The Chambers dictionary defines 'utility' as: usefulness: power to satisfy the wants of people in general (philos); profit (obs); a useful thing. Economics describes utility as a measure of relative satisfaction; seemingly, utility is a subjective measure. Which makes sense as the value of something, particularly money, is relative to how much you've got, how much you want, how much you want it and what you're willing to risk in order to get it.
By asking questions to ascertain indifference between gaining a certain outcome or a lottery option, it is possible to allocate utility values to each outcome and subsequently plot a graph which illustrates the 'risk behaviour' of the individual. Figure 1 shows the plot of my own utility function using this method. The shape and direction of the graph indicates that I am 'risk neutral' as opposed to 'risk seeking' which would show a steep incline levelling out as the monetary amount increases, and 'risk aversive' where the curve would incline gradually, increasing as the monetary amount increases. (I produced a very nice graph to show this, but can't insert it in the blog tut)
Probability equivalence is another way in which utility can be assessed. In this procedure, instead of asking what value of outcome would result in indifference between a certain outcome and a lottery outcome, we ask what 'probability' of winning a lottery outcome would result in indifference of a certain outcome. Figure 2 shows my own probability equivalence plot, which although less clear cut than the previous plot, shows risk neutral behaviour.
So why the differences?
In my case I think it boils down to 'numbers'. I am a resolute arithmophobe. I see numbers and give up, its that simple! In order to calculate the certainty equivalence the mathematical terms were easy to understand...I know that 50% is half, therefore I can easily calculate half of a sum of money and can 'see' that amount and 'understand' the risk and can weigh it up. I really struggled to understand the questions for the probability equivalence! Having written notes on the question sheet where 100% probability = 1 and 0% probability = 0, I still didn't really 'get' what I was doing. Funnily I understand the mathematical mechanics, but couldn't apply it to the way I think about money. Perhaps the way I think about money is as important as my inability to do number...The question asks what probability of winning a lottery would make me indifferent to a certain outcome..... the way think: I haven't got anything to start with so have nothing to lose, I don't see the potential gain as something to lose (that sentence is followed by a shrug, for sure). In which case I'm indifferent about the whole scenario, which is shown in the graphs - risk neutral.
Does that imply then, that the questions that are asked and the way in which they are worded influence the resulting utility value or am I just difficult?
