Expected Utility

Definition

Expected utility is a concept in decision theory that represents the average or anticipated satisfaction (utility) that a person expects to receive from an uncertain outcome, taking into account the probabilities of various outcomes. It plays a crucial role in understanding how individuals make choices under risk by quantifying their preferences for different prospects based on their potential utilities and the likelihood of those prospects occurring.

5 Must Know Facts For Your Next Test

1. Expected utility is calculated as the sum of the utilities of all possible outcomes, each weighted by its probability of occurring, represented mathematically as $$EU = \sum_{i=1}^{n} p_i u(x_i)$$ where $$p_i$$ is the probability and $$u(x_i)$$ is the utility of outcome $$x_i$$.
2. Individuals who are risk-averse will generally prefer a certain outcome over a gamble with a higher expected utility but greater uncertainty.
3. The concept of expected utility extends to situations involving continuous random variables, where integration is used to compute expected values and variances.
4. Expected utility theory provides a framework for analyzing decisions in economics, finance, and behavioral sciences, helping explain why people make certain choices under risk.
5. Expected utility can lead to inconsistent decision-making when individuals exhibit preferences that violate the axioms of rational choice, such as in the case of the Allais Paradox.

Review Questions

• How does the concept of expected utility help in understanding decision-making under uncertainty?
  • Expected utility helps individuals quantify their preferences when faced with uncertain outcomes by combining the potential benefits (utilities) of each outcome with their likelihoods (probabilities). This allows decision-makers to evaluate various choices and select those that maximize their anticipated satisfaction. By weighing both utility and probability, expected utility serves as a guide for rational decision-making amidst risks.
• Discuss how risk aversion influences the expected utility and choice behavior of individuals in uncertain situations.
  • Risk aversion significantly impacts expected utility by causing individuals to favor certain outcomes over uncertain ones, even when the latter may offer higher expected utilities. This preference leads them to choose options that minimize potential losses rather than maximize potential gains. Consequently, risk-averse individuals might settle for lower expected utilities if it means avoiding uncertainty, illustrating how their attitudes toward risk shape their decision-making processes.
• Evaluate the implications of expected utility theory in economic behavior and its limitations in explaining real-world decisions.
  • Expected utility theory provides a foundational framework for analyzing economic behavior by assuming that individuals make rational choices to maximize their satisfaction based on probabilities. However, its limitations become evident when individuals exhibit behaviors that contradict its predictions, such as in cases like the Allais Paradox. These inconsistencies highlight that human decision-making often involves psychological factors and biases that aren't fully captured by traditional expected utility models, suggesting a need for more comprehensive theories that incorporate behavioral insights.

Related terms

Utility: A measure of satisfaction or value that an individual derives from consuming goods, services, or outcomes.

Risk Aversion: The preference of individuals to avoid uncertainty and potential losses, leading them to choose options with lower risk over those with potentially higher but uncertain rewards.

Probability Distribution: A mathematical function that describes the likelihood of different possible outcomes in a random variable.