The expected value from paying for insurance would be to lose out monetarily. Expected value is the probability-weighted average of a mathematical outcome. The expected utility theorem simply says that when a preference satisfies the vNM axioms, there exists a linear utility function that represents it. Of course we could also choose a dif-ferent form; any monotonic transformation of an expected utility function What matters is that such a function (which reflects an individual’s preferences over uncertain games) exists. The good news: Savage showed that if a decision maker’s preference relation on acts satisﬁes certain postulates, she is acting as if she has a probability on states and a utility on outcomes, and is maximizing expected utility. Marginal Utility Bernoulli argued that people should be maximizing expected utility not expected value u( x) is the expected utility of an amount Moreover, marginal utility should be decreasing The value of an additional dollar gets lower the more money you have For example u(\$0) = 0 u(\$499,999) = 10 u(\$1,000,000) = 16 Expected value. Expected utility, in decision theory, the expected value of an action to an agent, calculated by multiplying the value to the agent of each possible outcome of the action by the probability of that outcome occurring and then summing those numbers.The concept of expected utility is used to elucidate decisions made under conditions of risk. Specifying Risk-Aversion through a Utility function We seek a \valuation formula" for the amount we’d pay that: Increases one-to-one with the Mean of the outcome Decreases as the Variance of the outcome (i.e.. Risk) increases ... To maximize Expected Utility of Wealth W = W 1 (at time t = 1) • Moreover, Savage argues that his postulates are ones The expected utility can be transformed into a money-equivalent satisfaction measure, by mapping it back into the dimension of the performance through the inverse of the utility function. U : P → R. is an example of a standard utility function. Again, note that expected utility function is not unique, but several functions can model the preferences of the same individual over a given set of uncertain choices or games. The underlying u function is sometimes called a Bernoulli utility function or a von Neumann-Morgenstern utility function after the pioneers of this idea, and the overall expression above (4) is called expected utility … (functions from states to outcomes). von Neumann-Morgenstern utility function u : C → R. is not a standard utility function. Expected utility is a weighted average; to calculate it, multiply the utility of each possible outcome by the probability of that outcome actually taking place. expected utility function, or that the consumer's preferences have the ex-pected utility property, we mean that we can choose a utility function that has the additive form described above. So, if there is a 50% chance of making 10 US Dollars (USD) dollars and a 50% chance of making no money, the expected utility is \$5 USD. For example, suppose: (1) It is not hard to see that this is in fact the de ﬁning property of expected utility. The theorem does not say, in particular, that all linear utility function represents a preference that satisfies the axioms. evaluated by the mathematical expectation or expected value of this utility. \$\endgroup\$ – Herr K. May 15 '19 at 22:16 But, the possibility of large-scale losses could lead to a serious decline in utility because of the diminishing marginal utility of wealth. Expected utility function U : P → R. represents preferences t on P just like in Lectures 1—2. Crucially, an expected utility function is linear in the probabilities, meaning that: U(αp+(1−α)p0)=αU(p)+(1−α)U(p0).