Non-expected Utility Theory

The expected utility/subjective probability model of risk preferences and beliefs has long been the preeminent model of individual choice under conditions of uncertainty. It exhibits a tremendous flexibility in representing aspects of attitudes toward risk, has a well-developed analytical structure, and has been applied to the analysis of gambling, games of strategy, incomplete information, insurance, portfolio and investment decisions, capital markets, and many other areas. This model posits a cardinal utility function over outcomes (usually alternative wealth levels), and assumes that an individual evaluates risky prospects on the basis of the expected value of his or her utility function In situations of objective uncertainty (e.g., roulette wheels), this expectation based on the objective probabilities involved. In situations of subjective uncertainty (e.g., horse races) likelihood beliefs are represented by the individual’s personal or subjective probabilities of the various alternative occurrences. First proposed by the Dutch mathematician Daniel Bernoulli in 1738 as a solution to the well-known St. Petersburg Paradox, the expected utility model has since been axiomatized under conditions of both objective and subjective uncertainty. Many consider these axioms and the resulting model to be the essence of rational risk preferences and beliefs.