Expected Utility Hypothesis UP077

The expected utility hypothesis model is a popular concept in economics, game theory and decision theory that serves as a reference guide for judging decisions and behaviors that are influenced by economic and psychological factors. The theory recommends which option a rational individual should choose in a complex situation, based on his tolerance for risk and personal preferences. Within the utility function, individual preferences about risk and the perceived value of attributes are captured to allow people to choose the most rational decision in an unclear scenario. The introduction of St. Petersburg Paradox by Daniel Bernoulli in 1738 is considered the beginning of the hypothesis and has explained why some choices seems to contradict the expected value criterion of payouts and probability of occurrence.

Other hypothesis established by Frank Ramsey and Leonard Jimmie Savage has successfully proven to explain why some popular choices seem to contradict the expected value criterion in the contexts of gambling and insurance. Additionally, the von Neumann–Morgenstern utility theorem provides necessary and sufficient conditions under which the expected utility hypothesis holds. From relatively early on, it was accepted that some of these conditions would be violated by real decision-makers in practice but that the conditions could be interpreted nonetheless as 'axioms' of rational choice. Until the mid-twentieth century, the standard term for the expected utility was the moral expectation, contrasted with "mathematical expectation" for the expected value.

Psychologist and economists theorists have been developing new theories to explain the deficiencies of this model. Theories such as prospect theory, rank-dependent expected utility and cumulative prospect theory, and economic models such as St. Petersburg paradox, Von Neumann–Morgenstern formulation, etc) are considered insufficient to predict preferences and the expected utility. There has been almost no recognition in decision theory of the distinction between the problem of justifying its theoretical claims regarding the properties of rational belief and desire. One of the main reasons is because people's basic tastes and preferences for losses cannot be represented with utility as they change under different scenarios. Personal behaviors may be different between individuals even when they are facing the same choice problem.