Expected Utility

Definition

Expected utility is a concept in decision theory that quantifies the overall satisfaction or benefit a decision-maker anticipates from uncertain outcomes, by considering both the probability of each outcome and its utility. It connects risk preferences to decision-making under uncertainty, allowing individuals to make rational choices by comparing expected utilities across different alternatives.

5 Must Know Facts For Your Next Test

1. Expected utility is calculated by multiplying the utility of each possible outcome by its probability and summing these products.
2. It serves as a foundational principle in Bayesian decision theory, where beliefs are updated based on new evidence.
3. Individuals use expected utility to guide choices in various fields, including economics, finance, and statistics.
4. The concept helps explain how people make decisions when faced with uncertainty and differing levels of risk.
5. Expected utility can lead to paradoxes, such as the Allais Paradox, which challenges the assumption that people always act rationally according to expected utility theory.

Review Questions

• How does the expected utility framework assist in making decisions under uncertainty?
  • The expected utility framework helps individuals evaluate uncertain choices by quantifying potential outcomes' satisfaction through their probabilities. By calculating the expected utility for different options, decision-makers can systematically compare these values and choose the alternative that maximizes their anticipated benefit. This approach integrates both risk assessment and personal preferences into the decision-making process.
• Discuss how expected utility relates to Bayesian decision-making in the context of inverse problems.
  • In Bayesian decision-making, expected utility serves as a key criterion for evaluating different hypotheses or models based on prior beliefs and observed data. In inverse problems, where one seeks to infer hidden parameters from observed data, decision-makers use expected utility to weigh the trade-offs between various models and their predictive accuracy. By updating prior beliefs with new evidence, they can refine their expectations and choose models that best align with their objectives and risk preferences.
• Evaluate the implications of expected utility theory on real-world decision-making processes and its limitations.
  • Expected utility theory has profound implications for real-world decisions, influencing how people assess risks and make choices in uncertain environments. However, its limitations include potential deviations from rational behavior due to cognitive biases and emotional factors. Situations like the Allais Paradox highlight discrepancies between predicted behavior under expected utility theory and actual human choices. Recognizing these limitations can help improve models of decision-making by incorporating psychological insights alongside traditional economic assumptions.

Related terms

Utility Function: A mathematical representation that assigns a numerical value to the level of satisfaction or benefit derived from different outcomes.

Probability Distribution: A function that describes the likelihood of various outcomes in a random experiment, which is crucial for calculating expected utility.

Risk Aversion: A behavioral trait where individuals prefer outcomes with lower uncertainty over potentially higher, but riskier, returns.