Choices under uncertainty and expected utility: Choices under uncertainty refer to situations where an individual faces the possibility of multiple outc...
Choices under uncertainty and expected utility:
Choices under uncertainty refer to situations where an individual faces the possibility of multiple outcomes with associated probabilities and payoffs. For example, if an individual is considering two investment options, each with a different probability of making a profit, they are making a choice under uncertainty.
Expected utility is a measure of the average satisfaction an individual derives from a particular choice under uncertainty. It is calculated by considering the product of the probability of each outcome and the corresponding payoff.
Expected utility provides a valuable tool for understanding and comparing choices under uncertainty. By comparing the expected utilities of different options, an individual can make informed decisions that maximize their overall satisfaction.
Assumptions in expected utility:
Probabilities: The probabilities of each outcome must be known.
Payoffs: The payoffs for each outcome must be known or estimated.
Risk aversion: The individual must have a risk aversion behavior, meaning they prefer options with higher expected utilities to options with lower expected utilities.
Example:
Suppose an individual is considering two investment options:
Option 1: 70% chance of gaining 50.
Option 2: 50% chance of gaining $150, 50% chance of losing nothing.
The expected utility of option 1 is:
(0.7)(100) + (0.3)(-50) = $70
The expected utility of option 2 is:
(0.5)(150) + (0.5)(-0) = $75
Comparing the expected utilities, the individual should choose option 2, even though it has a lower expected payoff, because option 1 carries more risk