Question

Could wealth effects affect an expected utility maximizer’s preferences? Briefly explain.

Answer 1

Expected Utility is the weighted sum of the utility of various states with weights being the respective probabilities. The Expected Utility maximization depends on the preference structure of the individual which among other things depends on the nature of the person in attitude towards risk, i.e. whether he is risk averse, risk neutral or risk lover. The usual case is when the individual is a risk averse individual. When the individual is risk averse then the individual values a loss of 1 dollar more than the gain of 1 dollar and thus is opposed to a fair bet where there is equal probability of winning or losing same amount. Thus the marginal utility of wealth falls as the level of wealth rises. Thus wealth affects the preferences of the individual. If the person already has high wealth then the marginal utility of additional unit of wealth is lower than when he starts off with a lower amount of wealth. Thus depending on where he starts from initial wealth, the individual will accordingly maximize expected utility.