Expected utility
Expected utility is the expected value in terms of the utility produced by an action. It is the sum of the utility of each of its possible consequences, individually weighted by their respective probability of occurrence.
A rational decision maker will, when presented with a choice, take the action with the greatest expected utility. Von Neumann and Morgenstern provided 4 basic axioms of rationality. Under this axioms, they proved the expected utility theorem, which says that there exists a utility function defined on possible outcomes and every decision maker's preferences are characterized by maximizing the expected value of the function. The expected utility hypothesis holds that this axioms truly model the notion of a rational agent. Either way, humans often deviate from ratinality by committing cognitive biases.
Blog posts
- Extreme risks: when not to use expected utility
- Expected utility without the independence axiom
- Money pumping: the axiomatic approach
- In conclusion: in the land beyond money pumps lie extreme events
- VNM expected utility theory: uses, abuses, and interpretation
