classical economist take utility as the key decision-making factor that
drives economic players.

They consider that those deciders sort the things they want
according to their "relative utility", in other word their range / hierarchy
of personal values.

They opt for the deal that brings them the highest personal value, the best
surplus of satisfaction over dissatisfaction and risk.

That theory see people as walking computers who compare wisely
the utilities of all available alternatives and make the choice that "maximize
their utility / satisfaction"
. (see the "utility maximization" article).

However obvious this maximization principle might look,

it is in fact rather controversial and far from being proven.

It supposes without much evidence that even average
deciders are ice cold / fully dedicated animals with.

* A high capability of anticipating outcomes,

* A high degree of rationality to make decisions that are

fully consistent with their scale of preferences.

Types of utilities,
     and related economic / financial assumptions

From satisfaction and saturation to expectation.

Utility in economics and finance has several specialized meanings,
each one based on related assumptions:

Utility is a key

economic
concept
,
as the source
of
 
market prices

 

 




 







 

 

 

 

 

 

 

It assumes that, in a market, all sellers and
buyers operate according to their utility

This supposes that people:

Use for economic decisions personal and 
  
rational (or at least measurable) criteria .

Choose the solution, action or commitment that
   can bring them the most satisfaction,
in other

words the behavior that would give them the
most valuable outcome
.

Therefore the market price is supposed to reflects a
balance
between the economic utilities / preferences
of all sellers and buyers.

Some economists object that prices
are directly linked to
productioncosts to which
sellers add their profit margins.

It is obviously a factor, but one
conditioned by demand.
No business launches a product /
ervice without some - objective or
subjective idea of what buyers are
ready to pay for it.

Also the economic utility theory considers that
people have a precise idea of that value.

But precisely this is ...theoretical.

People often have only a fuzzy and instinctive
idea of the value
they give to their utility.

Also, various behavioral biases (see that phrase)
can warp their perception of utility

There is also

an economic
concept called


"marginal
utility"





 



Economists and marketers use this parameter in
their offer / demand models for goods
and services.

You might find use for a first bicycle. The
second one might be a bit less useful,
the tenth one will just take too much
room in the garage.
It has more "disutility" than utility.
The needs saturation strikes!

That assumption of decreasing satisfaction is
commonly verified.

There might be some exceptions: some people
might "hoard" bicycles, either as collectibles,
or because they like the safety of never lacking
bicycles.

Also, appetite might come via eating and addiction
can lead to more and more drug taking.

Last but not least,

the "expected
utility"
(see
the phrase)
addresses

financial
decisions
.

To optimize the balance between monetary
risks  and returns  is assumed to
be the main motivator in such decisions.

That assumption, however useful it is for economic
reasoning, gives a rather narrow approach of
financial motivations
, see the "utility
maximization" article below.

Details on how utility works.

Some arithmetic


Here are more details about what is this concept and how it works:

1) In relation with market prices

Utility is a mathematical measure of a personal set of economic

preferences and anticipations.

The individual uses this measure as a comparison criterion to determine
what he/she considers the personal value of a thing, a job, a service, an
asset
(or liability), and therefore that will (normally) guide his/her choices
between those items.

Market prices are the result of the confrontation of those individual
     values
on the market.

2) In relation with risk-taking

In financial decisions, the expected utility concept (see article below) is
linkedto the person's preference in risk taking.

It can apply to the financial aspects of consuming, borrowing, job
application,but it is mostly related to investing.

Investors who have a choice between:

A sure gain,

And a probable one which "mathematical

expectancy" (*) is somewhat higher (for example 20%, or
200%, or whatever).

Would normally choose the first option, just because the second
one bears a possibility of loss.

This is called risk aversion (see that phrase).

(*) See "expectancy".

To sum it up it is the ...sum of the expected gains and losses
multiplied by their probabilities.

 

Dates of related message(s) in the
Behavioral-Finance group (*):

Year/month, d: developed / discussed,
i: incidental

Expected Utility



00/7i,8i,9i,10i - 01/1i,3i,4i,7d,11i -
02/4i,5i,8i,12i - 03/2i,5d
- 07/6i,7i -
08/11i
+ see utility, utility maximization,
risk premium, risk attitude / aversion,
preferences, ophemility + bfdef

When betting 50, your odds

* to get 100 are 80%

* and to lose 50 are 20%.

How much are you ready to bet?


That bet is worth normally (.8 x 100) - (.2 x 50) = 80 - 10 = 70.

But out of caution maybe you give it a maximum value
of only 55
.

You would not accept to bet an higher amount than that.

Definition:

In investment matters, the "expected utility" (or the "certain
equivalent"
of a probable gain) is a monetary value

that represents:

The investor's mathematical gain expectancy (*),

Divided by the investor's
   risk attitude
(aversion, tolerance...) coefficient (see risk attitude).

U = E / R, where:

U = (expected) Utility

E = Mathematical expectancy (*) of the financial outcome

R = Risk attitude (usually risk aversion) coefficient (**)
of the decider.

(*) The sum of expected gains and losses multiplied by
      their probabilities
.

For a mathematical example, see expectancy / expectation

(**) This is the investor's "personal value divisor for risk". It is:

Higher than 1 for risk averse people

(in the above example it is 60/40 = 1.5),

Equal to 1 for risk neutral people,

Lower than 1 for risk seekers.

The theory considers people as mostly risk averse and this
coefficient is in average higher than 1.

See "aversion".

Utility function, financial market incidences

The rich and the poor might see risk differently.


Utility and risk aversion are supposed to be inversely linked to
wealth  and income.

The poorer somebody is, the more risk averse he is supposed to be.

Just because to lose the few means it has would endanger its life.

This supposes an individual utility curve / function,
   that links wealth and risk attitude,

Financial market incidences

Personal (utility) curve and general (risk) premium

Applied to financial market, in which all investors, lenders, borrowers, etc.
rub elbows continuously, the risk attitude coefficient translates into a risk

premium (the additional return that the average investor demands
above the return he would get from a completely safe investment).

Related controversies and problems

Are human flawless computers, really?


The expected utility has become a controversial concept in economics and
finance.

There are several problems about the reality of the expected utility as
a rational motivator of decisions, about

1) The reality of utility functions and

2) The supposed practice of expected utility maximization (see
     below a specific article) by investors:

Here are the main issues:

As said above, it assumes that investors (and all economic players)
    use
+ = logic and math

to make all their decisions,

This is far from realistic, as it would suppose a perfect mastery of
those
tools and an absence of cognitive and emotional biases.


Risk aversion / risk attitude, or at least its measurement,
    is a
debated topic.

The risk aversion as well as the loss aversion (see those
phrases) mixes objective and subjective factors.

The prospect theory shows reversals of preferences /
of risk
attitudes,
thus of expected utility, that depend whether
an asset shows:

* a loss (here loss aversion overrides risk aversion)

* or a gain (then risk aversion is operating) compared to a 
  
reference price


The concept of risk premium (see that phrase) raises also
    various debates,

The individual utility curve / function existence is far from
     proven.

  Various studies have shown how utility paradoxes interfere.


The utility concept rests on assumptions of strict economic
    rationality,
as if humans were only interested in monetary matters

(see for example genetic utility, ethics, trophy seeking, pride...).

Actually, other decision factors than utility maximization (see
article below) seem to make that universal paradigm a bit
overrated.

Improvements to the theory,
     patches or
complications?


To tackle those flaws, some academics have explored new - albeit a bit unclear
and unpractical - concepts about the incidence of expected utility on decision
making:

* Cumulative expected utility (in case of repeated decisions)

* Rank-dependent expected utility (weighed with transitive or intransitive
   preferences)

* Generalized expected utility (well, taking into account ...everything)

 

Dates of related message(s) in the
Behavioral-Finance group (*):

Year/month, d: developed / discussed,
i: incidental

(expected) Utility maximization

See utility, expected utility,
preferences +
utility paradoxes,
probabilities

Hitting the road to find the best bargain

Expected utility maximization applies usually to situations in which people can
choose between several economic or financial decisions that entail possible
monetary gains and risks
.

In those cases, they are supposed to maximize

Their (expected) utility
(= choosing the solution
that gives the
highest expected utility, taking
into account their risk attitude),

Instead
of

 


Their plain
mathematical

gain expectancy

(as defined in the
"expectancy"
article).

=> Thus they apply to that gain expectancy a risk 
    
/ risk tolerance coefficient (see risk attitude),
      something akin to a "risk premium", see that phrase, to compare
     it to a solution that
offer a much lower possible gain
     but no risk at all.

A dented paradigm?

Is utility more than just a good bargain?

What if it is not what is usually thought?

What if it is an overrated notion, not too relevant
as an economic explanation?


The expected utility maximization concept, invented by Daniel Bernoulli,
reigned upon economic theory for more than two centuries.

This paradigm seems now a bit overrated (see also the expected utility
article).

It links too much rationality in human decisions to monetary self-interest
(see "economic man").

This reductive criterion cannot explain all economic behaviors,
as there are:

Other kinds of drives and preferences (see that word),

Also cognitive and emotional biases that perturb the decision
   process.

People do not systemically make gain / risk calculations
when they decide.


Last but not least, a loss aversion (see prospect theory)

* It is not directly proportional to the size of the potential gain

and it is not a direct comparison with a riskless investment.

* It is actually linked to a "reference point" from which to
   measure
and compare gains and losses.

* More important it opposes the idea of utility, at it leads to 

risk taking on losing operations.

All this leads to wonder if utility is well defined and understood,

and if it is really a key factor in economic decisions.

(*)To find those messages: reach that BF group and, once there,
     1) click "messages", 2)
enter your query in "search archives".

Members of the Behavioral Finance Group,
please vote on the glossary quality at
BF polls

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This page last update: 18/07/15  

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