Expected Utility Theory

Definition

Expected utility theory is a decision-making framework that helps individuals and organizations evaluate risky choices by assigning values to different outcomes based on their probabilities and the utilities associated with those outcomes. This theory assumes that people choose options that maximize their expected utility, guiding their decisions in uncertain situations. It serves as a fundamental concept in understanding how rational agents approach risk and uncertainty in various contexts, including extensive form games and decision trees.

5 Must Know Facts For Your Next Test

1. Expected utility theory provides a mathematical approach to decision-making under risk, allowing individuals to calculate the expected value of different choices.
2. The theory posits that individuals make rational decisions based on the expected utility rather than simply maximizing monetary outcomes.
3. In extensive form games, expected utility theory helps players determine their strategies by considering the potential payoffs of their choices over various paths in a decision tree.
4. Utility can vary among individuals, which means different people may perceive the same risky choice differently based on their preferences and values.
5. Expected utility theory is foundational for many economic models and is widely used in fields like finance, economics, and behavioral science.

Review Questions

• How does expected utility theory apply to decision-making in extensive form games?
  • Expected utility theory is crucial in extensive form games as it helps players evaluate their strategies based on the potential payoffs associated with different decisions. Players analyze the decision tree by calculating the expected utility for each path, considering both the probabilities of various outcomes and the utilities of those outcomes. This enables players to make informed choices that maximize their expected payoff, guiding them through complex interactions.
• Compare how expected utility theory and traditional utility approaches differ when analyzing risk in decision-making.
  • Expected utility theory differs from traditional utility approaches by emphasizing that decisions are made based on the maximization of expected utility rather than just the total or immediate payoff. Traditional approaches might focus on certainty or guaranteed outcomes, while expected utility theory accounts for uncertainty by weighing both the probability of outcomes and their associated utilities. This distinction allows for a more nuanced understanding of how individuals perceive risk and make choices in uncertain environments.
• Evaluate the limitations of expected utility theory when applied to real-world decision-making scenarios, especially regarding behavioral biases.
  • While expected utility theory provides a robust framework for rational decision-making under risk, it has limitations when applied to real-world scenarios due to human behavioral biases. People often exhibit risk aversion or are influenced by factors such as framing effects, leading them to make decisions that deviate from what would be predicted by expected utility theory. Additionally, individuals may misjudge probabilities or be inconsistent in their preferences, indicating that while expected utility theory is valuable, it may not fully capture the complexities of human behavior in uncertain situations.

Related terms

Utility: A measure of the satisfaction or value that an individual derives from a particular outcome or choice.

Risk Aversion: The tendency of individuals to prefer certainty over uncertainty, often leading them to choose safer options with lower expected returns.

Payoff Matrix: A table that displays the possible outcomes of different strategies chosen by players in a game, helping to analyze decisions and expected utilities.