The Expected Utility Model: Its Variants, Purposes, Evidence and ...

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Journal of Economic Literature Vol. XX (June 1982),pp. 529-563 The Expected Utility Model: Its Variants, Purposes, Evidence and Limitations Graduate School of Business University of Chicago The author would like to express his appreciation to David Brbe, Victor Goldberg, Paul Kleindorfer, Roger Kormendi, Michael Rothschild, and the anonymous referees for their helpful comments on earlier drafts of this article. Additionally, his colleagues in the Center for Decision Research at the University of Chicago, especially Hillel Einhorn, Robin Hogarth and J. Edward Russo, are acknowledged for stimulating discussions on the present topic. Funding for this review was received from the Graduate School of Management in Delft and the Erasmus University of Rotterdam, both in the Netherlands. Th,eir support is much appreciated. I. Introduction research (e.g., Ward Edwards, 1961; Gor- T IS NO EXAGGERATION to consider ex- I pected utility theory the major paradon Becker and Charles McClintock, 1967; Amnon Rapoport and Thomas Wallsten, 1972; Paul Slovic et al., 1977; digm in decision making since the Second Robert Libby and Peter Fishburn, 1977; World War. It has been used prescrip- Charles Vlek and Willem Wagenaar, 1979; tively in management science (especially and Hillel Einhorn and Robin Hogarth, decision analysis), predictively in finance 1981), few have attempted to organize the and economics, descriptively by psycholo- relevant evidence around the different gists, and has played a central role in theo- purposes served by the EU model. Simiries of measurable utility. The expected larly, there has been no systematic examiutility (EU) model has consequently been nation of the way various descriptive exthe focus of much theoretical and empiri- tensions of expected utility theory relate cal research, including various interpreta- to their progenitor, or of how the current tions and descriptive modifications as to normative variant differs from its historiits mathematical form. This paper reviews cal roots. the major empirical studies bearing on the In addressing these issues, the present EU model. Although previous reviews of paper first discusses various EU modificadecision making have covered some of this tions. Special attention will be given to
530 Journal of Economic Literature, Vol. XX (June1982) the types of cardinal utility used in various models, as well as the manner in which probabilities are incorporated. Ther\eafter four conceptually different purposes of the EU model are identified, namely: descriptive, predictive, postdictive and prescriptive. The types of evidence relevant in testing the model's adequacy for each purpose are discussed. Building on these distinctions, the empirical evidence is then divided into four clusters centering around tests of the axioms, field research, information processing studies, and recent findings on context effects. Although the review covers considerable ground, its focus is on major studies; it does not provide a comprehensive discussion of all relevant research. Moreover, the focus is on individual decision making rather than the behavior of firms or markets. It shows that at the individual level most of the empirical evidence is difficult to reconcile with the principle of EU maximization. Whereas the simplicity of EU theory, especially its mathematical tractability, may make it a very attractive model for purposes of social aggregation, its structural validity at the individual level is questionable. As such, a separate section is devoted to important behavioral decision aspects that are currently ignored in EU theory. Finally, the discussion section synthesizes the divergent strands of research touched upon, with an eye to future roles of the EU model. 11. Expected Utility Variants Expected utility models are concerned with choices among risky prospects whose outcomes may be either single or multidimensional. If we denote these various (say n) outcome vectors by g and denote the n associated probabilities by pi such n that L\ pi = 1, we then generally dehe i =l an EU model as one which predicts or prescribes that people maximize n L\ F(pi)U(g). The key characteristics of ị =lthis general maximization model are: (1) a holistic evaluation of alternative^,^ (2) separable transformations on probabilities and outcomes, and (3) an expectation-type operation that combines probabilities and outcomes multiplicatively (after certain transformations). Within this general EU model different variants exist depending on (1)how utility is measured, (2)what type of probability transformations F(-)are allowed, and (3) how the outcomes are measured. In this section we examine some of the major variants, including their extra-mathematical interpretations. We start with some background information on EU theory as traditionally understood. Thereafter the neoclassical notion of cardinal utility is compared with the modern day one. Special attention is given to the ways in which EU theory can be cardinal. Finally the concept of probability is discussed, both in terms of its ontology and its treatment in various EU models. The section concludes with a summary table listing the major EU variants. a. Background Information The mathematical form of expected utility theory goes back as far as Gabriel Cramer (1728) and Daniel Bernoulli (1738), who sought to explain the so-called Petersburg paradox. The issue they addressed was why people would pay only a small dollar amount for a game of infinite mathematical expectation. This wellknown game involves flipping a fair coin as many times as is necessary to produce "heads" for the first time. The payoff of this experiment depends on the number A holistic model is one in which the attractiveness of an alternative is evaluated independently of the other alternatives in the choice set. In contrast, a non-holistic or decomposed model directly compares alternatives, e.g., one dimension at a time, without assigning a separate utility level to each.
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