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Evaluating gambles using dynamics

### Abstract

Gambles are random variables that model possible changes in wealth. Classic decision theory transforms money into utility through a utility function and defines the value of a gamble as the expectation value of utility changes. Utility functions aim to capture individual psychological characteristics, but their generality limits predictive power. Expectation value maximizers are defined as rational in economics, but expectation values are only meaningful in the presence of ensembles or in systems with ergodic properties, whereas decision-makers have no access to ensembles, and the variables representing wealth in the usual growth models do not have the relevant ergodic properties. Simultaneously addressing the shortcomings of utility and those of expectations, we propose to evaluate gambles by averaging wealth growth over time. No utility function is needed, but a dynamic must be specified to compute time averages. Linear and logarithmic “utility functions” appear as transformations that generate ergodic observables for purely additive and purely multiplicative dynamics, respectively. We highlight inconsistencies throughout the development of decision theory, whose correction clarifies that our perspective is legitimate. These invalidate a commonly cited argument for bounded utility functions.

© 2016 Author(s). All article content, except where otherwise noted, is licensed under a Creative Commons Attribution 3.0 Unported License.

Received 29 September 2015
Accepted 21 December 2015
Published online 02 February 2016

Lead Paragraph:
Over the past few years, we have explored a conceptually deep, simple, change of perspective that leads to a novel approach to economics. Much of current economic theory is based on early work in probability theory, performed specifically between the 1650s and the 1730s. This foundational work predates the development of the notion of ergodicity, and it assumes that expectation values reflect what happens over time. This is not the case for stochastic growth processes, but such processes constitute the essential models of economics. As a consequence, nowadays expectation values are often used to evaluate situations where time averages would be appropriate instead, and the result is a “paradox,” “puzzle,” or “anomaly.” This class of problems, including the St. Petersburg paradox and the equity-premium puzzle, can be resolved by ensuring the following: the stochastic growth process involved in the problem needs to be made explicit; the process needs to be transformed to find an appropriate ergodic observable. The expectation value of the new observable will then indeed reflect long-time behavior, and the puzzling essence of the problem will go away. Here we spell out the general recipe, which we phrase as the solution to the general gamble problem that stood at the beginning of the debate in the 17th century. We hope that this recipe will resolve puzzles in many different areas.

Acknowledgments:
We thank K. Arrow for discussions that started at the workshop “Combining Information Theory and Game Theory” in 2012 at the Santa Fe Institute, and for numerous helpful comments during the preparation of the manuscript. O.P. would like to thank A. Adamou for discussions and a careful reading of the manuscript and D. E. Smith for helpful comments.

Article outline:

I. PRELIMINARIES
II. OUTLINE
III. THE DYNAMIC PERSPECTIVE
A. Additive repetition
B. Multiplicative repetition
IV. HISTORICAL DEVELOPMENT OF DECISION THEORY
A. Pre-1713 decision theory: Expected wealth
B. 1738–1814 decision theory: Utility
C. 1814–1934 Decision theory: Expected utility
D. Post-1934 decision theory: Bounded utility
V. SUMMARY AND CONCLUSION

/content/aip/journal/chaos/26/2/10.1063/1.4940236

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http://dx.doi.org/10.2307/1881800
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2016-07-25

### Abstract

Gambles are random variables that model possible changes in wealth. Classic decision theory transforms money into utility through a utility function and defines the value of a gamble as the expectation value of utility changes. Utility functions aim to capture individual psychological characteristics, but their generality limits predictive power. Expectation value maximizers are defined as rational in economics, but expectation values are only meaningful in the presence of ensembles or in systems with ergodic properties, whereas decision-makers have no access to ensembles, and the variables representing wealth in the usual growth models do not have the relevant ergodic properties. Simultaneously addressing the shortcomings of utility and those of expectations, we propose to evaluate gambles by averaging wealth growth over time. No utility function is needed, but a dynamic must be specified to compute time averages. Linear and logarithmic “utility functions” appear as transformations that generate ergodic observables for purely additive and purely multiplicative dynamics, respectively. We highlight inconsistencies throughout the development of decision theory, whose correction clarifies that our perspective is legitimate. These invalidate a commonly cited argument for bounded utility functions.

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