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Expected Utility Theory - Case Study Example

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This work called "Expected Utility Theory" describes this economic theory, its advantages. From this work, it is clear that the expected utility theory is not effective in determining people’s choices. The author outlines factors in psychological needs, aspects of prospect theory. …
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Expected Utility Theory
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Download file to see previous pages 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 of individuals in the economy. The 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 behave rational, which is not the case. Decision-makers faced 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. The common ratio is the systematic violation of the axiom of independence. Alias 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. Alias Paradox is against the axiom of the independence idea that agents make choices independently. The decision-makers make the judgement in the economy before choosing an alternative available. The paradox uses the indifference curve to determine the choices of an individual in the economy. The indifference curve shows the maximum choice of decisions that maximize an individual utility (Wakkern 2010).  ...Download file to see next pagesRead More
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