Expected Utility Hypothesis

Abstract

The expected utility hypothesis of behaviour towards risk is essentially the hypothesis that the individual decision–maker possesses (or acts as if possessing) a ‘von Neumann-Morgenstern utility function’ U(·) or ‘von Neumann-Morgenstern utility index’ {U¡} defined over some set of outcomes, and when faced with alternative risky prospects or ‘lotteries’ over these outcomes, will choose that prospect which maximizes the expected value of U(·) or {U¡}. Since the outcomes could represent alternative wealth levels, multidimensional commodity bundles, time streams of consumption, or even non–numerical consequences (e.g. a trip to Paris), this approach can be applied to a tremendous variety of situations, and most theoretical research in the economics of uncertainty, as well as virtually all applied work in the field (e.g. optimal trade, investment or search under uncertainty) is undertaken in the expected utility framework.