Expected Utility Theory

Definition

Expected utility theory is a decision-making framework that posits individuals evaluate risky options based on the expected utility of their outcomes, rather than their expected values. It suggests that people make rational choices by weighing the potential benefits and losses of different options and selecting the one that maximizes their overall satisfaction or utility. This concept connects to rational decision-making as it emphasizes logical reasoning in evaluating uncertain outcomes.

5 Must Know Facts For Your Next Test

1. Expected utility theory assumes that individuals are rational and will choose options that maximize their expected utility based on perceived risks and benefits.
2. The theory helps explain why people often make decisions that may seem irrational, as they prioritize their subjective satisfaction over objective outcomes.
3. It incorporates the concept of risk preferences, meaning that individuals have different attitudes towards risk, influencing their decision-making process.
4. Expected utility can be mathematically represented as the sum of the utilities of all possible outcomes, each weighted by its probability of occurrence.
5. This theory has applications in various fields, including economics, finance, and psychology, as it provides insights into how people approach risk and uncertainty.

Review Questions

• How does expected utility theory differ from traditional models of decision-making under uncertainty?
  • Expected utility theory differs from traditional models by focusing on the satisfaction or utility derived from outcomes rather than just their monetary value. While traditional models may consider only the expected value of options, expected utility theory emphasizes individual preferences and attitudes toward risk. This means that two individuals might choose differently between the same set of options based on their personal assessments of utility and risk.
• Discuss the role of risk aversion in expected utility theory and how it influences decision-making.
  • Risk aversion plays a crucial role in expected utility theory as it describes how individuals prioritize certainty over potential gains. People who are risk-averse prefer choices that minimize uncertainty, even if those choices yield lower expected returns. This tendency affects how individuals weigh potential outcomes and can lead to conservative decisions, illustrating that not all decision-makers act solely to maximize financial gain.
• Evaluate the implications of expected utility theory on organizational decision-making processes when facing uncertain outcomes.
  • Expected utility theory has significant implications for organizational decision-making, especially when dealing with uncertainties like market changes or investment risks. Organizations can use this framework to assess different strategies by evaluating potential outcomes against their associated probabilities and utilities. Understanding team members' diverse risk preferences can also improve consensus building and lead to more informed strategic choices, ultimately enhancing organizational performance in uncertain environments.

Related terms

Utility: A measure of satisfaction or pleasure derived from consuming goods or services, used in economics to represent preferences.

Risk Aversion: A preference for certainty over uncertainty, where individuals prefer outcomes that are more predictable even if they may offer lower returns.

Probability: The likelihood of an event occurring, often expressed as a fraction or percentage, which is crucial in assessing the expected outcomes in decision-making.