What is Expected Utility?

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Expected Utility is a concept in economics and decision theory used to describe how individuals make choices under uncertainty. The expected utility theory assumes that when faced with decisions involving different possible outcomes, individuals will calculate the expected utility value of each decision based on the utility (i.e., the satisfaction or value) of each outcome and the probability of that outcome occurring. The individual will then choose the decision with the highest expected utility.

Definition

Expected utility describes how individuals make choices under uncertainty. The expected utility theory assumes that when faced with decisions involving different possible outcomes, individuals calculate the expected utility value of each decision based on the utility (i.e., satisfaction or value) of each outcome and the probability of its occurrence. They then choose the decision with the highest expected utility.

Origin

The expected utility theory was introduced by John von Neumann and Oskar Morgenstern in 1944 as part of their work in the book "Theory of Games and Economic Behavior." This theory provides a mathematical framework for analyzing choice behavior under uncertainty in economics and decision sciences.

Categories and Features

Expected utility theory is mainly divided into two categories: linear and nonlinear. Linear expected utility assumes utility is proportional to probability, while nonlinear expected utility considers factors like risk preferences. Linear models are simple and easy to use but may not accurately reflect actual decision-making behavior; nonlinear models are more complex but better capture individual risk attitudes.

Case Studies

Case 1: In the insurance market, consumers often use expected utility theory to decide whether to purchase insurance. Suppose a person faces the risk of property loss; they will evaluate the cost of insurance against the utility of potential loss and choose the option with the highest expected utility. Case 2: In investment decisions, investors might use expected utility to assess the risks and returns of different portfolios, selecting the one with the highest expected utility.

Common Issues

Common issues include accurately assessing utility and probability, and handling risk preferences. A misconception might be that everyone evaluates risk and utility in the same way, whereas in reality, individual risk preferences and utility assessments can vary significantly.

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