Expected utility hypothesis

Expected Utility Hypothesis

The Expected Utility Hypothesis is a fundamental concept in economics and decision theory that describes how rational individuals make choices under conditions of uncertainty. It is a cornerstone of modern economic theory and has significant implications for understanding human behavior in various contexts, including finance, insurance, and healthcare.

Historical Background

The concept of expected utility was first introduced by Daniel Bernoulli in the 18th century. Bernoulli's work was motivated by the St. Petersburg Paradox, a problem that challenged the classical understanding of value and risk. He proposed that individuals do not evaluate risky prospects based on their expected monetary value, but rather on the expected utility, which accounts for the diminishing marginal utility of wealth.

Theoretical Framework

The Expected Utility Hypothesis posits that when faced with uncertain outcomes, individuals choose the option that maximizes their expected utility. The utility function, \( U(x) \), represents the satisfaction or value derived from a particular outcome \( x \). The expected utility of a gamble or uncertain prospect is calculated as:

\[ E[U] = \sum_{i} p_i U(x_i) \]

where \( p_i \) is the probability of outcome \( x_i \) occurring, and \( U(x_i) \) is the utility of that outcome.

Assumptions

The Expected Utility Hypothesis relies on several key assumptions:

• Completeness: Individuals can rank all possible outcomes in terms of preference.
• Transitivity: If an individual prefers outcome A to B and B to C, then they prefer A to C.
• Independence: Preferences between two outcomes should not be affected by the introduction of a third, irrelevant alternative.
• Continuity: If an individual prefers A to B and B to C, there exists a probability mix of A and C that is equally preferable to B.

Applications

The Expected Utility Hypothesis is widely used in various fields:

• Economics: It helps explain consumer choice, investment decisions, and market behavior.
• Finance: It underpins portfolio theory and risk management strategies.
• Insurance: It justifies the purchase of insurance as a means to maximize expected utility by reducing risk.
• Healthcare: It aids in decision-making regarding treatment options and health interventions.

Criticisms and Alternatives

Despite its widespread use, the Expected Utility Hypothesis has faced criticism. Behavioral economists have pointed out that real-world decision-making often deviates from the predictions of expected utility theory. Notable alternatives include:

• Prospect Theory: Developed by Daniel Kahneman and Amos Tversky, this theory accounts for observed behaviors such as loss aversion and framing effects.
• Rank-Dependent Utility: This model modifies the probability weighting in the expected utility formula to better match observed choices.

Conclusion

The Expected Utility Hypothesis remains a foundational concept in understanding decision-making under uncertainty. While it has limitations, it provides a useful framework for analyzing choices and predicting behavior in uncertain environments.

See Also

• Utility
• Risk Aversion
• Prospect Theory
• Decision Theory

References

• Bernoulli, D. (1738). Exposition of a New Theory on the Measurement of Risk. Econometrica.
• Kahneman, D., & Tversky, A. (1979). Prospect Theory: An Analysis of Decision under Risk. Econometrica.