Logarithmic utility functions are already risk-averse by virtue of their concavity. The expected value of a 50% chance of doubling or halving is a 25% gain.
People are often risk-averse in terms of utility. That is, they would sometimes not take a choice with positive expected value in utility because of the possible risk.
For instance, if you have to choose between A and B, where A is a definite gain of 1 utile and B is a 50% chance of staying the same, and a 50% chance of gaining 2 utiles, both choices have the same expected value, but a risk-averse person would prefer choice A because it has smaller risk.
No, the whole point is that people can be risk averse of utility. This seems to be confusing people (my original post got voted down to −2 for some reason), so I’ll try spelling it out more clearly:
Choice X: gain of 1 utile.
Choice Y: no gain or loss.
Choice Z: gain of 2 utiles.
Choice B was a 50% chance of Y and a 50% chance of Z. To calculate the utility of choice B, we can’t just take the expected value of the utility of choice B, because that doesn’t include the risk. For a risk-averse person, choice B has a utility of less than 1, although the expected value of choice B is 1.
This would be entirely true if instead of utiles you had said dollars or other resources. As it is, it is false by definition: if two choices have the same expected utility (expected value of the utility function) then the chooser is indifferent between them. You are taking utility as an argument in something like a meta-utility function, which is an interesting discussion to have (which utility function we might want to have) but not the same as standard decision theory.
But the utility is the output of your utility function. If you’re not including the risk-aversion cost of choosing B in its expected value in utiles, then you’re not listing the expected value in utiles properly.
That’s just plain false. Risk-aversion is a valid preference, and can be included as a term in a utility function (at slight risk of circularity, but that’s not really a problem).
ETA: well, the stated units were utils, so risk-aversion should be included, so I think you’re correct.
The expected value of choice B is 1, but the utility of choice B to a risk-averse person would be less than 1. Risk-averse people just don’t equate utility of a choice with the expected value of that choice.
I don’t think opportunities to make choices are usually considered to be in the domain of a utility function. (If I’m wrong, educate me. I’d appreciate it.)
Ok, I looked it up and it looks like you and thomblake (ETA: and Technologos. Thanks for correcting me!) are right: the usual way of doing it is to include risk aversion in the utility function. Sorry about that.
Wikipedia on risk-neutral measures does discuss the possibility of adjusting the probabilities, rather than the utility, when calculating the expected value of a choice, but it looks like that’s usually done for ease of financial calculation.
So, one explanation for why people don’t take the “half or double” gamble is that they do have the log(x) utility function, but don’t behave accordingly because of loss aversion (as opposed to risk aversion).
Logarithmic utility functions are already risk-averse by virtue of their concavity. The expected value of a 50% chance of doubling or halving is a 25% gain.
People are often risk-averse in terms of utility. That is, they would sometimes not take a choice with positive expected value in utility because of the possible risk.
For instance, if you have to choose between A and B, where A is a definite gain of 1 utile and B is a 50% chance of staying the same, and a 50% chance of gaining 2 utiles, both choices have the same expected value, but a risk-averse person would prefer choice A because it has smaller risk.
Nitpick: you put the values in utiles, which should include risk-aversion. If you put the values in dollars or something, I would agree.
No, the whole point is that people can be risk averse of utility. This seems to be confusing people (my original post got voted down to −2 for some reason), so I’ll try spelling it out more clearly:
Choice X: gain of 1 utile. Choice Y: no gain or loss. Choice Z: gain of 2 utiles.
Choice B was a 50% chance of Y and a 50% chance of Z. To calculate the utility of choice B, we can’t just take the expected value of the utility of choice B, because that doesn’t include the risk. For a risk-averse person, choice B has a utility of less than 1, although the expected value of choice B is 1.
This would be entirely true if instead of utiles you had said dollars or other resources. As it is, it is false by definition: if two choices have the same expected utility (expected value of the utility function) then the chooser is indifferent between them. You are taking utility as an argument in something like a meta-utility function, which is an interesting discussion to have (which utility function we might want to have) but not the same as standard decision theory.
But the utility is the output of your utility function. If you’re not including the risk-aversion cost of choosing B in its expected value in utiles, then you’re not listing the expected value in utiles properly.
I would say that such a person doesn’t have preferences representable by a utility function.
That’s just plain false. Risk-aversion is a valid preference, and can be included as a term in a utility function (at slight risk of circularity, but that’s not really a problem).
ETA: well, the stated units were utils, so risk-aversion should be included, so I think you’re correct.
The expected value of choice B is 1, but the utility of choice B to a risk-averse person would be less than 1. Risk-averse people just don’t equate utility of a choice with the expected value of that choice.
I don’t think opportunities to make choices are usually considered to be in the domain of a utility function. (If I’m wrong, educate me. I’d appreciate it.)
Ok, I looked it up and it looks like you and thomblake (ETA: and Technologos. Thanks for correcting me!) are right: the usual way of doing it is to include risk aversion in the utility function. Sorry about that.
Wikipedia on risk-neutral measures does discuss the possibility of adjusting the probabilities, rather than the utility, when calculating the expected value of a choice, but it looks like that’s usually done for ease of financial calculation.
So, one explanation for why people don’t take the “half or double” gamble is that they do have the log(x) utility function, but don’t behave accordingly because of loss aversion (as opposed to risk aversion).
The post is technical, but Stuart_Armstrong analyzed some special cases of not-quite-utility-function agents.