Expected Utility Theory

Definition

Expected utility theory is a decision-making framework that helps individuals choose between risky alternatives by calculating the expected outcomes based on probabilities and their associated utilities. This theory assumes that people will make rational choices to maximize their overall satisfaction or utility, weighing both the likelihood of various outcomes and the value they place on those outcomes.

5 Must Know Facts For Your Next Test

1. Expected utility theory suggests that individuals calculate the expected utility of each option by multiplying the utility of each outcome by its probability and summing these values.
2. People often display risk-averse behavior, meaning they prefer options with lower risk even if higher-risk options have higher expected utilities.
3. The theory is built on the assumption that individuals act rationally, which may not always hold true in real-world situations due to biases and emotions.
4. This framework can explain various economic behaviors, such as insurance purchasing, where individuals buy policies to protect against unlikely but significant losses.
5. Expected utility theory has been foundational in economics and psychology, influencing models of consumer behavior and decision-making under uncertainty.

Review Questions

• How does expected utility theory explain the decision-making process in situations involving risk?
  • Expected utility theory explains decision-making under risk by guiding individuals to evaluate options based on their potential outcomes and associated probabilities. By calculating the expected utility for each choice, people can determine which option offers the highest overall satisfaction. This rational approach assumes that individuals will seek to maximize their utility, balancing both risk and reward in their decisions.
• In what ways does expected utility theory account for individual differences in risk aversion when making decisions?
  • Expected utility theory accommodates individual differences in risk aversion by recognizing that people assign different utilities to outcomes based on personal preferences and experiences. For example, a risk-averse person may assign lower utility to high-risk options, thus favoring safer choices with more certain outcomes. This variation allows for a more nuanced understanding of how different individuals navigate risk and make decisions based on their unique perceptions of utility.
• Evaluate the limitations of expected utility theory in accurately predicting real-world decision-making behaviors.
  • While expected utility theory provides a structured approach to decision-making under risk, its limitations become apparent when considering human behavior in real-world situations. People often act irrationally due to cognitive biases, emotions, and social influences, which can lead them to deviate from what the theory predicts. Additionally, the assumption of rationality may not hold true for all individuals, as factors such as framing effects and loss aversion can significantly impact choices. These discrepancies highlight the need for complementary theories that better capture the complexities of human decision-making.

Related terms

Risk Aversion: A preference for certainty over uncertainty, leading individuals to avoid risky choices even when potential benefits are high.

Probability: The measure of the likelihood that a given outcome will occur, often expressed as a number between 0 and 1.

Utility: A measure of satisfaction or value derived from a particular outcome or choice, used to evaluate the desirability of different options.