3 Utility Theory

In this chapter, we seek to systematically describe preferences of an investor who has to com-
pare random outcomes like the future payo of a nancial asset or the return of a portfolio. To
this end, we will follow the axiomatic approach proposed by von Neumann and Morgenstern.

3.1 Measure theoretic preliminaries

For a nonempty interval D ⊂ R, denote by BD the Borel σ -algebra on D, i.e., BD = {A ∩ D :

A ∈ B}. If (Ω, F, P) is a probability space and X a D-valued random variable, then the
distribution PX of X is a probability measure on (D, BD ), dened by

PX [B] := P[X ∈ B].

If ν is a probability measure on (D, BD ) and h : D → R a measurable function that is

ν -integrable, we set Z
h(x) ν(dx) := Eν [h]

and call h(x) ν(dx) the integral of h with respect to ν .1

R

The following result is a generalisation of Lemma 0.3.

Lemma 3.1. Let (Ω, F, P) be a probability space and D ⊂ R a nonempty interval. Moreover,
let X be a D-valued random variable with distribution ν := PX and h : D → R a measurable
function. Then h(X) is P-integrabe if and only if h is ν -integrable and in this case
Z
E [h(X)] = h(x) ν(dx).

An important example of a probability measure ν on (D, BD ) is the Dirac measure δx for

a point x ∈ D, which is dened by

1 if x ∈ B,
δx (B) :=
0 if x ∈
/ B.

The Dirac measure represents the distribution of a D-valued random variable X that takes the
value x with probability 1, i.e., X = x P-a.s. Note that for any measurable function h : D → R,
Z
h(y) δx (dy) = h(x).

In the sequel, we also need the notion of the mixture of two distributions. If ν1 and ν2
are probability distributions on (D, BD ) and α ∈ [0, 1], then the distribution αν1 + (1 − α)ν2
1
Note that usually the expectation is dened via the integral (and not vice versa).

1
is called the mixture of ν1 and ν2 with weights α and (1 − α).2 If (Ω, F, P) is a probability
space, then a random variable X has distribution αν1 + (1 − α)ν2 , if and only if there is a
Bernoulli random variable Y with P[Y = 1] = α and P[Y = 0] = (1 − α) such that X has
condition distribution ν1 given that Y = 1 and conditional distribution ν2 given that Y = 0.3
Warning: If X1 is a random variable with distribution ν1 and X2 is a random variable
with distribution ν2 , then in general αX1 +(1−α)X2 does not have distribution αν1 +(1−α)ν2 .
The following result states that the integral h(x) ν(dx) is linear not only in the integrand
R

h but also in the integrator ν .

Lemma 3.2. Let D ⊂ R be a nonempty interval, ν1 , ν2 probability measures on (D, BD ) and

α ∈ [0, 1]. Then αν1 + (1 − α)ν2 is again a probability measure on (D, BD ). Moreover, if
h : D → R is a measurable function that this integrable with respect to ν1 and ν2 , then h is
also integrable with respect to αν1 + (1 − α)ν2 , and we have
Z Z Z


h(x) αν1 + (1 − α)ν2 (dx) = α h(x) ν1 (dx) + (1 − α) h(x) ν2 (dx).

3.2 Preferences on lotteries

Let D ⊂ R be a nonempty interval. A probability measure ν on (D, BD ) is also called a lottery

(on D). It is called a simple lottery (on D) if it is a mixture of nitely many Dirac measures,
n=1 αn = 1 such that
i.e., there exist x1 , . . . , xN ∈ D and α1 , . . . , αN ∈ (0, 1) with N
P

ν = α1 δx1 + · · · + αN δxN .

Note that ν is the distribution of a discrete random variable Y taking the value xn with
probability αn , n ∈ {1, . . . , N }.
Denition 3.3. Let D ⊂ R be a nonempty interval and M a nonempty convex subset of all
probability measures on (D, BD ). A preference order on M is a binary relation ⪰ with the
following properties:
(a) Completeness: For all ν1 , ν2 ∈ M, either ν1 ⪰ ν2 or ν2 ⪰ ν1 or both are true.
(b) Transitivity: If ν1 ⪰ ν2 and ν2 ⪰ ν3 , then also ν1 ⪰ ν3 .
If ν1 ⪰ ν2 , we say that ν1 is weakly preferred over ν2 .
If ν1 ⪰ ν2 and ν2 ⪰ ν1 , we say to be indierent between ν1 and ν2 , and write ν1 ∼ ν2 . By
contrast, if ν1 ⪰ ν2 and ν2 ⪰̸ ν1 , we say that ν1 is strictly preferred over ν2 and write ν1 ≻ ν2 .
2
The cases α = 0 and α = 1 are somewhat degenerate.
3
PN More generally, ifPνN1 , . . . , νN are probability distributions on (D, BD ) and α1 , . . . , αN ∈ [0, 1] with
n=1 αn = 1, then n=1 αn νn is called the mixture of ν1 , . . . ,P
νN with weights α1 , . . . , αN . If (Ω, F, P)
is a probability space, then a random variable X has distribution N n=1 αn νn if and only if there is a random
variable Y with P[Y = n] = αn such that X has condition distribution νn given that Y = n, n ∈ {1, . . . , N }.

2
3.3 Von Neumann-Morgenstern representation

Mathematically, the denition of a preference order is satisfactory. From a practical perspec-

tive, however, it is very unhandy because we need to specify for each pair of lotteries ν1 and ν2 ,
whether we weakly prefer ν1 over ν2 , or ν2 over ν1 , or both. For this reason, we seek to nd
another description of preference orders that encodes preferences by a single mathematical
object.
In a seminal paper in 1944, von Neumann and Morgenstern showed that many preference
orders can be neatly described by specifying a single function.
Denition 3.4. Let D ⊂ R be a nonempty interval and M a nonempty convex subset of all
probability measures on (D, BD ). A preference order ⪰ on M is said to have a von Neumann-
Morgenstern representation if there exists a measurable function U : D → R that is integrable
with respect to any ν ∈ M such that
Z Z
ν1 ⪰ ν2 ⇔ U (x) ν1 (dx) ≥ U (x) ν2 (dx).

Remark 3.5. Linearity of the expectation and the fact that inequalities remain unchanged by
multiplication with positive constants imply that a von Neumann-Morgenstern representation
can only be unique up to a positive ane transformation, i.e., if U describes a preference
order, then aU + b, where a > 0 and b ∈ R, describe the same preference order.
Our goal is now to nd axioms for preference orders that together imply a von Neumann-
Morgenstern representation. Surprisingly, essentially only two axioms are needed to ensure a
von Neumann-Morgenstern representation
The rst axiom is quite intuitive from an economic perspective.
Denition 3.6. Let D ⊂ R be a nonempty interval and M a nonempty convex subset
of all probability measures on (D, BD ). A preference order ⪰ on M is said to satisfy the
independence axiom, if for all lotteries ν1 , ν2 ∈ M, the strict preference ν1 ≻ ν2 implies

αν1 + (1 − α)ν3 ≻ αν2 + (1 − α)ν3

for all lotteries ν3 ∈ M and all α ∈ (0, 1).

The independence axiom says that if we strictly prefer lottery ν1 over lottery ν2 , then
we should also strictly prefer the mixed lottery αν1 + (1 − α)ν3 over the mixed lottery
αν2 + (1 − α)ν3 . From a normative perspective, this is quite reasonable: Comparing the
mixed lotteries, with probability α, we have to choose between ν1 and ν2 , and with probabil-
ity (1−α), we do not have to make any choice because we get the lottery ν3 . The independence
axiom says that the conditional and the unconditional choice should coincide.
Even though the independence axiom has a good theoretical foundation, it is not clear if
it reects people's preferences in practice.

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 The second axiom is economically less intuitive but natural from a mathematical perspec-
tive.

Denition 3.7. Let D ⊂ R be an nonempty interval and M a nonempty convex subset of all
probability measures on (D, BD ). A preference order ⪰ on M is said to satisfy the continuity
axiom if for any triple ν1 ≻ ν2 ≻ ν3 , there is α ∈ (0, 1) such that

αν1 + (1 − α)ν3 ∼ ν2 .

The continuity axiom says that if a lottery ν2 lies preference-wise strictly in between two
other lotteries ν1 and ν3 , then there is a convex combination of ν1 and ν3 such that one is
indierent between ν2 and this convex combination.
For simple lotteries, the independence and the continuity axiom together imply a von
Neumann-Morgestern representation. For a proof of the following result, we refer to [2, Section
2.2].4

Theorem 3.8. Let M denote the collection of all simple lotteries on (D, BD ), where D ⊂ R
is a nonempty interval. Let ⪰ be a preference order on M satisfying the independence and
the continuity axiom. Then ⪰ admits a von Neumann-Morgenstern representation:
Z Z
ν1 ⪰ ν2 ⇔ U (x) ν1 (dx) ≥ U (x) ν2 (dx),

where the measurable function U : D → R is unique up to a positive ane transformation.

3.4 Concave functions and Jensen's inequality

In order to study further properties of preference orders admitting a von Neumann-Morgenstern

representation, we need to recall the notion of a concave function.

Denition 3.9. Let D ⊂ R be a non-empty interval. A real-valued function U : D → R is

called concave if

U (λx1 + (1 − λ)x2 ) ≥ λU (x1 ) + (1 − λ)U (x2 ), x1 , x2 ∈ D, λ ∈ [0, 1]. (3.1)

It is called strictly concave if the inequality in (3.1) is strict for x1 ̸= x2 and λ ∈ (0, 1).

Graphically speaking, (strict) concavity means that straight line segments joining (x1 , U (x1 ))
to (x2 , U (x2 )) always lie (strictly) below the graph of U .

Remark 3.10. (a) If U is (strictly) concave then, −U is (strictly) convex.

4
Note that the result is wrong for general lotteries on (D, BD ). For the general case, one needs stronger
continuity properties of ⪰; see [2, Theorems 2.27 and 2.29].

4
 U (x)

0 x1 x2 x

Figure 1: Example of a concave function

(b) If U : D → R is twice continuously dierentiable then U is concave if and only if

U ′′ ≤ 0. Moreover, it is strictly concave if U ′′ < 0.5

We proceed to state and prove the fundamental inequality for concave functions.

Lemma 3.11 (Jensen's inequality). Let (Ω, F, P) be a probability space and X an integrable
random variable with values in a non-empty interval D ⊂ R. Let U : D → R be concave and
suppose that E [|U (X)|] < ∞. Then

E [U (X)] ≤ U (E [X]) .

Moreover, the inequality is strict when U is strictly concave and X is not P-a.s. constant.
Proof. First, using the denition of concavity, one can show that for each a ∈ D, there is
b ∈ R such that
U (x) ≤ U (a) + b(x − a), (3.2)
where the inequality in (3.2) is strict for x ̸= a if U is strictly concave.6
Next, choose a := E [X]. One can show that a ∈ D because D is an interval. Let b ∈ R
be such that (3.2) is satised. Then

U (X) ≤ U (a) + b(X − a).

and
P[U (X) < U (a) + b(X − a)] = P[X ̸= a] > 0,
5
The converse is not true: For example, the function U : R → R, x 7→ −x4 is strictly concave, but U ′′ (0) = 0.
6
If U is twice continuously dierentiable, the (weak) inequality (3.2) can be easily derived as follows: Fix
a ∈ D and set b := U ′ (a). By a Taylor expansion of U in a of order 1 with Lagrange remainder term, we
obtain for xed x ∈ D
1 ′′
U (x) = U (a) + b(x − a) + U (ξ)(x − a)2 ,
2
where ξ lies in the interval with the endpoints x and a. Since U ′′ ≤ 0 by concavity of U , (3.2) follows.

5
if U is strictly concave and X is not P-a.s. constant. Thus, by monotonicity and linearity of
the integral and the fact that a = E [X],

E [U (X)] ≤ E [U (a) + b(X − a)] = U (a) + b(E [X] − a) = U (a) + b(a − a) = U (a)
= U (E [X]),

where the inequality is strict if U is strictly concave and X is not P-a.s. constant.