Briefly discuss expected utility theory of decision-making.

Expected Utility Theory of Decision-Making

Expected utility theory is a fundamental concept in economics and decision theory that describes how individuals make choices based on the potential outcomes and their associated probabilities. The theory suggests that individuals make decisions by considering the possible outcomes of each choice and evaluating the utility, or satisfaction, they expect to receive from each outcome.

Key Principles:

1. Utility Function: Central to expected utility theory is the concept of a utility function, which assigns a numerical value to each possible outcome based on the individual's preferences. The utility function represents the individual's subjective assessment of the desirability of each outcome.

2. Probability Weighting: Expected utility theory assumes that individuals assess probabilities subjectively, often overweighting low-probability events and underweighting high-probability events. This phenomenon, known as probability weighting, can lead to decisions that deviate from the predictions of traditional probability theory.

3. Risk Aversion: Expected utility theory suggests that individuals are generally risk-averse, meaning they prefer certain outcomes over uncertain outcomes with equivalent expected values. This behavior is captured by concave utility functions, where the marginal utility of wealth decreases as wealth increases.

4. Expected Utility Maximization: The central principle of expected utility theory is that individuals seek to maximize their expected utility when making decisions. This means choosing the option that offers the highest expected utility, considering both the probability of each outcome and the utility associated with each outcome.

Applications and Criticisms:

Expected utility theory has been widely used to model decision-making in economics, finance, and psychology. It provides a formal framework for analyzing choices under uncertainty and has been instrumental in understanding various phenomena, such as risk-taking behavior and insurance demand.

However, the theory has also faced criticism for its assumptions, such as the use of a single, consistent utility function to represent preferences and the assumption of rational decision-making. Critics argue that these assumptions do not always align with observed behavior, leading to alternative theories, such as prospect theory, which seeks to explain decision-making using more realistic psychological principles.