Expected utility theory

Chapter 7

2 - In what ways have people been observed to violate expected utility theory?


Expected utility theory suggests that rational decision makers should weight the utilities of outcomes by their probability of occurrence. According to Baron (2000), expected utility theory as descriptive model of decision making under risk and it deals with those decisions that can be seem as gamble and gamble as one knows does not indicate any knowledge of prospect, so therefore, individual’s base their decision mainly on probabilities. Expected utility theory has always been accepted as a normative model rational choice and largely applied as a descriptive model of economic behaviour and it assumes that all reasonable individual would wish to obey the axioms of the theory, and that most people actually do majority of time.


According to Baron (2000), the use of expected value as a way of deciding about the money gamble seems fairly reasonable if individuals who want to choose between two gambles and it would make more sense to take the one with higher expected value, so that their average winning will get closer to the expected value itself. Utility judgment are useful in making important decisions, however, as the expected utility theory is a normative model, this means if individuals try to calculate expected utility for every decisions they make it will mean that they would have to spend a lot of time making calculations. However, instead of doing this we should simply familiarize ourselves with more prescriptive rules of different sorts such as, moral and personal behaviour rules. Expected utility theory seems to be a useful and adequate model of risk aversion for many purposes, and it is especially attractive in lieu of an equally obedient alternative model. Rabin (2000) suggests that extremely concave expected utility may even be useful as a parsimonious tool for modelling aversion to modest scale risk.


However, many researchers criticised expected utility theory due to the fact that they believe that this is descriptive model of decision making under risk and so alternative model was created known as prospect theory. According to this theory choice among risky prospects exhibit several pervasive effects that are inconsistent with the basic tenets of utility theory. In particular an individual underweight outcomes that are merely probable in comparison with outcomes that are obtained with certainty, and this contributes to risk aversion in choices involving sure gains and to risk seeking in choices of sure loses. Overweighting of low probabilities may contribute to the attractiveness of both insurance and gamble. Hardman (2009), suggests that prospect theory can be considered as a psychological variant of subjective to expected utility theory. Many decision makers are involved in process of editing stage whereby they first structure the decision problem in such a way as to simplify sequent evaluations and choice. This is important because it allows the decision makers to determine the potential outcomes as gains and loses relative to some reference point often known as status quo and at the evaluation stage; both a value function and weighting are applied to prospect.




In conclusion, utility theory as normative model suggests that the way of achieving good decisions comes from goals. Isenberg (1989) Researches in the area of individual decision behaviour and strategic decisions, however, has indicated that individual do not always behave according to the assumptions of utility theory. That is, they do not seek to know all possible outcomes, always assign accurate probabilities to the outcomes they recognise or consistently select the best payoff from considered alternatives.






References:


Baron, J. (2000). Thinking and Deciding (3r edition). Cambridge University Press,

Hardman, D. (2009). Judgment and Decision Making: Psychological Perspectives. BPS Blackwell