When does expected utility theory provide a good explanation of behaviour in the presence of risk?

Expected utility theory hypothesises that rational behaviour in the presence of risk can be modelled as a maximising an expected value. Its validity relies upon a series of axioms, proposed by Neumann and Morganstern, outlining the behaviour of rational agents, hich ill be examined belo . !s expected utility theory"s explanatory po er is limited to hen agents" behaviour can be modelled by these axioms, behaviouralist criti#ues emphasise the extent to hich human behaviour departs from this, both because of irrationality and because of rational concerns that cannot be modelled in expected utility theory. $efore the axioms underpinning expected utility theory"s explanation of behaviour can be laid out and criti#ued, the background to these axioms must be explained. In expected utility theory, any decision has as its only and entire conse#uence some probability distribution of incomes %also kno n as a prospect&, so choosing bet een decisions is e#uivalent to choosing bet een prospects. ! preference ordering of decisions must therefore be derived from a preference ordering of associated prospects. If certain assumptions %axioms& concerning preferences are satisfied, e can represent these preferences as a utility curve. 'his does not have to represent actual thought processes of decision makers to be a good explanation of behaviour in the presence of risk( it must merely be predictively useful. ' o terms must be defined before these axioms can be explained) ! "standard prospect" is a probability distribution of incomes involving only t o outcomes, the greatest and smallest possible incomes, ith probabilities v and * + v respectively, here * ,- v ,- .. /or example, if 0arry, ith a group of six other rather desperate gamblers, plays a round of 1ussian roulette ith a pistol ith six chambers, only one of hich is loaded, v ill e#ual 234. ! "compound prospect" is a probability distribution of incomes for hich at least one outcome has another prospect, rather than a single value of income. /or example, if before the first round 0arry ere to decide to play a second round of roulette if he on the first one, his initial prospect %the probability distribution of outcomes hen he first decided to play& ould be compound. 'he first axiom re#uired for expected utility theory is that preferences for prospects must be transitive. 'his ill mean that preferences are complete and consistent. 'o illustrate this, if 0arry prefers %in a slightly less deadly game& a 2.)2. chance of inning 5*. or 56. to a 2.)2. chance of inning 52 or 562, and he prefers the latter to a 2.)2. chance of inning 5. or 57., then 0arry ill also prefer the first gamble to the last gamble. 'ransitivity of preferences is a idely accepted assumption for agents selecting bet een goods, although !nand argues that preferences can rationally be changed by the removal or addition of another item, and therefore be intransitive. Nevertheless, this is not an axiom that is usually considered to be fre#uently violated. 'he second axiom is that preference increases ith probability( given t o standard prospects, the agent ill prefer the one hich gives the better chance of getting the higher valued outcome, and t o preferences ith identical probabilities ill be indifferently preferred. In 0arry"s case, presuming that his potential innings are unchanged, it seems sensible that he ould prefer a scenario in hich he is less likely to be shot than one here he is more likely to be shot. 'he third axiom is that an e#uivalent standard prospect ill exist for any certain income such that) greatest potential income ,- certain income ,- lo est potential income. !n e#uivalent standard prospect is a standard prospect for hich v makes the agent indifferent to hether they get the certain income or the chance of inning the greatest or smallest income. We can imagine

0arry"s friend offering 0arry money to convince him not to risk his life by playing 1ussian roulette( it seems sensible that if 0arry"s friend keeps increasing his offer, at some point %up to the maximum 0arry could have on by participating& 0arry ill be indifferent to accepting the offer or participating %if 0arry places any value on his o n life, it is likely that this ill be long before his friend offers him the maximum he could have on&. !ssuming that more income is preferred to less, the second axiom implies that as 0arry"s chances of inning increase, the value that his friend ill have to offer him to make him indifferent to participating ill increase. 'he fourth axiom is that of rational e#uivalence. 8iven any compound prospect ith outcomes composed only of standard prospects, its rationally e#uivalent simple prospect ill be indifferently preferred to it. 'his simply says that any compound prospect can be broken do n into a simple prospect. /or example, 0arry"s compound prospect described earlier can be thought of as a 234 chance to have a 234 chance of inning, or it can be thought of as the simple prospect of having a 62374 chance of inning. 'he fourth axiom supposes that 0arry ill be indifferent to playing t o rounds of 1ussian roulette ith a gun ith one bullet and playing one round of 1ussian roulette ith a %rather uni#ue& thirty six chambered gun loaded ith eleven bullets, presuming that the ultimate innings are the same. 'hough this seems sensible, it presumes that the agent does not suffer from the "risk illusion" of a t o stage bet, hich is a behavioural #uirk that has been empirically noted. 'his axiom might also be said to assume a high computational ability in agents, if the bets involved are fairly complex. 'he fifth axiom supposes that the agent is indifferent bet een a given prospect and a compound prospect formed by replacing each income value ith its e#uivalent standard prospect. /or example, 0arry ill be indifferent bet een playing a normal round of 1ussian roulette in hich if he ins he collects immediately and an unusual round of 1ussian roulette in hich he collects only the chance of inning a specific greater amount. 'his implies that e can express each of a set of simple prospects as a compound prospect involving only various chances of obtaining standard prospects. 'he individual prospects can therefore be compared simply as chances of inning one or the other of the same t o outcomes. /rom the second axiom it follo s that the rational e#uivalent standard prospects can be completely ordered by the values of v hich appear in them. 'he agent ill therefore choose among the prospects in such a ay as to maximise the value of v. 'his preference ordering of the rational e#uivalent standard prospects is identical to the preference ordering of the initial prospects. 'he anticipated payoff produced by v can be referred to as the expected utility of the prospect, on the understanding that this utility is a reference to an abstract numerical outcome rather than to an experiential state. 9ince, axiomatically, v is maximised to produce the highest anticipated payoff, the agent can be considered in this model to be maximising expected utility. In conclusion, expected utility theory provides a good explanations of behaviour in the presence of risk hen agents have transitive preferences hich increasingly prefer a standard prospect as the probability of its better outcome increases, and any standard prospect is indifferently preferred to an e#uivalent certain income, and simple prospects are indifferently preferred to rationally e#uivalent complex prospects, and finally simple prospects are indifferently preferred to compound prospects formed by replacing each income value ith its e#uivalent standard prospect. 'his outlines a particular vie of rational behaviour hich can accommodate behavioural preferences like risk aversion and discounted futures. 0o ever, its explanatory po er fails hen human foibles hinder rational risk assessment %for example, the risk illusion of t o stage bets, and mathematical incompetence& or if rational preferences do not conform to the axioms, as !nand claims is possible.