Question

2. Expected Utility Theory

An individual goes to the store to buy a new iClicker for $40. The clerk at the store tells the individual that the same iClicker is on sale for $20 across campus. The individual goes to the other store. The same individual goes to the store to buy a new computer for $600. The clerk at the store tells the individual the same computer is on sale at the same store across campus for $580. The student does not go. Is this consistent with expected utility theory? Why or why not

Answer 1

The above scenario is consistent with the expected utility theory.

The expected utility theory occurs in the situations when the individual must make a decision without knowing the corresponding outcomes and hence the decision making becomes uncertain. In such situations, the individual will choose the act 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 upon the individual’s risk aversion and the utility of other agents.

The theory can be described with the help of the following diagram:

In the figure, an increase in wealth from £10 to £20, leads to a large increase in utility from 3 util units to 8 util units. However, an increase in wealth from £70 to £80 leads to a correspondingly small increase in utility i.e. 30 util units to 31 util units. This happens because it exhibits diminishing marginal utility of money. This provides the justification for why an individual may exhibit risk aversion for potential large losses with small probabilities.