Expected utility hypothesis

In economics, game theory, and decision theory the expected utility hypothesis is a hypothesis concerning people's preferences with regard to choices that have uncertain outcomes (gambles). This hypothesis states that if specific axioms are satisfied, the subjective value associated with an individual's gamble is the statistical expectation of that individual's valuations of the outcomes of that gamble. This hypothesis has proved useful to explain some popular choices that seem to contradict the expected value criterion (which takes into account only the sizes of the payouts and the probabilities of occurrence), such as occur in the contexts of gambling and insurance. Daniel Bernoulli initiated this hypothesis in 1738. Until the mid-twentieth century, the standard term for the expected utility was the moral expectation, contrasted with ""mathematical expectation"" for the expected value.The von Neumann–Morgenstern utility theorem provides necessary and sufficient conditions under which the expected utility hypothesis holds. From relatively early on, it was accepted that some of these conditions would be violated by real decision-makers in practice but that the conditions could be interpreted nonetheless as 'axioms' of rational choice. Work by Anand (1993) argues against this normative interpretation and shows that 'rationality' does not require transitivity, independence or completeness. This view is now referred to as the 'modern view' and Anand argues that despite the normative and evidential difficulties the general theory of decision-making based on expected utility is an insightful first order approximation that highlights some important fundamental principles of choice, even if it imposes conceptual and technical limits on analysis which need to be relaxed in real world settings where knowledge is less certain or preferences are more sophisticated.