Utility Theory

A utility function is simply a "quantification" of a person's preferences with respect to certain objects.

Six conditions that guarantee the existence of a Utility Function

If a player's preferences are to be expressed by a utility function, these preferences must be consistent:

• Everything is comparable.
• Preference and indifference are transitive. That is, if A>B and B>C, then A>C.
• A player is indifferent when equivalent prizes are substituted in a lottery.
• A player will always gamble if the odds are good enough.
• The more likely the preferred prize, the better the lottery.
• Players are indifferent to gambling. A player's attitude toward a compound lottery - a lottery in which the prizes may be tickets to other lotteries - is dependent only on the ultimate prizes and the chances of getting them as determined by the laws of probability; the actual gambling mechanism is irrelevant.

It has even been suggested that these conditions should be used as a definition of rationality in decision making.

Restrictions

In reality, it is easy to show that a person cannot consistently prefer the one type of bet to be the other and still satisfy the six conditions necessary for consistency.

Another souce of difficulty is the variation in people's preferences over a period of time.

Experiments have shown that decisions often depend on seemingly irrelevant variables.

Context of a problem can influence decision making. It was found that most subjects made different decisions in two identical or equivalent situations when these situations were discribed in different ways. The general rule was this: pelple who feel they have won something generally try to conserve their winnings by avoiding risks. In an identical situation, the same people who perceive that they have just lost something will take risks they considered unacceptable before, to make themselves whole. Also people are more sensitive to the percentage of changes, but not the absolute changes.