Expected Utility Theory

Definition

Expected utility theory is a foundational concept in economics and decision-making that describes how individuals make choices under uncertainty by calculating the expected outcomes of different actions and assigning values to them. This theory assumes that people evaluate risky options based on their expected utility, which is derived from the probabilities of potential outcomes and their respective utilities. By comparing these expected utilities, individuals can choose the option that maximizes their perceived satisfaction or benefit.

5 Must Know Facts For Your Next Test

1. Expected utility theory assumes that individuals are rational actors who make decisions based on maximizing their expected utility rather than merely focusing on the outcomes.
2. The formula for expected utility is calculated as the sum of the utilities of all possible outcomes, each weighted by its probability of occurrence.
3. This theory forms the basis for many economic models and analyses, influencing how businesses and policymakers understand consumer behavior and market dynamics.
4. One key criticism of expected utility theory is its inability to explain certain observed behaviors, such as loss aversion, where individuals show a stronger reaction to losses than equivalent gains.
5. Despite its limitations, expected utility theory remains a crucial framework for understanding economic decision-making and serves as a starting point for more complex theories like prospect theory.

Review Questions

• How does expected utility theory explain individual decision-making under risk compared to other models?
  • Expected utility theory explains individual decision-making under risk by suggesting that people evaluate the expected outcomes of their choices based on their assigned utilities and the probabilities of different outcomes. This contrasts with other models, such as prospect theory, which highlight psychological biases and how individuals might weigh losses more heavily than gains. Expected utility theory relies on a rational assessment of risks and rewards, making it a fundamental concept in economics.
• Discuss how expected utility theory relates to concepts like risk aversion and its implications for economic behavior.
  • Expected utility theory is closely related to risk aversion, as it assumes that individuals will seek to maximize their expected utility by avoiding risky choices when they perceive a loss. Risk-averse individuals will often prefer guaranteed outcomes over uncertain ones, even if the uncertain option has a higher expected value. This behavior has significant implications for economic behavior, as it affects consumer choices, investment strategies, and market dynamics, leading economists to consider both rational assessments and emotional responses in their models.
• Evaluate the relevance of expected utility theory in light of empirical evidence from behavioral economics that challenges its assumptions.
  • Expected utility theory remains relevant as a foundational concept in economics; however, behavioral economics has provided substantial evidence that challenges its assumptions. For instance, phenomena like loss aversion and framing effects illustrate how actual decision-making often deviates from rational models. Evaluating these empirical findings encourages a more nuanced understanding of human behavior, prompting further developments in economic theories that integrate psychological insights alongside traditional economic rationality.

Related terms

Utility: Utility refers to the satisfaction or pleasure derived from consuming goods and services, which can be quantified to assess preferences in decision-making.

Risk Aversion: Risk aversion is the tendency of individuals to prefer outcomes that are more certain over those that involve risk, often leading them to choose safer options.

Prospect Theory: Prospect theory is an alternative model to expected utility theory, highlighting how people evaluate potential losses and gains differently, emphasizing psychological factors in decision-making.