What is Utility Theory?

Utility Theory is an economic term summarizing the utility that an entity or aggregate
economy is expected to reach under any number of circumstances. The expected utility
is calculated by taking the weighted average of all possible outcomes under certain
circumstances, with the weights being assigned by the likelihood, or probability, that
any particular event will occur.

Understanding Utility Theory:

The utility theory of an entity is derived from the expected utility hypothesis. This
hypothesis states that under uncertainty, the weighted average of all possible levels of
utility will best represent the utility at any given point in time.

Utility theory is used as a tool for analyzing situations where individuals must make a
decision without knowing which outcomes may result from that decision, i.e., decision
making under uncertainty. These individuals will choose the action that will result in
the highest expected utility, which is the sum of the products of probability and utility
over all possible outcomes. The decision made will also depend on the agent’s risk
aversion and the utility of other agents.

This theory also notes that the utility of a money does not necessarily equate to the total
value of money. This theory helps explains why people may take out insurance policies
to cover themselves for a variety of risks. The expected value from paying for insurance
would be to lose out monetarily. But, the possibility of large-scale losses could lead to
a serious decline in utility because of diminishing marginal utility of wealth.

History of the Utility Theory Concept:

The concept of utility theory was first posited by Daniel Bernoulli, who used it as a tool
to solve the St. Petersburg Paradox.

The St. Petersburg Paradox can be illustrated as a game of chance in which a coin is
tossed at in each play of the game. For instance, if the stakes starts at $2 and
double every time heads appears, and the first time tails appears, the game ends and the
player wins whatever is in the pot. Under such game rules, the player wins $2 if tails
appears on the first toss, $4 if heads appears on the first toss and tails on the second,
$8 if heads appears on the first two tosses and tails on the third, and so on.
Mathematically, the player wins 2k dollars, where k equals number of tosses (k must be
a whole number and greater than zero). Assuming the game can continue as long as the
coin toss results in heads and in particular that the casino has unlimited resources, this
sum grows without bound and so the expected win for repeated play is an infinite
amount of money.

Bernoulli solved the St. Petersburg Paradox by making the distinction

between expected value and expected utility, as the latter uses
weighted utility multiplied by probabilities, instead of using weighted outcomes.
Example of Utility Theory:
Decisions involving expected utility are decisions involving uncertain outcomes. In
such events, an individual calculates probability of expected outcomes and weighs them
against the expected utility before taking a decision.

For example, purchasing a lottery ticket represents two possible outcomes for the buyer.
He or she could end up losing the amount they invested in buying the ticket or they
could end up making a smart profit by winning either a portion or the entire lottery.
Assigning probability values to the costs involved (in this case, the nominal purchase
price of a lottery ticket), it is not difficult to see that the expected utility to be gained
from purchasing a lottery ticket is greater than not buying it.

Expected utility is also used to evaluating situations without immediate payback, such
as an insurance. When one weighs the expected utility to be gained from making
payments in an insurance product (possible tax breaks and guaranteed income at the
end of a predetermined period) versus the expected utility of retaining the investment
amount and spending it on other opportunities and products, insurance seems like a
better option.

Explanation:

The conjunction of utility theory and decision theory involves formulations of decision
making in which the criteria for choice among competing alternatives are based on
numerical representations of the decision agent's preferences and values. Utility theory
as such refers to those representations and to assumptions about preferences that
correspond to various numerical representations. Although it is a child of decision
theory, utility theory has emerged as a subject in its own right as seen, for example, in
the contemporary review by Fishburn (see REPRESENTATION OF PREFERENCES).
Readers interested in more detail on representations of preferences should consult that
essay. Our discussion of utility theory and decision theory will follow the useful three-
part classification popularized by Luce and Raiffa (1957), namely decision making
under certainty, risk and uncertainty. I give slightly different descriptions than theirs.
Certainty refers to formulations that exclude explicit consideration of chance or
uncertainty, including situations in which the outcome of each decision is known
beforehand. Most of consumer demand theory falls within this category. Risk refers to
formulations that involve chance in the form of known probabilities or odds, but
excludes unquantified uncertainty. Games of chance and insurance decisions with
known probabilities for possible outcomes fall within the risk category. Note that 'risk'
as used here is only tangentially associated with the common notion that equates risk
with the possibility of something bad happening. Uncertainty refers to formulations in
which decision outcomes depend explicitly on events that are not controlled by the
decision agent and whose resolutions are known to the agent only after the decision is
made. Probabilities of the events are regarded either as meaningless, unknowable, or
assessable only with reference
Utility and probability to personal judgement. Situations addressed by the theory of
noncooperative games and statistical decision theory typically fall under this heading.
A brief history of the subject will provide perspective for our ensuing discussion of the
three categories. HISTORICAL REMARKS. The first important paper on the subject
was written by Daniel Bernoulli (1738) who, in conjunction with Gabriel Cramer,
sought to explain why prudent agents often choose among risky options in a manner
contrary to expected profit maximization. One example is the choice of a sure $10,000
profit over a risky venture that loses $ 5000 or gains $ 30,000, each with probability
1/2. Bernoulli argued that many such choices could be explained by maximization of
the expected utility (,moral worth') of risky options, wherein the utility of wealth
increases at a decreasing rate. He thus introduced the idea of decreasing marginal utility
of wealth as well as the maximization of expected utility. Although Bernoulli's ideas
were endorsed by Laplace and others, they had little effect on the economics of decision
making under risk until quite recently. On the other hand, his notion of decreasing
marginal utility became central in consumer economics during the latter part of the 19th
century (Stigler, 1950), especially in the works of Gossen, Jevons, Menger, Walras and
Marshall. During this early period, utility was often viewed as a measurable
psychological magnitude. This notion of intensive measurable utility, which was
sometimes represented by the additive form Ut(x t ) + U2(X2 + ... + un(xn) for
commodity bundles (x t , X 2, ... , X n), was subsequently replaced in the ordinalist
revolution of Edgeworth, Fisher, Pareto and Slutsky by the view that utility represents
nothing more than the agent's preference ordering over consumption bundles. A revival
of intensive measurable utility occurred after 1920 when Frisch, Lange and Alt
axiomatized the notion of comparable preference differences, but it did not regain the
prominence it once held. Bernoulli's long-dormant principle of the maximization of
expected utility reappeared with force in the expected utility theory of von Neumann
and Morgenstern (1944, 1947). Unlike Bernoulli and Cramer, who favoured an
intensive measurable view of utility, von Neumann and Morgenstern showed how the
expected utility form can arise solely from simple preference comparisons between
risky options. They thus accomplished for decision making under risk what the
ordinalists accomplished for demand theory a generation earlier. Although little noted
at the time, Ramsey (1931), in an essay written in 1926 and published posthumously,
attempted something more ambitious than the utility theory for risky decisions of von
Neumann and Morgenstern. Ramsey's aim was to show how assumptions about
preferences between uncertain decisions imply not only a utility function for outcomes
but also a subjective or personal probability distribution over uncertain events such that
one uncertain decision is preferred to another precisely when the former has greater
subjective (probability) expected utility. Ramsey's outline of a theory of decision
making under uncertainty greatly influenced the first complete theory of subjective
expected