Expected Utility

Definition

Expected utility is a concept in decision theory and economics that represents the anticipated satisfaction or benefit derived from a particular choice, weighted by the probabilities of various outcomes occurring. It plays a crucial role in understanding how individuals make choices under uncertainty, as it combines both the utility of potential outcomes and their likelihood, enabling more rational decision-making in economic models.

5 Must Know Facts For Your Next Test

1. Expected utility is calculated by multiplying the utility of each possible outcome by the probability of that outcome occurring, then summing these products.
2. In decision-making under uncertainty, individuals tend to choose the option with the highest expected utility, reflecting their preferences and risk attitudes.
3. The concept challenges the idea of expected value by incorporating individual risk preferences, leading to different choices based on whether a person is risk-averse, risk-seeking, or risk-neutral.
4. Expected utility theory serves as the foundation for many economic models related to consumer behavior, investment decisions, and insurance markets.
5. The development of expected utility theory was significantly influenced by mathematicians like Daniel Bernoulli and later formalized by John von Neumann and Oskar Morgenstern in their work on game theory.

Review Questions

• How does expected utility differ from expected value when making economic decisions?
  • Expected utility differs from expected value as it incorporates individual preferences and attitudes towards risk. While expected value simply averages possible outcomes based on probabilities, expected utility weighs those outcomes by their perceived satisfaction. This means a person who is risk-averse might choose an option with lower expected value if it has a higher expected utility due to their preference for certainty over potential risks.
• Discuss the implications of risk aversion on an individual's decision-making process regarding investments using expected utility.
  • Risk aversion significantly impacts an individual's investment decisions as it leads them to favor safer investments even if they have lower expected returns. Using expected utility, a risk-averse investor will assess the potential outcomes of different investment options and choose those that maximize their expected utility rather than merely looking at the expected value. This behavior can result in a preference for bonds or fixed-income securities over stocks, especially in uncertain economic conditions.
• Evaluate how the concept of stochastic processes can enhance our understanding of expected utility in dynamic economic scenarios.
  • Stochastic processes provide a framework for modeling scenarios where outcomes evolve over time under uncertainty, which can deepen our understanding of expected utility. By incorporating random variables and probabilistic transitions between states, we can analyze how an individual's expectations may change as new information becomes available. This evaluation allows economists to predict consumer behavior more accurately in situations like market fluctuations or policy changes, leading to more informed decisions that align with maximizing expected utility over time.

Related terms

Utility: A measure of the satisfaction or pleasure derived from consuming goods and services, reflecting individual preferences.

Risk Aversion: A behavioral trait where individuals prefer certainty over uncertainty, often leading them to choose options with lower expected returns to avoid potential losses.

Stochastic Process: A mathematical object defined by a collection of random variables representing a process that evolves over time in a probabilistic manner.