What is 'Expected Utility'

Expected utility is an economic term summarizing the utility that an entity or aggregate economy is expected to reach under any number of circumstances. The expected utility is calculated by taking the weighted average of all possible outcomes under certain circumstances, with the weights being assigned by the likelihood, or probability, that any particular event will occur.

BREAKING DOWN 'Expected Utility'

The expected utility of an entity is derived from the expected utility hypothesis. This hypothesis states that under uncertainty, the weighted average of all possible levels of utility will best represent the utility at any given point in time.

Expected utility theory is used as a tool for analyzing situations where individuals must make a decision without knowing which outcomes may result from that decision, i.e., decision making under uncertainty. These individuals will choose the act that will result in the highest expected utility, being this the sum of the products of probability and utilityover all possible outcomes. The decision made will also depend on the agent’s risk aversion and the utility of other agents.

This theory also notes that the utility of a money does not necessarily equate to the total value of money. This theory helps explains why people may take out insurance policies to cover themselves for a variety of risks. The expected value from paying for insurance would be to lose out monetarily. But, the possibility of large-scale losses could lead to a serious decline in utility because of diminishing marginal utility of wealth.

History of the Expected Utility Concept

The concept of expected utility was first posited by Daniel Bernoulli, who used it as a tool to solve the St. Petersburg Paradox.

The St. Petersburg Paradox can be illustrated as a game of chance in which a coin is tossed at in each play of the game. For instance, if the stakes starts at $2 and double every time heads appears, and the first time tails appears, the game ends and the player wins whatever is in the pot. Under such game rules, the player wins $2 if tails appears on the first toss, $4 if heads appears on the first toss and tails on the second, $8 if heads appears on the first two tosses and tails on the third, and so on. Mathematically, the player wins 2k dollars, where k equals number of tosses (k must be a whole number and greater than zero). Assuming the game can continue as long as the coin toss results in heads and in particular that the casino has unlimited resources, this sum grows without bound and so the expected win for repeated play is an infinite amount of money.

Bernoulli e solved the St. Petersburg Paradox by making the distinction between expected value and expected utility, as the latter uses weighted utility multiplied by probabilities, instead of using weighted outcomes.

RELATED TERMS
  1. Electric Utilities Industry ETF

    An exchange-traded fund that invests in companies which generate ...
  2. Marginal Utility

    Marginal utility is the additional satisfaction a consumer gains ...
  3. Bernoulli's Hypothesis

    Bernoulli's hypothesis states a person accepts risk not only ...
  4. Law Of Diminishing Marginal Utility

    The Law Of Diminishing Marginal Utility is a law of economics ...
  5. Dow Jones Utility Average - DJUA

    The Dow Jones Utility Average is a price-weighted average of ...
  6. Utilization Fee

    Utilization fees are what lenders may charge borrowers, against ...
Related Articles
  1. Investing

    Utility Funds: A Bright Choice In Bear And Bull Markets

    Gas, electric and water companies' non-cyclical nature can power strong gains in any portfolio.
  2. Investing

    5 Popular Utilities ETFs in 2016 (XLU, NEE)

    Discover how the five most popular utilities ETFs for 2016 can add growth and income to your portfolio. Four of these utilities ETFs outperformed the S&P 500.
  3. Investing

    How Utilities ETFs Deal With Rising Rates

    Utilities stocks and ETFs may be vulnerable to rising interest rates, but there are other factors to consider.
  4. Investing

    Utilities ETFs to Date 2016 Performance Review (UPW, FXU)

    Discover the best and worst performing exchange-traded funds (ETFs) within the domestic and international utilities sector year-to-date.
  5. Investing

    XLU: Utilities Select Sector SPDR ETF

    Learn about the Utilities Select Sector SPDR ETF and the benchmark index it tracks, and understand what type of investors may be interested in the fund.
  6. Trading

    Why Utility Stocks Are Looking So Attractive

    Investors are in a risk-off mode and are looking to put their capital to work in safer stocks like utilities.
  7. Trading

    Hesitant Traders Turn Their Attention to Utilities

    Nearby support on the charts of key utilities suggests that the sector could be a good choice in the coming months.
  8. Trading

    Nearby Resistance Suggests Utility Stocks Are Headed Lower

    Resistance of major trendlines and 200-day moving averages on the charts of key utilities companies suggests a potential move lower.
  9. Investing

    Utilities Sector: Industries Snapshot (NEE, GAS)

    Discover how the utilities sector is broken down into different subcategories that each function to fill a different need.
RELATED FAQS
  1. What kind of investors buy utility stocks?

    Take a look at why income investors like utilities, why value investors might like utilities and why growth investors tend ... Read Answer >>
  2. What are the main factors that drive share prices in the utilities sector?

    Learn why the share prices of companies in the utility sector have sensitivity to interest rates and to changes in the amount ... Read Answer >>
  3. What is a utility stock?

    Investing in difficult economic conditions requires knowledge of different stock classes. Utility stocks are one vehicle ... Read Answer >>
  4. What is the downside of investing in the utility sector?

    Learn about the pros and cons of investing in the utility sector, and determine whether the steady dividend income possibility ... Read Answer >>
  5. How many different types of utility stocks are there?

    Learn more about utility stocks and about some of the differences between different kinds of utility companies, including ... Read Answer >>
  6. What are the different ways that utility is measured in economics?

    Learn about the two methods used to measure the concept of utility and how utility influences other economic models of consumer ... Read Answer >>
Hot Definitions
  1. Return On Equity - ROE

    The profitability returned in direct relation to shareholders' investments is called the return on equity.
  2. Working Capital

    Working capital, also known as net working capital is a measure of a company's liquidity and operational efficiency.
  3. Bond

    A bond is a fixed income investment in which an investor loans money to an entity (corporate or governmental) that borrows ...
  4. Compound Annual Growth Rate - CAGR

    The Compound Annual Growth Rate (CAGR) is the mean annual growth rate of an investment over a specified period of time longer ...
  5. Net Present Value - NPV

    Net Present Value (NPV) is the difference between the present value of cash inflows and the present value of cash outflows ...
  6. Price-Earnings Ratio - P/E Ratio

    The Price-to-Earnings Ratio or P/E ratio is a ratio for valuing a company that measures its current share price relative ...
Trading Center