Explain the concept of expected utility.

Explain the concept of expected utility. 

Ans. When we think of investment, returns will flow on in future. In present, we can only have some expectations but we cannot be sure of the utility we shall get from our investment. Therefore, decisions are taken from expected utilities and not actual utility. As the name suggested, expected utility is the utility that an investor or consumer is expecting to get from an investment of consumption of a commodity but under uncertainty, his expectations may or may not hold good. A strong assumption is made about the utility function. It is of independent utilities which means that the choice individuals make in one state of nature do not depend on the choices that they make in other state of nature. It can be understood by taking equations and variables. To understand the concept of expected utility,

let us assume two mutually independent states s 1 and s 2 . Their probability of occurrence is denoted by 1 and 2 . As there are only two states, simplifying assumption, utility function can be written as: 

U = (C1 , C2 , 1 , 2 ) the above function gives the function of expected or average value of consumption, where C is consumption and  indicate probability. The expected utility can take following form U = 1 v (C1 ) + 2 v (C2 ) If s 1 occurs, then 2 will be zero and U = v (C1 ) and If s 2 occurs then 1 will be zero and U = v (C2 )