Expected utility theory

Definition

Expected utility theory is a fundamental concept in decision-making that posits individuals make choices based on the expected outcomes of their actions, weighing the potential benefits against the probabilities of those outcomes. This theory assumes that people aim to maximize their utility, or satisfaction, when faced with uncertainty and risk, leading them to evaluate decisions rationally by calculating expected values. It serves as a key framework for understanding how choices are made in various contexts, including economics and psychology.

5 Must Know Facts For Your Next Test

1. Expected utility theory assumes individuals are rational actors who weigh the probabilities of various outcomes when making decisions.
2. The theory suggests that people evaluate risky options based on their expected utility rather than just their potential monetary value.
3. It can explain behaviors in various scenarios, such as gambling, insurance purchasing, and investment choices.
4. Critics of expected utility theory argue that it doesn't fully account for human behavior in real-world situations, leading to the development of alternative theories like prospect theory.
5. The concept is widely applied in economics, finance, psychology, and behavioral sciences to understand how decisions are made under uncertainty.

Review Questions

• How does expected utility theory explain the decision-making process when individuals face uncertain outcomes?
  • Expected utility theory explains that individuals make decisions by calculating the expected outcomes of their choices, considering both the potential benefits and the likelihood of each outcome occurring. By weighing these factors, people aim to maximize their overall satisfaction or utility. This rational approach helps clarify why individuals may choose one option over another when faced with uncertainty, allowing for systematic evaluation of risks involved.
• Discuss the limitations of expected utility theory and how prospect theory provides a different perspective on decision-making under risk.
  • While expected utility theory assumes rational decision-making based on calculated outcomes, it has limitations in accounting for real human behaviors and biases. Prospect theory challenges this by illustrating how people perceive gains and losses differently, often exhibiting risk aversion towards potential losses. This difference highlights that individuals may not always act rationally as expected utility theory suggests, leading to inconsistencies in choices when faced with risky scenarios.
• Evaluate the implications of expected utility theory for understanding consumer behavior in economic markets.
  • Expected utility theory plays a crucial role in understanding consumer behavior by explaining how individuals make choices based on perceived benefits and risks associated with products or services. By evaluating expected outcomes, consumers are likely to favor options that align with maximizing their satisfaction while minimizing potential losses. However, recognizing the limitations of this theory also prompts further exploration into factors such as emotional responses and cognitive biases that can influence consumer decisions beyond rational calculations.

Related terms

Risk Aversion: A preference for certainty over uncertainty, where individuals choose options that minimize potential losses rather than maximize potential gains.

Prospect Theory: A behavioral economic theory that describes how people make decisions in situations involving risk, emphasizing that individuals value gains and losses differently.

Utility: A measure of satisfaction or benefit derived from consuming goods and services or making specific choices.