An Intuitive Explanation of Expected Utility Theory- Behavioural Economics 1
In what I’m planning to make a five-part series, I plan to write articles on the major dominant behavioural models, evaluate them, and conclude on their effectiveness. The first of these theories is Expected Utility Theory.
Expected utility theory, for many decades, served as the cornerstone for economics, and still plays a part in today’s society despite being replaced by more modern models of human behaviour.
The basis of the theory is that economic agents are hypothesised to perform acts in accordance with the expected utility of an act, choosing one particular action among others based on the fact that it has the maximum expected utility.
The three important concepts in this theory are: outcomes, states, and acts. To illustrate this better, let us take an example of choosing between reading a book or not reading it. Outcomes are the possible end-states of the system being considered, for example, becoming more knowledgeable as a result of having read the book. States are properties of the system that you cannot control that have an effect on the ultimate outcome, for example, the book being informative or repetitive. And finally, acts are actions you can take to reach your desired outcome, for example, choosing to read or not to read the book. To represent this system graphically, we can construct a matrix that looks as follows.
Based on this definition, we can now derive a formula for calculating the expected utility of an act R.
PR(O) is the probability of the action R leading to an outcome O. U(O) is the utility (an objective number) of that outcome O.
The mathematics involved in deriving this formula is beyond the scope of this article, but I highly recommend reading the Stanford Encyclopaedia of Philosophy’s entry on this topic, as it provides a wonderful, mathematically-intuitive explanation regarding expected utility theory.
This theory, however, also has been subject to numerous criticisms, that include, among others: gaining the prerequisite knowledge to effectively calculate expected utility of any act is impossible in the real world, utility is a subjective measure and cannot be expressed in mathematical terms, and that maximising expected utility (in certain cases) is irrational.
While this theory did serve as a predictive model for human behaviour for a brief period, it has now largely been relegated to the role of a descriptive theory and serves only as a relic of historical economic thinking.
Mathematics of the theory [Stanford Encyclopaedia of Philosophy] — https://plato.stanford.edu/entries/rationality-normative-utility/
Detailed objections to the theory [Allais and Hagen, 1979] — https://doi.org/10.1007%2F978-94-015-7629-1