Expected Utility

The utility of an action or event over a time period when the circumstances are unknown

What is Expected Utility?

Expected utility is a theory in economics that estimates the utility of an action when the outcome is uncertain. It advises choosing the action or event with the maximum expected utility. At any point in time, the expected utility will be the weighted average of all the probable utility levels that an entity is expected to reach under specific circumstances.

 

Expected Utility

 

Summary

  • Expected utility is the utility of an action or event over a time period when the circumstances are unknown.
  • The expected utility will be the aggregate of the products of possible outcomes with the probability of occurrence of the events.
  • While analyzing uncertain situations, entities may or may not choose the action with the highest value of expected utility, depending on their risk aversion.

 

Understanding Expected Utility

Expected utility is used as a tool for decision-making under circumstances where the outcomes of decisions are not known. The entity computes the probability of outcomes and compares them with expected utility. The expected utility value is calculated by aggregating the products of possible outcomes with the probability of occurrence of the events.

The expected utility theory considers it a logical choice to choose the event with the maximum expected utility. However, in case of risky outcomes, decision-makers may not choose the action with a higher expected utility. The decision to choose an action will also depend on the entity’s risk aversion and other entities’ utility. While some entities choose the option with the riskier highest expected utility, some highly risk-averse entities prefer the low-risk option even if it shows a lower expected value.

Expected utility theory also helps to explain the reason for people taking out insurance policies. It is a situation where the payback is not immediate; however, insurance policies cover individuals for several risks. Insurance policyholders receive tax benefits and a certain income at the expiry of a predetermined period. Hence, when one compares the expected utility to be received from paying insurance premiums with the expected utility of investing the amount on other products, insurance appears to be a better choice.

The concepts of marginal utility and expected utility are related. The expected utility of wealth or a reward reduces when the entity possesses sufficient wealth. Such entities may go for the safer alternative instead of the riskier ones.

The addition of $1,000 to the income may not impact the marginal utility of two different entities in the same way. For example, if the annual income of a low-earning family is increased from $1,250 to $2,250, it will improve their quality of life as well as the marginal utility. On the contrary, if the income of a high-earning family increases from $120,000 to $121,000 in a year, there is a very small utility improvement.

 

Some Applications of Expected Utility

 

1. Public and Economics Policy

The expected utility theory finds application in public policy, as it explains that the social arrangement that maximizes the total welfare across society is the most socially right arrangement. The concept of micromort, introduced by American professor Ronald Howard in the 1980s, uses the expected utility concept to measure the acceptability of various mortality risks.

The expected utility concept is also used to guide health policies. The expected utilities of various health interventions are used while framing health policies. The area of insurance sales also uses expected utility theory to calculate risks with the goal of financial gain in the long term while taking into consideration the possibility of going bust temporarily.

 

2. Ethics

Utilitarians believe that the result of an act determines whether or not the right action is taken. However, it is extremely difficult to establish the long-term consequence of an act. Hence, some authors argue that instead of the act that results in the best consequences, the act with the highest expected moral value should be considered as the right act.

Others argue that even if we should do what will have the best outcome, the expected utility theory may help in making decisions when the consequences of the acts become uncertain. The consequentialism version of maximizing the expected utility is a moral choice.

 

More Resources

CFI offers the Certified Banking & Credit Analyst (CBCA)™ certification program for those looking to take their careers to the next level. To keep learning and advancing your career, the following resources will be helpful:

  • Decision Analysis
  • Indifference Curve
  • Law of Diminishing Marginal Utility
  • Moral Hazard

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