Expected Utility

Definition

Expected utility is a concept in economics and decision theory that represents the average outcome of a risky choice, adjusted for the utility or satisfaction derived from each possible outcome. It allows individuals to evaluate uncertain prospects by weighing the potential benefits against their likelihood, thus guiding choices in investment and consumption under uncertainty.

5 Must Know Facts For Your Next Test

1. Expected utility theory provides a framework for understanding how rational agents make decisions under uncertainty by maximizing their expected utility.
2. In the context of the intertemporal capital asset pricing model, expected utility helps investors evaluate the trade-off between risk and return over different time periods.
3. Individuals may have different expected utility functions based on their personal preferences, leading to varying investment strategies even under similar market conditions.
4. The concept assumes that people assign probabilities to outcomes and calculate the expected value of those outcomes in terms of utility.
5. Expected utility can explain phenomena such as why some investors prefer certain returns over higher expected values with more risk, showcasing behavioral tendencies.

Review Questions

• How does the concept of expected utility influence investor behavior when faced with risk and uncertainty?
  • Expected utility significantly shapes investor behavior by providing a structured way to evaluate risky investments. Investors calculate the expected utility of potential outcomes, which helps them determine whether the risk associated with an investment aligns with their risk preferences. This process can lead them to select lower-risk options that provide more predictable returns, even if other options might offer higher expected returns.
• Discuss how expected utility theory applies to the intertemporal capital asset pricing model in investment decisions.
  • Expected utility theory is fundamental in the intertemporal capital asset pricing model as it assists investors in making decisions about asset allocation across different time periods. By assessing the expected utility of future cash flows, investors can better understand how to balance their portfolios to achieve optimal returns while accounting for risks over time. This involves considering how changes in market conditions affect future utilities and adjusting their strategies accordingly.
• Evaluate the limitations of expected utility theory in explaining real-world investor behavior compared to prospect theory.
  • While expected utility theory provides a rational framework for decision-making under uncertainty, it often falls short in capturing actual investor behavior, particularly in instances where psychological factors come into play. Prospect theory highlights how people value gains and losses differently, often leading to irrational choices that deviate from what expected utility would predict. This discrepancy shows that while expected utility offers valuable insights into decision-making, it may not fully account for the emotional and cognitive biases that influence how investors react to risk and uncertainty.

Related terms

Risk Aversion:

The preference of an individual to avoid uncertainty and potential losses, often leading them to choose options with more predictable outcomes.

Utility Function:

A mathematical representation of how an individual's satisfaction or preference changes with varying levels of consumption or wealth.

Prospect Theory:

A behavioral economic theory that describes how people make decisions involving risk, highlighting deviations from expected utility due to psychological factors.