Expected Utility Theory

Definition

Expected utility theory is a framework for understanding how individuals make choices under uncertainty by evaluating the expected outcomes of their options based on their preferences. It posits that people will choose the option that maximizes their expected utility, which is calculated as the sum of the utilities of all possible outcomes, each weighted by its probability. This theory connects deeply with concepts of bounded rationality and satisficing behavior, highlighting that while people strive for optimal choices, they often settle for satisfactory solutions due to cognitive limitations.

5 Must Know Facts For Your Next Test

1. Expected utility theory provides a systematic approach for individuals to evaluate risky choices by considering both the potential benefits and their likelihoods.
2. The theory suggests that individuals do not always act in their own best interest because they often use heuristics or rules of thumb when making decisions.
3. In situations with high uncertainty, individuals might exhibit risk aversion, leading them to prefer safer options with lower potential gains.
4. Bounded rationality plays a key role in expected utility theory as it recognizes that cognitive limitations can affect decision-making processes.
5. Satisficing behavior refers to the tendency of individuals to accept an option that meets their criteria rather than searching exhaustively for the best possible choice.

Review Questions

• How does expected utility theory help explain decision-making under uncertainty?
  • Expected utility theory explains decision-making under uncertainty by illustrating how individuals evaluate various options based on their potential outcomes and associated probabilities. By calculating the expected utility for each option, individuals can determine which choice maximizes their satisfaction. This helps clarify why people may choose less optimal outcomes if they believe those options provide acceptable levels of utility given their risk preferences.
• Discuss the relationship between bounded rationality and expected utility theory in decision-making processes.
  • Bounded rationality directly relates to expected utility theory as it acknowledges the limitations in human cognitive abilities when making decisions. While expected utility theory assumes rational evaluation of choices, bounded rationality highlights that people may not have access to complete information or sufficient mental resources. This often results in satisficing behavior, where individuals opt for satisfactory rather than optimal choices due to these constraints, leading to potentially suboptimal outcomes.
• Evaluate how satisficing behavior can affect the outcomes predicted by expected utility theory in real-life scenarios.
  • Satisficing behavior can significantly alter the predictions made by expected utility theory in real-life scenarios by leading individuals to settle for options that may not maximize their expected utility. Instead of thoroughly analyzing all available alternatives and their probabilities, people often choose the first option that meets their criteria for acceptability. This deviation from strict rationality can lead to decisions that are less advantageous and might result in missed opportunities for higher utility gains, especially in complex environments with many uncertain factors.

Related terms

Utility: A measure of satisfaction or happiness that an individual derives from consuming goods and services.

Risk Aversion: The tendency of individuals to prefer certain outcomes over uncertain ones, even when the expected values are the same.

Bounded Rationality: The idea that individuals make decisions based on limited information and cognitive resources, rather than fully rational calculations.