The value of an item must not be based on price, but rather on the utility it yields. ~ 18th-century Swiss mathematician and physicist Daniel Bernoulli
People purchase products for their benefits. Accordingly, a key concept in economics is utility: the satisfaction derived from consumption. More broadly, utility is a measure of preferences. Economists myopically consider utility to be revealed by people’s willingness to pay dissimilarly for different goods.
To consume a product or service is to make some use of it. In economics, consumption does not imply using something up, even as that often happens in the act.
The term expected value was coined in 1654 by Blaise Pascal after abstractly examining the probabilities of outcomes. Expected value is the anticipated utility of some specific consumption and is probabilistic; but people value things differently than indifferent mathematics can ascertain, and human decisions are not impartial. Probability applied to human utility is wonky.
Men of good sense value money in proportion to the usage they may make of it. ~ Gabriel Cramer
In the mid-18th century, Swiss mathematician Gabriel Cramer attributed limits to human appetite with the concept of a declining marginal utility. The appreciation of growing wealth is never zero, but beyond a threshold of want, each coin added to the pile means a bit less than the one before it.
One implication of a concave utility curve has to do with risk aversion: people prefer to receive a smaller but certain amount rather than gamble with the chance for a larger haul. This explains why investors expect a higher return for risky assets. It is worth noting that risk is entirely within the mind: a psychological attribution of probability with no statistical basis in actuality.
In the early 1950s, French economist Maurice Allais pointed out that utility theory does not always account for people’s behavior. Faced with lopsided choices, people do not necessarily make a rational decision (e.g., the certainty of $1 million versus the chance at either hundreds of millions or nothing at all). This is called the Allais paradox.
A few years later, American sociologist and economist Herbert Simon proposed that people, often unable to gather all relevant information and process it, do not try to maximize utility, but instead set modest goals of what would satisfy them.
In 1979, Israeli American psychologists Daniel Kahneman and Amos Tversky came out with prospect theory, which posits that people make decisions based on the potential of immediate loss or gain rather than a probabilistic final outcome. This explains the commonness of short-sightedness.
Insights from prospect theory include that losses hurt more than gains feel good (loss aversion); decisions depend upon how situations are framed (framing effect); and that probabilities are perceived to be smaller than they actually are, except for quite unlikely probabilities, or those considered certain, which are perceived as larger.
Further, certainty is not as desired as utility theory would have it. Instead, a sense of certainty increases aversion to loss as well as the desirability of gains.
Human heuristics have their own internal, emotively based logic, existing in a conceptual universe parallel to probability.
People often prefer insurance programs that offer limited coverage with low or zero deductible over comparable policies that offer higher maximal coverage with higher deductibles – contrary to risk aversion. Evidently, the intuitive notion of risk is not adequately captured by the assumed concavity of the utility function for wealth. ~ Daniel Kahneman & Amos Tversky
The experimental findings by which prospect theory was developed demonstrate that utility theory, based upon expected values, is inapt, as human rationality is biased.
Utility theory, as it is commonly interpreted and applied, is not an adequate descriptive model. ~ Daniel Kahneman & Amos Tversky