Expected Utility Theory

Definition

Expected utility theory is a fundamental concept in economics and decision-making that proposes individuals make choices based on the expected outcomes of their actions, weighing the utility (satisfaction or value) of each possible outcome by its probability. This theory helps explain how people assess risk and make rational decisions when faced with uncertainty, connecting to various cognitive biases that can affect their judgment.

5 Must Know Facts For Your Next Test

1. Expected utility theory assumes that individuals have consistent preferences and can evaluate the expected utility of different options based on probabilities.
2. The theory provides a mathematical framework for understanding how people make decisions under risk, where outcomes are uncertain.
3. People often struggle to adhere strictly to expected utility theory due to cognitive biases, such as overconfidence or loss aversion, which can skew their perceptions of probabilities and outcomes.
4. In real-life situations, expected utility theory helps economists and psychologists analyze behavior in various contexts, including gambling, investment, and insurance decisions.
5. Critics argue that expected utility theory does not fully capture human decision-making, as it often overlooks emotional and psychological factors influencing choices.

Review Questions

• How does expected utility theory relate to rational choice theory in terms of decision-making?
  • Expected utility theory is closely linked to rational choice theory as both frameworks assume individuals make decisions aimed at maximizing their satisfaction or benefit. While rational choice theory emphasizes the consistency and logic behind choices, expected utility theory introduces the element of probability, suggesting that individuals weigh potential outcomes based on their likelihood. Together, these theories provide insights into how people approach choices under uncertainty and assess risks.
• Discuss the impact of cognitive biases on adherence to expected utility theory in real-world decision-making.
  • Cognitive biases can significantly influence how individuals apply expected utility theory in practice. For example, biases such as loss aversion lead people to overemphasize potential losses compared to gains, skewing their evaluations of risk. This can result in decisions that deviate from the predictions of expected utility theory, as people may choose safer options even when they are not aligned with maximizing expected utility. Understanding these biases is crucial for improving decision-making strategies.
• Evaluate the strengths and limitations of expected utility theory as a model for human decision-making under risk.
  • Expected utility theory is strong in providing a structured approach for analyzing decisions involving risk by combining probabilities with potential outcomes. It helps predict behaviors in various contexts like finance and insurance. However, its limitations arise from the assumption of rationality; it often fails to account for emotional responses or cognitive biases that can impact real-life decisions. This gap has led to the development of alternative theories like prospect theory, which seeks to address some of the shortcomings by incorporating psychological factors into understanding decision-making.

Related terms

Rational Choice Theory: A framework that assumes individuals always make decisions that provide the greatest benefit or satisfaction, relying on their preferences and available information.

Risk Aversion: The tendency of individuals to prefer outcomes with less uncertainty and lower potential losses, even if it means sacrificing potential higher gains.

Cognitive Bias: Systematic patterns of deviation from norm or rationality in judgment, which can influence decision-making processes and lead to irrational choices.