Criticism
Expected utility theory is criticized by behavioral decision science. It argues that, whilst Bernoulli's paper was concise and brilliant, the theory is not perfect. For example, in 2000 behavioral economist Matthew Rabin proved mathematically that the utility of wealth cannot explain loss aversion and attempts to so use it will fail. Bernoulli's theory on the utility of wealth assumed that if two people have the same wealth all other things being equal the people should be equally happy. However, where two people have US$1m but one has just prior to that had US$2m but lost US$1m whereas the other had US$500 and had just gained US$999,500 they will not be equally happy. Bernoulli's theory thus lacked a reference point. Nevertheless it remained a dominant theory for over 250 years. Kahneman and Tversky in 1979 presented their prospect theory which showed empirically, among other things, how preferences of individuals are inconsistent among same choices, depending on how those choices are presented.
Like any mathematical model, expected utility theory is an abstraction and simplification of reality. The mathematical correctness of expected utility theory and the salience of its primitive concepts do not guarantee that expected utility theory is a reliable guide to human behavior or optimal practice.
The mathematical clarity of expected utility theory has helped scientists design experiments to test its adequacy, and to distinguish systematic departures from its predictions. This has led to the field of behavioral finance, which has produced deviations from expected utility theory to account for the empirical facts.
Read more about this topic: Expected Utility Hypothesis
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