Expected Utility Theory - Case Study Example

EXPECTED UTILITY THEORY No) (Lecturer)   Introduction Expected utility theory is an economic theory that deals with the consumer behaviours. The theory was developed in 1938 by Daniel Bernoulli to deal with the problem of gambling. According to Bernoulli individuals, give out money in the economy in exchange of utility. The theory states that rational consumer choices in uncertain events depend on the expected utility. Expected utility is obtained by addition of all the weighted utility multiply by their own probabilities of occurrence. There are four maxims that explain the expected utility in economics: completeness, which states that all the economic agents have define preference of alternatives available. If a consumer prefers A he or she will dislike B (Widekind 2008). Transitivity depends on the axiom of completeness to make choices. The agent is consistent with the choices, if there are three alternatives A, B and C. An agent who prefers A to B, B to C will prefer A to C by transitivity. Independence axioms assume that all the agents have their own way of gambling in the economy. The axiom of continuity assumes that the agents are indifferent between the three alternatives in the economy. A rational decision maker obeys all the four axioms of expected utility theory. Expected utility theory is a theory that explains how people make choices in the economy. However, it is never a good theory to explain the economic choices by individuals in the economy. Expected theory is not applicable in the real world because of its deviation from the real world experiment. The theory assumes that decision makers at the time of uncertainty behaves rational, which is not the case. Decision makers faced with uncertainty use alternative theory to make their decision whether to invest or not. The decision maker should deal with uncertainty before making any decision in the economy (Gollier & Machina 1995). Not all the economic agents follow the expectation theory axioms to make decisions. The agents in the economy violate the axiom of independence. Independence axiom states that an economic agent prefers one alternative to the other at a particular time. The rule applies to a specific way that preference is formed in the economy. According to the expectation theory, the preference should be found as per the axioms of independence, which is not the case in the real world. Common ratio is the systematic violation of the axiom of independence. Allias Paradox challenges the axiom of independence in his work. The Paradox showed the deviation of the actual choices from the prediction by the expected utility approach. Allias Paradox is against the axiom of independence idea that agents make choices independently. The decision makers make judgement in the economy before choosing an alternative available. The paradox uses the indifference curve to determine the choices of individual in the economy. The indifference curve shows the maximum choice of decisions that maximize an individual utility (Wakkern 2010). Expectation theory is not a valid theory to explain the people choice because of the axiom of independence, which fails to hold on a rational agent. From the Paradox, people prefer sure information to undermined information. The people prefer the devil they know than the one they do not know. The preference Reversal experiment shows the weakness of transitivity theory. The axiom of transitivity procedures fails to account for overpricing, high probability and a high pay outcome. Transitivity theory is a weak theory and should be replaced with the regret theory. Regret theory in times of uncertainty in cooperate the regret concept before making any decision making. A rational investor should research on the opportunities before investment to avoid regrets that might occur in the future after investment. The preference reversal theory and the Allias Paradox have criticized the independence and the transitivity axioms without giving better alternatives to decisions under uncertainty. Economic journals give a better understanding if the expectation theory explains the people’s choices. The economic journals assess the utility maximization; the agents depend on their emotion state to make rational decisions in the economy. The agent learns from the past investment to make present investment. The journal suggests that the theory of expected utility is good to make people’s choices when the utility is at the maximum point. However, expected utility theory has never been good since it expects the agents to make choices that are rational in the economy. Expected utility does not take into account the endowment effect in people’s choices. Endowment effect explains why people love the things in their possession than acquiring property own by another person. Agents in the society raise the prices of the things they own and lower the price of the property of another person. The endowment effect raises maintain the status quo the owner of the property in the economy leading to bias decision making by the agents. The deviation is explained well with the loss aversion. Loss aversion is the avoidance of risk in the investment opportunities, the avoidance of loss is believed to double that of making profit. The agents prefer to remain at the same status quo than to change it and make a loss. The expected utility theory fails to be a good theory to explain the people’s choice because it does not include prediction models to the four axioms. The theory should include assumptions of loss aversion in the prediction of people choices. Loss aversion assumption will make the investors to invest more in conditions of uncertainty. Expected utility theory fails to recognise the psychological principles. The psychological principle requires the theory include in its assumption anomalies and loss aversion to making choices. The theory majorly focused on the axioms ignoring the psychological needs of individuals in the economy. The theory focused on heuristics to speedily find the solution to the problem. There are three heuristic used by the agents in making choices: representativeness, adjustment from anchor and availability of scenario. Although the three heuristic models are effective in the decision-making process, the models have systematic errors. Systematic errors arise due to use of the four axioms to make choices and judgement. The economic agents should use other approaches in making decision instead of the expected utility theory approach to avoid the systematic error. The entire economy depends on the psychological needs of all agents to make choices and judgement on investment under uncertainty. Expectation theory has been replaced by the prospect theory. Prospect theory in cooperate psychological needs of agents in making economic decisions. The theory focused on the loss eversion by the investors. Elimination of loss in an investment leads to an increase in profit. The prospect theory eliminates the independence and transitivity axioms, and adopts the other two axioms. The theory explains two problematic of investment under uncertainty; people invest with existence of probabilities of outcome and the concept of risk aversion. Investor’s main interest is the investment with high probability of return. Risk averse investors will never invest in risk, the investors prefer less risk with minimal outcome than high risk with maximum outcome. An investor, who is a risk taker, will invest in the riskiest project with high returns while a neutral investor, is indifferent of the investment. The prospect theory differs with expected utility in a number of ways; utility is linear and the value is determined in terms of gains in expected utility theory. Prospect theory predicts involve loss aversion and predict the violation of axioms of expected theory. Prospect theory is psychological theory that states how people make their choices. The theory describes how people make crucial decisions in risk investment. The theory explains how people make a decision to take up the life insurance policies. People take a lot of time and stages to decide on the choice to make. The decision maker at the first stage should simplify the decision to be easily understood by others. The simplification process varies between persons and the nature of investment. It is easy to simplify the purchase of a new car than investment in lotteries because of the risk associated with lotteries. Most people in the economy make decisions basing on the simplification of the investment opportunity. An individual after simplifying the investment will choose the one with a higher value and weights of the two options (Wakker 2010). For example if the value of having a car outweighs losing money, the investor will choose to purchase a car. The combination of the value and the weight will give the investor maximum choice among the alternative. Prospect theory is unique because it explains why and how people make decisions. It has also explained why some individuals make wrong investment decisions. The expected theory explains how the people should make a rational decision in the economy. Unlike the expected theory, prospect theory explains to the investor’s procedures to follow to make decisions. The value and weight in prospect theory explain should be assign to a particular outcome. For example to state, that someone is shorter should be compared with another person (Grant & Kajii 1994). Prospect theory makes decisions with comparison with other available options in the investment plan. The reference point in prospect theory assists the individuals to make different decisions. Options can be accepted or rejected by others depending on the value and weight of the outcome. Prospect theory uses the s-shape to determine the value and weight of the investment (Kahneman & Tversky, 1979). The concave represents the outcome while convex represents the losses. The gains above the reference point are in the higher side of the concave while the losses below the reference point are on the higher side of the convex point. Gaining and loosing far away from the reference point is minimal. The value for losing in a gable according to the prospect theory is greater than that of gaining. If a person in a gable game wins $15 and other losses $15, the one that loses is assigned a higher value although the value is the same. The investor gives losing a greater value than gaining as motivation to work for more gains. The assignment of higher value makes individuals invest in gambling with the equal chance probabilities. The three-value assignment assists the decision maker in deciding on the best investment possible (Levy 2006). The s-shape function assists people go make the decision from the reference point. Reference serves as a guide in decision-making, investors’ values around the inference point are likely to be influenced by the decision made. However, decision-making affects the values far away from the reference point. The difference between the loss and gain values has made most people to be the loss averse. An individual will prefer a loss than gain in the same reference point (Barbera, Hammond & Seidl 1998). The assignment of value will encourage most investors to invest more under risk. The risk condition has more gain than the less risk situation. The theory of prospect explains more on how people make choices than the expected utility theory (Thaler & Sunstein, 2009). The prospect theory predicts that weights assigned to various investment depends on the perceive outcome the decision weight. However, the expected utility weight depends on the objective of the decision maker. The prospect theory explains that the difference between the weights and probabilities is the extreme lower probability of 1% and extremely high probability of 99%. People use the probability to make investment decisions in real life. The outcome of every decision is assigning a probability of occurrences. A gambler will gamble in a game with a higher probability by investing a higher amount of money. The game with a lower probability will require an investor investing a lower amount of money. The prospect b theory assists the investors in gambling to make viable decisions in gambling using the assign weights of the various games (D. Kahneman 2011). The slight difference in the probability has a greater impact on decision making by the individuals faced in investment decisions. Prospect theory has gain more popularity that the expected theory in various fields. The theory has gained its fame in economics, sociology and psychology. The theory is applicable in the real world, gambling games, which happen in reality depend on the theory to assign the probabilities. The theory provides the best decision to risky investment made by people in the economy. In economics, the theory makes the decision-maker to make and choose from the alternatives available the best choices that yield the best outcomes (Thaler & Sunstein 2009). The outcomes must be economically viable to attract more investment in the society. In sociology and psychology, the theory explains how social psychology affects the judgement of individuals in the society. The expected utility theory was criticised because it did not included the psychological thought in its four axioms (Hirshleifer & Riley 1992). The prospect theory explains the concept of endowment point that affects the decision-making of an individual. The endowment effects explain why being a buyer is much better than a seller is. People will tend to invest more because one get property unlike a seller who losses. Conclusion In answering the question if expected utility is a good theory to explain how people make economic choices, my conclusion remains that it is never a good theory to explain people choices. However, it is still useful in making economic decisions. Expectations utility theory is an analytical tool for economic decision because no single theory can predict human behaviour under uncertainty. The physiology and the prospect theory is an improvement of the expected utility theory. The two combine mathematical tools and psychological concept for efficiency. Individuals in the economy are not always rational in decision making as depicted in the expected utility theory. People with the ability to save, may refuse to save now for future use. Most people choose to satisfy others now and sacrifice their future happiness of utility maximization. If an individual saves now for the future, they will derive maximum utility from the consumption and investment. Uncertainty gives investors more chance of gaining more unlike certainty. Overall, expected utility theory is not effective in determining people’s choices. The theory fails to make people structure the problems as universal. The people do not process probabilities as suggested by the theory. The choices made by people do not depend on the theory because it fails to factor in psychological needs. Hence, expected theory is never a good theory to explain how people make choices. The agents should adopt the prospect theory to make sound decisions under uncertainty. Prospect theory focuses more on the individual psychological needs. Expected theory has no real life application unlike the prospect theory, which really applies in the gambling decisions to choose the best outcome. Prospect theory is a universal theory that explains how people make real life decision in the available investment opportunities. Reference Barbera, S., Hammond, P. J., & Seidl, C.1998. Handbook of utility theory. Dordrecht: Kluwer Academic Publishers. D. Kahneman 2011 Thinking fast and slow Farrar, Straus & Giroux New York Gollier, C., & Machina, M. J. 1995. Non-expected utility and risk management: A special issue of the Geneva papers on risk and insurance theory. Boston: Kluwer Academic Publishers. Grant, S., & Kajii, A. 1994. Ausi expected utility: An anticipated utility theory of relative disappointment aversion. Louvain-la-Neuve: Center for Operations Research and Econometrics, Univ. Levy, H. 2006. Stochastic dominance: Investment decision making under uncertainty. New York, NY: Springer. Thaler R. & Sunstein C. 2009 Nudge: Improving decisions about health, wealth and happiness Penguin London Hirshleifer H. Riley J. 1992- The Analytics of Uncertainty and Information Cambridge University Press Cambridge p. 33-39) Kahneman, D., & Tversky, A. 1979 Prospect Theory: An Analysis of Decision under Risk. Economica, Vol. 47,(No. 2), 263-292. Kahneman, D., & Thaler, R. 2006. Utility Maximization and Experienced Utility. The Journal of Economic Perspectives, Vol. 20,(No. 1), 221-234. Retrieved from http://www.jstor.org/stable/30033642 Wakker, P. P.2010. Prospect theory: For risk and ambiguity. Cambridge: Cambridge University Press. Widekind, S. . 2008. Evolution of non-expected utility preferences. Berlin: Springer. Read More