Expected utility

Definition

Expected utility is a concept in decision theory that quantifies the anticipated satisfaction or benefit derived from different choices, factoring in both the likelihood of various outcomes and their associated utilities. This framework helps individuals make rational decisions under uncertainty by calculating a weighted average of possible outcomes, where weights are determined by their probabilities. It connects to prior and posterior distributions as it uses probabilities to assess potential outcomes, and to decision theory and loss functions by providing a way to evaluate different strategies based on their expected results.

5 Must Know Facts For Your Next Test

1. Expected utility combines both the probability of an outcome and its utility to inform decision-making under uncertainty.
2. It is foundational in various fields like economics, finance, and psychology for modeling rational behavior.
3. The expected utility theory assumes individuals aim to maximize their overall satisfaction when making choices.
4. In scenarios with risk, expected utility allows comparison of options by calculating their average expected benefits.
5. The concept also lays the groundwork for understanding risk aversion, as individuals may prefer certain outcomes over uncertain ones with higher expected utilities.

Review Questions

• How does expected utility relate to prior and posterior distributions when making decisions under uncertainty?
  • Expected utility relies on probabilities that are often derived from prior distributions, which represent beliefs about uncertain events before observing new data. After acquiring new information, posterior distributions update these beliefs, influencing the expected utilities of different decisions. This relationship ensures that decisions are informed by both existing knowledge and new evidence, ultimately leading to more rational choices under uncertainty.
• Discuss the role of expected utility in decision theory and how it interacts with loss functions when evaluating different strategies.
  • Expected utility plays a critical role in decision theory as it provides a framework for evaluating the desirability of various strategies based on their anticipated benefits. When coupled with loss functions, which quantify potential costs associated with decisions, expected utility helps individuals minimize losses while maximizing gains. By assessing expected utilities alongside loss functions, decision-makers can identify strategies that not only align with their preferences but also mitigate risks effectively.
• Evaluate the implications of expected utility theory on behavioral economics, especially regarding risk aversion and irrational decision-making.
  • Expected utility theory suggests that individuals make rational choices aimed at maximizing satisfaction; however, behavioral economics reveals that real-world decisions often diverge from this model. Factors like risk aversion can lead individuals to prefer guaranteed outcomes over risky ones, even if the latter has a higher expected utility. Understanding these deviations allows for better predictions of consumer behavior and helps develop policies that account for human irrationality in economic decision-making.

Related terms

Utility: A measure of the satisfaction or benefit derived from consuming goods and services, often used to evaluate preferences in economic models.

Probability Distribution:

A mathematical function that provides the probabilities of occurrence of different possible outcomes in a random experiment.

Loss Function: A mathematical representation that quantifies the cost associated with an incorrect decision, guiding the choice of strategies to minimize potential losses.