PRESENTATION ON

EXPECTED UTILITY

PRESENTED BYAKANKSHA KATIYAR

DHEERENDRA PRATAP SINGH
MOHIT TAYAL
NEHA VARSHNEYA

EXPECTED VALUE
In the presence of risk outcomes, usually a
decision-maker uses the expected value
criterion for an investment option.

UTILITY
The value of each outcome, measured in terms
of real numbers (mathematical form) is called a
utility.

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EXPECTED UTILITY

Predicted utility value for one of several

options, calculated as the sum of the utility
of every possible outcome each multiplied
by the probability of its occurrence.
Expected Utility Theory (EUT) states that
the decision maker (DM) chooses between
risky or uncertain prospects by comparing
their expected utility values.

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EXPECTED UTILITY

The weighted sums obtained by

adding the utility values of
outcomes multiplied by
their respective probabilities.

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DEVELOPMENT OF EXPECTED UTILITY

THEORY

Thought of Expected Utility Theory was

coined initially with the description given in
terms of mathematical explanations given by
Nicolas Bernoulli. He proposed that a
mathematical function should be corrected
with the expected value of asset depending on
the probability of outcome.
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RISK AVERSION

Expected value as a criterion for making

decisions makes sense provided that the
stakes at risk in the decision are small
enough to play the long run averages.

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EXPECTED UTILITY

Risk aversion implies that the utility

function of risk-averse investors is concave
in nature and show diminishing marginal
wealth utility. Risk-neutral individuals have
linear utility functions, while risk-seeking
individuals have convex utility functions.

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EXPECTED MARGINAL UTILITY

The additional satisfaction a consumer gains from

consuming one more unit of a good or service.
Marginal utility is an important economic concept
because economists use it to determine how much
of an item a consumer will buy. Positive marginal
utility is when the consumption of an additional
item increases the total utility. Negative marginal
utility is when the consumption of an additional
item decreases the total utility.

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Highlights of expected utility theory with

reference to loss aversion

Investors are consistently deviated to one

side only from the point of view of
prediction of risk neutrality and these
deviations are with risk aversion.

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Cont

In expected utility theory there is no

implication of calibration theory.

There is no relevance with the loss aversion

in the behavior of the investors.

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EXPECTED UTILITY THEORY

Expected utility theory can be defined as the

theory of decision-making under risk based on
a set of outcomes for preference ordering. The
independence of these outcomes imply that
the (expected) utility function that represents
the ordering is linear in probabilities.

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Expected Utility as a Basis for DecisionMaking

Expected Utility Theory (EUT) states that at

the time of decision-making, the decision
maker chooses among various risky or
uncertain

options

by

comparing

their

expected utilities with respect to his need.

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EXAMPLE
If its going to rain, and we have to decide
whether to carry an umbrella or not,
Outcome :

If we carry an umbrella, then

there are 10 per cent chance you lose it, 70

per cent chance we carry it around
needlessly, 20 per cent chance we use it.

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Criticism of Expected Utility Theory

Expected-utility theory explains systematic,

one-sided deviations from the predictions of
risk-neutral models because of the belief that
expected utility theory does not give right
explanation of risk attitudes over modest
stakes of investors in different asset classes.

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Cont

There is a lack of clarification on decision

theory developed on the basis of Expected
Utility Theory

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EXPECTED UTILITY MODELS

The expected utility of income and Initial

wealth model (EUI & IW)

The expected utility of income model (EUI)

The expected utility of terminal wealth

(EUTW)

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The distinctions among the

models are in assumed
identity of the gains.

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THE EXPECTED UTILITY OF INCOME UTILITY

AND INITIAL WEALTH (EUI&IW) MODEL

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This model assumes that the prizes are

ordered pairs of amounts of initial wealth
and income.
Indifference curves for this model are
parallel straight lines; therefore it is more or
less an expected utility model.

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Cont

The Arrow-Pratt theory of comparative risk

aversion can be applied to this model.

Agents

risk-avoiding

behavior

can

be

explained with the help of EUI&IW model (or

the EUI model) rather than the EUTW model.

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THE EXPECTED UTILITY OF INCOME (EUI)

MODEL

The expected utility of income (EUI) model

is based on the assumption that the prizes are
amounts of income. Also equivalently there
are changes in wealth or gains and losses.

The EUI model is mostly used in the theory

of auctions.

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Cont

The indifference curves for this model are

parallel straight lines whose slope is
independent of initial wealth

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THE EXPECTED UTILITY OF TOTAL WEALTH

(EUTW) MODEL

The expected utility of terminal wealth

(EUTW) model is based on the assumption that
the gains are amounts of terminal wealth.

This model was firstly used by Arrow and Pratt

in their research work in which they developed
the measures for comparing the risk attitudes of
agents.

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Cont

Higher risk aversion represent steeper slop

of indifference curve whereas respectively
lower risk aversion implies respectively
flatter slope of the indifference curves

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