Expected Utility

Definition

Expected utility is a concept in economics and decision theory that represents the anticipated satisfaction or value derived from different choices, taking into account the probabilities of various outcomes. This idea helps individuals and organizations make rational decisions under uncertainty by calculating the expected value of potential consequences associated with each option. It forms a foundational element for various theories that involve strategic interactions, beliefs updating, and revenue determination.

5 Must Know Facts For Your Next Test

1. Expected utility theory suggests that individuals will choose the option with the highest expected utility when faced with uncertainty.
2. The concept allows decision-makers to account for both the potential outcomes and their probabilities, leading to more informed choices.
3. Expected utility can be used to analyze strategic situations where players must consider the choices of others while updating their beliefs.
4. It plays a crucial role in establishing Bayesian Nash equilibria, where players maximize their expected utilities given their beliefs about others' strategies.
5. In auction theory, expected utility helps in understanding how bidders value items and how this influences their bidding strategies.

Review Questions

• How does expected utility theory influence decision-making in situations involving uncertainty?
  • Expected utility theory influences decision-making by providing a structured way to evaluate choices under uncertainty. Decision-makers assess potential outcomes and their associated probabilities to calculate expected utilities for different options. By comparing these values, individuals can choose the option that maximizes their anticipated satisfaction, thus guiding rational decision-making in uncertain scenarios.
• Discuss the relationship between expected utility and Bayesian Nash equilibrium in strategic settings.
  • In strategic settings, expected utility is fundamental to understanding how players make decisions based on their beliefs about others' strategies. The Bayesian Nash equilibrium occurs when each player's strategy maximizes their expected utility given their beliefs about the other players' strategies. This interplay allows for optimal decision-making where players consider both their own preferences and the possible actions of others, ultimately leading to a stable outcome in games with incomplete information.
• Evaluate how expected utility contributes to the revenue equivalence theorem in auction settings and its implications for bidder behavior.
  • Expected utility contributes to the revenue equivalence theorem by establishing that different auction formats yield the same expected revenue for sellers under certain conditions. This is significant because it suggests that bidders will behave consistently across various auction types, as they base their bidding strategies on maximizing expected utility. Understanding this relationship helps sellers design auctions that optimize revenue while considering how bidders value items differently based on their expectations.

Related terms

Utility Function: A mathematical representation that assigns a real number to each possible outcome, reflecting the level of satisfaction or preference associated with that outcome.

Risk Aversion: The tendency of individuals to prefer certain outcomes over uncertain ones, even when the expected utility may be higher for the risky option.

Bayesian Probability: A method of probability interpretation that updates the probability estimate for a hypothesis as more evidence or information becomes available.