Expected Utility and Insurance in a Two State Model
نویسنده
چکیده
Expected Utility (EU) theory is a technique developed by Von Neumann and Morgenstern (1944) to deal with situations of quantifiable risk. It requires preferences to exhibit two additional axioms of continuity and independence, which are somewhat controversial. Assume that states of nature can be indexed by an s = 1, ..., S, each with a probability of occurring of p1, ..., pS , which as probabilities obey ps ≥ 0 and PS s=1 ps = 1. 1 Let xs be the realization of some random variable, sometimes known as a prospect or lottery, x in state s, which yields utility u (xs). The Expected Utility Theorem states that if consumers have rational preferences that exhibit continuity and independence2 then agents will behave as if they maximize the expected value of their utility or just expected utility
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