Abstract
This paper is concerned with applying the concept of learning through a Bayesian process to individuals discovering their utility functions. In the usual formulation of decision theory the utility function is assumed to be known and fixed. The assumption of a fixed utility function gives rise to inconsistencies of the type illustrated by the ‘Allais paradox’. We have explored a series of examples in which the individual compares the expected utility from the consequences of a particular event before it occurs with the utility actually realized after the event occurs. Any discrepancy between the two is assumed to result in a change in the expected (anticipated) utility function. In other words, expected utilities can be changed as a result of actual experience. The process of discovering the parameters of the expected utility function through experience is assumed to be Bayesian.
Reprinted by kind permission of the Editors from: R. H. Day and T. Groves (Eds.), Adaptive Economic Models, Academic Press, 1975. (Presented at the Symposium on Adaptive Economics, Oct. 1974, Sponsored by the Mathematical Research Center, Madison, Wisc.)
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Notes and References
Allais, M.: (1953). ‘Le comportement de l’homme rationnel devant le risque: Critique des postulats et axioms de l’école Americaine,’ Econometrica 21, 503–546.
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Cf. Simon, H. A.: (1955). ‘A Behavioral Model of Rational Choice’, Quarterly Journal of Economics 69, 99–118.
Simon has put this well: “The consequences that the organism experiences may change the pay-off function - it doesn’t know how well it likes cheese until it has eaten cheese.”
Cf. Witsenhausen, H. S.: (1974). ‘On the Uncertainty of Future Preferences’, Annals of Economic and Social Measurement 3, 91–94.
In this paper, Witsenhausen emphasizes the need to incorporate these concepts in problems of long range planning.
Von Neumann, J., and Morgenstern, 0.: (1947). Theory of Games and Economic Behavior, Second Edition,Princeton University Press, Princeton, New Jersey; DeGroot, M. H., op. cit.
For example, the parameter B which determines how much utility or enjoyment an individual will derive from ordering a steak dinner at a particular restaurant will be closely related to the parameter cp which determines whether or not the restaurant prepares good steak dinners. As another example, the parameter B which determines how much utility an individual will realize from owning a stock that yields a particular gain is only slightly related to the parameter go representing external conditions which determine whether or not the stock will yield that gain.
The random variable X will in general be a function of the actual utility received from the realized consequence. For exampre, as mentioned earlier, X may be an indicator of whether the actual utility is greater or smaller than the expected utility for that consequence. The assumption made in the text that F(x I B) does not depend on which consequence occurs is special and need not be retained in the general theory.
Cf. Cohen, K. J., and Cyert, R. M.: (1965). Theory of the Firm: Resource Allocation in a Market Economy, Prentice-Hall, Inc., Englewood Cliffs, New Jersey.
Slutsky, E. E.: (1915). ‘On the Theory of the Budget of the Consumer’, Giornale degli Economisti, Vol. LI, pp.1–26. Reprinted in Readings in Price Theory, Stigler and Boulding (Eds.), Richard D. Irwin, Inc., Chicago, 1952, pp. 27–56.
Simon, H. A.: op. cit.
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Cf. Nord, O. C.: (1963). Growth of a New Product: Effects of Capacity-Acquisition Policies, The M. I. T. Press, Cambridge, Massachusetts, Chapter 1.
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Cyert, R.M., Degroot, M.H. (1979). Adaptive Utility. In: Allais, M., Hagen, O. (eds) Expected Utility Hypotheses and the Allais Paradox. Theory and Decision Library, vol 21. Springer, Dordrecht. https://doi.org/10.1007/978-94-015-7629-1_10
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DOI: https://doi.org/10.1007/978-94-015-7629-1_10
Publisher Name: Springer, Dordrecht
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