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Decisions under uncertainty / Decision criteriaƒ 45

Daniel Bernoulli's solution involved two ideas that have since revolutionized economics:

ƒ

firstly, that people's utility from wealth,

u(w)

, is not linearly related

to wealth,

w

, but rather increases at a decreasing rate - the famous

idea of

diminishing marginal utility

,

u’(w) > 0

and

u’’(w) < 0

;

and

ƒ

secondly, that a person's valuatio

n of a risky venture is not the

expected value,

E[w]

, of that venture, but rather the

expected

utility

,

E[w]

, from that venture.

Ä

(von Neumann-Morgenstern) expected utility criterion
Single-period random cash

flows: Utility theory

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