Expected utility theorem

From Wikipedia, the free encyclopedia

This article or section needs to be wikified to meet Wikipedia's quality standards. Please help improve this article with relevant internal links. (February 2008)

This article is orphaned as few or no other articles link to it. Please help introduce links in articles on related topics. (February 2008)

This article or section is in need of attention from an expert on the subject. WikiProject Economics or the Economics Portal may be able to help recruit one. If a more appropriate WikiProject or portal exists, please adjust this template accordingly.(January 2008)

This article or section needs copy editing for grammar, style, cohesion, tone or spelling. You can assist by editing it now. A how-to guide is available. (March 2008)

It has been suggested that this article or section be merged into Expected utility hypothesis. (Discuss)

The expected utility theorem of von Neumann and Morgenstern is that any "normal" preference relation over a finite set of states can be written as an expected utility.

Expected Utility Theory states, when faced with some type of uncertain choice, we make our decisions based on two factors - the utility of the outcomes and their respective probability.^{[citation needed]} Utility refers to whatever end a person would like to achieve, be it happiness, money, or something else. Baron (1999) suggests "good" might be a better word; utility refers to the amount of good from a decision (Broome, 1991). So basically, good that might come out of each alternative is weighed against the costs of that alternative. We also assess the probability of each alternative occurring. Which alternative provides the best combination of 'good' and 'likelihood of the turning out' will be the one chosen.

For example, choose between a flip of a coin (where heads wins $40) or roll one die (a 4 earns $50).

Most people would probably choose the first option because it seems like a better combination of good and probability. The payout ("good") is $10 less than if choosing the die roll, but the probability of winning is much greater. This offsets the slight difference in monetary value.

[edit] Violations of Expected Utility

Expected utility theory provides a "normative description of decision making", in it lays out the ways human beings would choose among alternatives if they were perfectly rational decision makers.

Normative Theory states what people should do under ideal situations

Expected Utility = Probability of Given Outcome X Utility of Outcome

ex. Let's say you're trying to choose an apartment You know the size, location, and rent for each one. You 'weigh' each factor differently (the utility of each)

The expected utility model fails to provide a good description of how we make choices in many circumstances because it assumes too much; humans rarely, if ever, have all the information necessary to make a decision. Even if they did, they would lack the ability to combine and weigh the information accurately. Also, the theory proposes we base our decisions on expected consequences, but there is no real way to foresee consequences with any certainty. Expected utility is still one of the most common yardsticks by which the rationality of human decision making is measured, but psychologists have attempted to develop descriptive models of how we actually do make decisions in order to accommodate 'irrationality'.

[edit] References

• Robinson-Riegler, Gregory and Bridget. Cognitive Psychology.

This article does not cite any references or sources. (February 2008) Please help improve this article by adding citations to reliable sources. Unverifiable material may be challenged and removed.