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Concept
Expected utility hypothesis
Summary
The expected utility hypothesis is a popular concept in economics that serves as a reference guide for decision making when the payoff is uncertain. The theory describes which options rational individuals should choose in a situation with uncertainty, based on their risk aversion.
The expected utility hypothesis states an agent chooses between risky prospects by comparing expected utility values (i.e. the weighted sum of adding the respective utility values of payoffs multiplied by their probabilities). The summarised formula for expected utility is where is the probability that outcome indexed by with payoff is realized, and function u expresses the utility of each respective payoff. Graphically the curvature of the u function captures the agent's risk attitude.
Standard utility functions represent ordinal preferences. The expected utility hypothesis imposes limitations on the utility function and makes utility cardinal (though still not comparable across individuals).
Although the expected utility hypothesis is standard in economic modelling, it has been found to be violated in psychological experiments. For many years, psychologists and economic theorists have been developing new theories to explain these deficiencies. These include prospect theory, rank-dependent expected utility and cumulative prospect theory, and bounded rationality.
In the early days of the calculus of probability, classic utilitarians believed that the option which has the greatest utility will produce more pleasure or happiness for the agent and therefore must be chosen The main problem with the expected value theory is that there might not be a unique correct way to quantify utility or to identify the best trade-offs. For example, some of the trade-offs may be intangible or qualitative. Rather than monetary incentives, other desirable ends can also be included in utility such as pleasure, knowledge, friendship, etc. Originally the total utility of the consumer was the sum of independent utilities of the goods.
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