Expected Utility Theory and its Assumptions

Key Insight

Expected utility theory is a foundational concept in the social sciences, serving as the bedrock of the rational-agent model. It is designed as a logic of choice, prescribing how decisions should ideally be made based on a set of elementary rules or axioms of rationality. For example, if someone prefers an apple over a banana, the theory dictates they should also prefer a chance to win an apple over the same chance to win a banana.

Developed by a mathematician and an economist, this theory outlines rational choice between gambles. It posits that people's choices are not based on the objective dollar values of outcomes, but rather on their subjective psychological values, known as utilities. The utility of a gamble is calculated as the weighted average of the utilities of its possible outcomes, with each outcome's utility weighted by its probability.

A key assumption of expected utility theory is the diminishing marginal utility of wealth, meaning that each additional unit of wealth provides less psychological satisfaction than the previous one. This principle is used to explain risk aversion, where individuals generally prefer a sure thing over a gamble with an equal or slightly higher expected value. The theory also tacitly assumes that an individual's utility at any given moment is determined solely by their current wealth, disregarding the history of how that wealth was acquired.