Expected Utility Theory

Definition

Expected Utility Theory is a framework for decision-making under uncertainty that assumes individuals make choices to maximize their expected utility, or the weighted average of the utilities of possible outcomes. It provides a rational and quantitative approach to understanding how people make decisions when faced with risk and uncertainty.

5 Must Know Facts For Your Next Test

1. Expected Utility Theory assumes that individuals have well-defined preferences and make decisions to maximize their expected utility.
2. The expected utility of a risky outcome is calculated as the weighted average of the utilities of the possible outcomes, where the weights are the probabilities of each outcome occurring.
3. Risk-averse individuals will choose the option with the higher expected utility, even if it has a lower expected monetary value, to avoid the potential for larger losses.
4. Diminishing marginal utility implies that as an individual's wealth increases, the additional utility derived from each additional unit of wealth decreases.
5. Expected Utility Theory is widely used in economics, finance, and decision-making to analyze how individuals make choices under uncertainty.

Review Questions

• Explain how the concept of diminishing marginal utility relates to expected utility theory and decision-making under uncertainty.
  • The principle of diminishing marginal utility is a key component of expected utility theory. As an individual's wealth or consumption increases, the additional utility derived from each additional unit decreases. This means that risk-averse individuals will prefer a more certain outcome with a lower expected monetary value over a riskier option with a higher expected monetary value, as the utility gained from the higher value is diminished by the increased uncertainty. The diminishing marginal utility of wealth incentivizes risk-averse behavior and influences how individuals make decisions under uncertainty to maximize their expected utility.
• Describe how the expected utility framework can be used to analyze insurance decisions in the context of imperfect information.
  • In the context of imperfect information, expected utility theory can be used to understand why individuals may choose to purchase insurance, even when the expected monetary value of the insurance policy is less than the cost of the premiums. Risk-averse individuals will prefer the certainty of the insurance payout over the potential for a larger loss, as the diminishing marginal utility of wealth makes them more sensitive to potential losses than potential gains. The expected utility framework can help explain how individuals weigh the costs and benefits of insurance coverage when faced with uncertainty about future events and imperfect information about the probability and magnitude of potential losses.
• Evaluate how the assumptions and predictions of expected utility theory may be challenged or limited in real-world decision-making scenarios involving insurance and imperfect information.
  • While expected utility theory provides a useful framework for understanding decision-making under uncertainty, its assumptions and predictions may not always align with observed behavior in real-world scenarios involving insurance and imperfect information. Factors such as cognitive biases, emotional influences, and the complexity of decision-making contexts can lead individuals to deviate from the rational, utility-maximizing behavior assumed by the theory. For example, individuals may exhibit loss aversion, overweighting the potential for losses relative to gains, or they may struggle to accurately assess probabilities and make decisions based on incomplete information. These behavioral factors can lead to suboptimal insurance decisions that do not align with the predictions of expected utility theory. As a result, the theory may have limited applicability in certain real-world situations and should be considered alongside other behavioral and psychological factors that influence decision-making.

Related terms

Utility:

Utility is a measure of the relative satisfaction or well-being that a person derives from the consumption of a good or service.

Risk Aversion:

Risk aversion is the tendency of a person to prefer outcomes with less uncertainty or variability, even if the expected value is lower.

Diminishing Marginal Utility:

Diminishing marginal utility is the principle that as a person consumes more of a good, the additional satisfaction or utility derived from each additional unit decreases.