Expected Utility
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 that outcome occurring. Then, individuals choose the decision with the highest expected utility.
Origin: The expected utility theory was proposed by Daniel Bernoulli in 1738 to address the St. Petersburg Paradox. Bernoulli suggested that decision-makers should consider utility rather than the absolute value of money, as utility reflects the subjective satisfaction of the individual with the outcome.
Categories and Characteristics: The expected utility theory mainly divides into two categories: 1. Risk-neutral: Individuals only care about the expected value, not the risk. 2. Risk-averse: Individuals prefer options with lower risk, even if the expected value is lower.
Characteristics: 1. Emphasizes subjective satisfaction. 2. Applicable to decisions under uncertainty. 3. Relies on the calculation of probabilities and utilities.
Comparison with Similar Concepts: Expected utility is similar to Prospect Theory, but prospect theory focuses more on the psychological reactions of decision-makers when facing gains and losses.
Specific Cases: Case 1: An investor choosing stocks will calculate the expected utility of each stock based on its expected return and risk, and select the stock with the highest expected utility.
Case 2: An insurance buyer will calculate the expected utility of different insurance plans based on the payout amount and the probability of occurrence, and choose the plan with the highest expected utility.
Common Questions: 1. How to calculate utility? Utility is usually estimated through personal preferences or historical data. 2. Why does the expected utility theory sometimes fail to explain actual behavior? Because in real decisions, psychological factors and cognitive biases may influence decision-making.
