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Utility and Scales. Outline. Fundamental questions of economic theory require a treatment different from that which they have found thus far in the literature

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outline
Outline
  • Fundamental questions of economic theory require a treatment different from that which they have found thus far in the literature
  • Application of mathematical theory of games of strategy to economic problems provides a new approach to a number of questions as yet unsettled
  • Intent of this is often misconstrued as merely pointing out an analogy between these two concepts
  • It must be noted that there exists at present no universal system of economic theory
slide3
Consider a comparison with physics. Considering the fact that economics is much more difficult, much less understood, and undoubtedly in a much earlier stage of its evolution as a science than physics, one should clearly not expect a rapid development in the near future
  • Differences in scientific questions make it necessary to employ varying methods which may afterwards have to be discarded if better ones offer themselves
slide4
Use of mathematics has not been highly successful so far in contrary to what one observes in other sciences
  • Before the development of the mathematical theory the possibilities of quantitative measurements were less favourable there than they are now in economics
  • Social scientists assert that economic theory cannot be modelled after other sciences since it is a science of social, human phenomena and has to take psychology into account
application of mathematics in economics problems
Application of Mathematics in Economics - Problems
  • Economic problems not formulated clearly and are often vaguely stated
  • Empirical background of economic science is inadequate
  • The problem is that one is offered not proofs but mere assertions which are no better than assertions in the literary form
notion of utility
Notion of Utility
  • Every claim of measurability must ultimately be based on some immediate sensation which possibly cannot and need not be analyzed any further
  • In case of utility, the measurability is in terms of the sensation of preference
  • Since there is no intuitive significant way to add two utilities, the assumption that utilities are of non-numerical character even seems plausible
slide7
Consider the following example:

“Feeling the elements of surrender in the intensity of relief”

mathematical foundations of economic theory
Mathematical Foundations of Economic Theory
  • The construction of mathematical foundations of any scientific discipline requires the identification of conditions that must be satisfied in order to enable the application of the mathematical operations of linear algebra and calculus.
  • In social science disciplines, in addition to that, the application of mathematical operations to non-physical operations is required
slide9
These variables describe the psychological or subjective properties such as preference
  • Whether psychological properties can be measured and hence whether mathematical operations can be applied to psychological variables was debated upon for a while
  • Game theory was proposed as the proper instrument with which to develop a theory of economic behaviour where utility theory was to be the means for measuring preference
slide10
Jonathan Barzilai showed that the use of utility scales leads to an intrinsic contradiction and that the operations of addition and multiplication are not applicable on utility scale values
  • Game theory involves the construction of value functions
  • Value/utility/preference is not a physical property of the objects being valued, that is, value is a subjective (or psychological, or personal) property
slide11
Therefore, establishing the applicability of mathematical operations is a prerequisite for a discussion of the mathematical foundations of economic theory
  • In particular, without the operations of addition and multiplication, which are elementary mathematical tools, very limited results can be derived
measurement of preference empirical addition
Measurement of Preference – Empirical Addition
  • Preference, or value, or utility, is not a physical property of the objects being valued, that is, preference is a subjective, psychological, property
  • The belief that psychological variables cannot be measured was divided among the peers
slide13
Consider an Empirical system E which is a set of empirical objects together with operations, i.e. Functions and possibly the relation of order which characterize the property under measurement
  • A mathematical model M of the empirical system E is a set with operations that reflect the empirical operations in E as well as the order in E when E is ordered
slide14
A scale s is a mapping of the objects in E into the objects in M that reflects the structure of E into M (in technical terms, a scale is a homomorphism from E into M)
  • The purpose of modelling E by M is to enable the application of mathematical operations on the elements of the mathematical system M
  • To enable the application of mathematical operations in a given empirical system, the empirical objects are mapped to mathematical objects on which these operations are performed
slide15
A given property must be characterized by empirical operations which are specific to this property and these property-specific empirical operations are then reflected to corresponding operations in the mathematical model
  • Therefore, the construction of measurement scales requires that the property-specific empirical operations be identified and reflected in the mathematical model
slide16
von Neumann and Morgenstern had to identify the empirical operations that characterize the property of preference and construct a corresponding mathematical model
  • Stevens proposed a uniqueness-based classification of “scale type” and research interest turned from the issues of the possibility of measurement of psychological variables and the applicability of mathematical operations on scale values to the construction of “interval” scales, i.e. scales that are unique up to an additive constant and a positive multiplicative constant
shortcomings of utility and game theory
Shortcomings of Utility and Game theory
  • Guild’s argument against the possibility of measurement of psychological variables can be rejected on the basis of the uniqueness argument but constructing utility scales that are immune from this argument is not equivalent to establishing that psychological variables can be measured
  • the operations of addition and multiplication do not apply to utility scale values
scale values vs scale operations
Scale Values Vs Scale Operations

It is important to emphasize the distinction between the application of the operations of addition and multiplication to scale values for a fixed scale (for example s(a)=s(b)+s(c)) as opposed to what appear to be the same operations when they are applied to an entire scale whereby an equivalent scale is produced (for example t=p + q x s)where s and t are two scales and p, q are numbers).

slide19
In the case of scale values for a fixed scale, the operations of addition and multiplication are applied to elements of the mathematical system M and the result is another element of M
  • In the case of operations on entire scales, addition or multiplication by a number are applied to an element of the set of all possible scales and the result is another element of S rather than M
  • These are different operations because operations are functions and functions with different domains or ranges are different
the principle of reflection
The Principle of Reflection
  • The Principle of Reflection is an essential element of modelling that states that operations within the mathematical system are applicable if and only if they reflect corresponding operations within the empirical system
  • In technical terms, in order for the mathematical system to be a valid model of the empirical one, the mathematical system must be homomorphic to the empirical system
slide21
By the Principle of Reflection, a necessary condition for the applicability of an operation on scale values is the existence of a corresponding empirical operation (the homomorphic pre-image of the mathematical operation)
  • That is, the Principle of Reflection applies in both directions and a given operation is applicable in the mathematical image only if the empirical system is equipped with a corresponding operation
slide22
The Principle of Reflection implies that the operations of addition and multiplication are not enabled on utility scales
  • These operations are not applicable to von Neumann and Morgenstern’s utility model because their axioms include one compound empirical ternary operation
utility s intrinsic self contradiction
Utility’s IntrinsicSelf-Contradiction
  • As an abstract mathematical system, von Neumann and Morgenstern’s utility axioms are consistent
  • Although the axioms are consistent in the abstract, the interpretation of the empirical utility operation creates an intrinsic inconsistency
slide24
The theory permits lotteries that are prizes and this leads to a contradiction since an object may be both a prize, which is not constrained, and a lottery which is constrained
  • Consider prizes A and C and the decision maker assigns the utility values u(A) = 0 and u(C) = 1 and D be the lottery D = {(0.6, A);(0.4, C)}
  • According to utility theory, u(D) = 0.6u(A) + 0.4u(C) = 0.4 so that the value of is determined by the other given parameters and the decision maker has no discretion as to its value
slide25
suppose that the decision maker assigns the value u(B) = 0.5 to the prize B, and is offered an additional prize E
  • According to utility theory, there are no constraints on the possible utility values for prizes so that the value of u(E) is at the discretion of the decision maker and is not dictated by the theory
  • The decision maker then assigns the utility value u(E) = 0.8
slide26
Since utility theory allows prizes that are lottery tickets, suppose that the prize E is the lottery E = {(0.6, A);(0.4, C)}
  • It follows that D = E yet the utility value of this object is either 0.8 or 0.4 depending on whether we label the object {(0.6, A);(0.4, C)} a prize or a lottery
  • That is, we have u(D) = 0.4 ≠ 0.8 = u(E) where D and E are the same object
slide27
Now we have u(D) < u(B) u(E) > u(B) yet D = E so that the object {(0.6, A);(0.4, C)} is rejected in favour of B if it is labelled a lottery and accepted as preferred to B if it is labelled a prize
game theory values
Game Theory Values
  • The assignment of values to objects such as outcomes and coalitions, i.e. the construction of value functions, is a fundamental concept of game theory
  • Value (or utility, or preference) is not a physical property of the objects being valued, that is, value is a subjective (or psychological, or personal) property
slide29
Therefore, the definition of value requires specifying both what is being valued and whose values are being measured
  • Game theory’s characteristic function assigns values to coalitions but von Neumann and Morgenstern do not specify whose values are being measured in the construction of this function
  • Since it is not possible to construct a value (or utility) scale of an unspecified person or a group of persons, game theory’s characteristic function is not well-defined
the value of a two person zero sum game is ill defined
“The Value” of a Two-Person Zero-Sum Game Is Ill-Defined
  • The concept of “the value” of two-person zero-sum game theory is not unique and consequently is ill-defined
  • The minimax theorem which states that every two-person zero-sum game with finitely many pure strategies has optimal mixed strategies is a cornerstone of game theory.
slide31
Given a two-person zero-sum game, denote by x* and y* the minimax optimal strategies and by u the utility function of player 1
  • Utility functions are not unique and for any p and positive q, u is equivalent to p+qxu
  • The value of the game varies when p and q vary so that it depends on the choice of the utility function u and given an arbitrary real number v, the numbers p and q can be chosen so that the value of the game equals v
slide32
As a result, the concept of “the value” of a game is ill-defined and any game theoretic concept that depends on “the” value of a game is ill-defined as well
the reconstruction of the foundations
The Reconstruction of the Foundations
  • In order to enable the “powerful weapon of mathematical analysis” to be applied to economic theory or any scientific discipline it is necessary, at a minimum, to construct models that enable the operations of addition and multiplication for without these operations the tools of linear algebra and elementary statistics cannot be applied
slide34
This construction, which leads to the well-known geometry of points on a straight line, is based on two observations:

1.)If the operations of addition and multiplication are to be enabled in the mathematical system M, these operations must be defined in M. The empirical system E must then be equipped with corresponding operations in order for M to be a model of E

2.)Mathematical systems with an absolute zero or one are not homogeneous: these special, distinguishable, elements are unlike others. On the other hand, since the existence of an absolute zero or one for empirical systems that characterize subjective properties has not been established, they must be modelled by homogeneous mathematical systems

slide35
Sets that are equipped with the operations of addition and multiplication, including the inverse operations of subtraction and division, are studied in abstract algebra and are called fields
  • A field is a not a homogeneous system since it contains two special elements, namely an absolute zero and an absolute one which are the additive and multiplicative identities of the field
slide36
To homogenize the multiplicative identity, we construct a one-dimensional vector space which is a partially homogeneous field
  • To homogenize the additive identity as well, we combine points with the vectors and scalars and construct a one-dimensional affine space, which is a homogeneous field, over the previously constructed vector space
slide37
The end result of this construction, the one-dimensional affine space, is the algebraic formulation of the familiar straight line of elementary (affine) geometry so that for the operations of addition and multiplication to be enabled on models that characterize subjective properties, the empirical objects must correspond to points on a straight line of an affine geometry
slide38
In an affine space, the difference of two points is a vector and no other operations are defined on points
  • In particular, it is important to note that the ratio of two points as well as the sum of two points are undefined
  • The operation of addition is defined on point differences, which are vectors
  • Multiplication of a vector by a scalar is defined and the result is a vector
  • In the one-dimensional case, and only in this case, the ratio of a vector divided by another non-zero vector is a scalar
slide39
Since the purpose of modelling is to enable the application of mathematical operations, we classify scales by the type of mathematical operations that are enabled on them
  • We use the terms proper scales to denote scales where the operations of addition and multiplication are enabled on scale values, and weak scales to denote scales where these operations are not enabled
implications
Implications
  • In order for the operations of addition and multiplication to be applicable, the mathematical system M must be
    • (i) a field if it is a model of a system with an absolute zero and one
    • (ii) a one-dimensional vector space when the empirical system has an absolute zero but not an absolute one, or
    • (iii) a one-dimensional affine space which is the case for all non-physical properties with neither an absolute zero nor absolute one
slide41
Proper scales enable the application of the operations of linear algebra but are not necessarily equipped with the relation of order which is needed to indicate a direction on the straight line (for example, to indicate that an object is more preferable, or heavier, or more beautiful than another)
  • To construct proper ordered scales the underlying field must be ordered
slide42
If a concept as powerful as calculus is to be enabled on ordered proper scales, the underlying field must be an ordered field where any limit of elements of the field is itself an element of the field.
  • In technical terms, the underlying field must be complete
slide43
Since the only ordered complete field is the field of real numbers, in order to enable the operations of addition and multiplication, the relation of order, and the application of calculus on subjective scales, the objects must be mapped into the real, ordered, homogeneous field, i.e. a one-dimensional, real, ordered, affine space, and the set of objects must be a subset of points on an empirical ordered real straight line
  • We use the term strong models to denote such models and strong scales to denote scales produced by strong models
slide44
The reason for the central role played by the real numbers in science is that the field of real numbers is the only ordered complete field
conclusion
Conclusion
  • The conditions that must be satisfied in order to enable the application of mathematical operations were identified, and it was established that there is only one model for strong measurement of subjective variables
  • When these conditions, which have not been correctly identified in the literature, are satisfied, the operations of addition and multiplication are applicable to scale values representing non-physical variables
  • The mathematical foundations of the social sciences need to be corrected to account for these conditions
references
References:
  • Jonathan Barzilai, On the Mathematical Foundations of Economic Theory, Technical Report, Dept. of Industrial Engineering, Dalhousie University, pp. 1-13, 2007
  • Jonathan Barzilai, Notes on Utility Theory, Proceedings of the IEEE International Conference on Systems, Man, and Cybernetics, pp. 1000-1005, 2004
  • Jonathan Barzilai, On the Mathematical Modeling of Measurement, http://arxiv.org/, math.GM/0609555, pp. 1-4, 2006
  • Jonathan Barzilai, Preference Function Modeling (PFM): The Mathematical Foundations of Decision Theory, Technical Report, Dept. of Industrial Engineering, Dalhousie University, pp. 1-16, 2008
  • Jonathan Barzilai, Game Theory Foundational Errors – Part II, Technical Report, Dept. of Industrial Engineering, Dalhousie University, pp. 1-9, 2008
slide47
Jonathan Barzilai, Game Theory Foundational Errors – Part III, Technical Report, Dept. of Industrial Engineering, Dalhousie University, pp. 1-4, 2009
  • Jonathan Barzilai, Game Theory Foundational Errors – Part IV, Technical Report, Dept. of Industrial Engineering, Dalhousie University, pp. 1-4, 2009
  • J. von Neumann and O. Morgenstern, Theory of Games and Economic Behaviour, Princeton University Press, 1944
two person zero sum games
Two-Person Zero-Sum Games
  • Two-person zero-sum games are games with only two players in which one player wins what the other player loses
  • For a two-person zero-sum game, the payoff function of Player II is the negative of the payoff of Player I
  • So we may restrict attention to the single payoff function of Player I
slide51
The strategic form, or normal form, of a two-person zero-sum game is givenby a triplet (X, Y,A), where

- X is a nonempty set, the set of strategies of Player I

- Y is a nonempty set, the set of strategies of Player II

- A is a real-valued function defined on X × Y

slide52
Player I chooses x ∈ X and Player II chooses y ∈ Y , each unaware of the choice of the other
  • Then their choices are made known and I wins the amount A(x, y) from II
  • If A is negative, I pays the absolute value of this amount to II
  • Thus, A(x, y) represents the winnings of I and the losses of II
slide53
The procedure used to ensure the return of the value of a game is called an optimal strategy or a minimax strategy
  • It is useful to make a distinction between a pure strategy and a mixed strategy
  • The more complex entity that chooses among the pure strategies at random in various proportions is called a mixed strategy
  • Also, every pure strategy, x ∈ X, can be considered as the mixed strategy that chooses the pure strategy x with probability 1
slide54
The subtle assumption made here is that when a player uses mixed strategy, he is only interested in his average return and does not care about his maximum possible winnings or losses
  • This is equivalent to assuming that a player is indifferent between receiving 5 million dollars outright, and receiving 10 million dollars with probability 1/2 and nothing with probability 1/2
slide55
The main justification for this assumption comes from utility theory
  • The basic premise of utility theory is that one should evaluate a payoff by its utility to the player rather than on its numerical monetary value
  • The main theorem of utility theory states that under certain reasonable assumptions, player’s preferences among outcomes are consistent with the existence of a utility function and the player judges an outcome only on the basis of the average utility of the outcome
slide56
However, utilizing utility theory to justify such an assumption raises a new difficulty - the two players may have different utility functions
  • The same outcome may be perceived in quite different ways
  • This means that the game is no longer zero-sum
  • Therefore, we need an assumption that says the utility functions of two players are the same back
the minimax theorem
The Minimax Theorem
  • For every finite two-person zero-sum game,
    • (1) there is a number V , called the value of the game,
    • (2) there is a mixed strategy for Player I such that I’s average gain is at least V no matter what II does, and
    • (3) there is a mixed strategy for Player II such that II’s average loss is at most V no matter what I does
  • If V is zero we say the game is fair. If V is positive, we say the game favors Player I, while if V is negative, we say the game favors Player IIback
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