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Showing posts with label expected value. Show all posts
Showing posts with label expected value. Show all posts

6/27/14

Expected Value vs. Expected Utility, what is the difference?

11:53
Expected Value vs. Expected Utility, what is the difference?
This post highlights the differences between expected value and expected utility and demonstrates how the difference between the two is in how they are calculated. Expected value shows us the value that is to be expected from engaging in a lottery (or risky situation) where there are 2 or more possible outcomes. Likewise, Expected utility shows us the utility that is expected out of a lottery with two or more possibilities. Remember that utility shows the satisfaction or happiness derived from a good/service/money while value simply shows us the monetary value. That is why the two terms are measured differently and show us different things. The rest of this post will describe how to calculate expected value and expected utility and has solved examples demonstrating the importance of the difference between them.

A good rule of thumb is to read the problem, and identify all of the key information. You need to know 4 things:
1) what is the probability of outcome 1?
2) what is the monetary value of outcome 1?, these go into the first term of your equations.
3) what is the probability of outcome 2? This can either be stated explicitly in the problem, or calculated from the probability given for outcome 1.
4) what is the monetary value of outcome 2?, these go into the second term of your equations.

Equations: