I.A.1.5.1 For an Individual (Encoding a Utility Function)

Question 1

1^st Step in Implementing Utility Theory

Answer 1

Draw a utility function over possible states of wealth of an individual or firm

Question 2

An Individual’s risk attitude

Answer 2

• Can be inferred from a series of decisions, provided the other elements of the decisions (outcomes, probabilities, alternatives) are clearly understood by all

Question 3

Guidlines for Problems Submitted for Decision

Answer 3

The should be:

1. Realistic - One should avoid game playing with all the distorions it may create (e.g. displays of bravado).
2. Meaningful - The range of monetary outcomes should be on a scale of gains and losses for which we can define a utility function
3. Clear and Simple - One should avoid ambiguities, or inducements that could lead to misinterpretations of the probem, or biases. In particular, probabilities should be clearly stated and these probabilities should not be so extreme that they cannot be comprehended

Question 4

Monetary Range of Interest

Answer 4

• A range that should cover the personal impact of decisions a decision maker may have to face (such as insuring their life, committing to a new deal…etc.) since the outcome could affect thier future.
• The maximum and minimum cash amount
• The first part of determining a persons individual risk attitude (should not be directly asked but gradually attained through a series of question pushing each of which getting more and more precise)
  
  • Examples of the types of question on p. 50

Question 5

Utility Function for a Firm (Should there be a single risk attitude for all decisions in the firm?)

Answer 5

• Tradition: using a single utility curve for the entire firm in order to formalize the risk attitude of the entire firm (between business units) (P.51-52)
• A single risk attitude (or utility function) for a firm across all levels of the firm is the traditional view asit provides consistancy and limits outsiders of the firm from taking advantage of different business units risk tollerance.
• A more practical approach is to have varring levels of risk attitude depending on level (top, intermediate, lower level) of management.
  
  • This approach provides allows for greater risk to be incorporated at the highest strategy level and allows for tightening of risk attitude down the chain. ( LImiting risk at lower levels allows for less disruption, not being able to stick to a plan, and reduces the need for complex contingency plans and cross subsidies between units)

Question 6

Utility Function for a Firm (Whose risk attitude should we encode?)

Answer 6

• Risk attitude to strategic decisions should be agreed at board level and then delineate that attitude down the managment chain allowing for each level some freedom in determining risk attitude at their level within the strategic mandate.
• Varring stakeholders in a firm should be considered though each may have a different risk attitude (shareholders, bondholders, managers…etc). These differing attitude should be used to negotiate a common risk-attitude agreed upon by all parties.
• Some industries, such as financial, have regulations setting requirements
• Having a explicit risk attitude allows managers to justify their decisions to do what is best for the firm rather than juding based only on their decisions (which to some extent are left to chance)m and do what is best in their own personal interest.