The Economics Book

194

I

n 1944, the US mathematician

John von Neumann and the

German-born economist Oskar

Morgenstern developed expected

utility theory to describe how people

make decisions under conditions of

uncertainty. “Utility” is a measure

of satisfaction, and economists use

units of utility to talk about the

amount of satisfaction gained from

various outcomes. The theory

assumes that people are rational

when faced with choices in which

there are no guaranteed outcomes:

they weigh the utility gained from

each possible outcome by the

probability that it will occur, then

choose the option that promises the

greatest utility. The model uses a

mathematical approach to decision

making, and has been used to

analyze all sorts of economic

behavior in situations of uncertainty.

However, in 1953, French economist

Individuals are

assumed to be rational

decision-makers.

But observed

behavior contradicts this.

People sometimes change

their preferences when

common alternatives

are added.

In theory they choose

only on the basis of the

probability and

desirability of

separate outcomes.

People are influenced by

irrelevant alternatives.

IN CONTEXT

FOCUS

Decision making

KEY THINKER

Maurice Allais (1911–2010)

BEFORE

1944 John von Neumann and

Oskar Morgenstern publish

A Theory of Games and

Co-operative Behavior, laying

the foundations for expected

utility theory.

1954 US mathematician

L. J. Savage shows how people

calculate the probabilities of

uncertain events.

AFTER

1979 Daniel Kahneman

and Amos Tversky explain

some discrepancies between

psychological experiments and

the claims of economic theory.

From 1980s Behavioral

economics is established,

integrating psychology with

the mathematical techniques

of economics.

PEOPLE ARE

INFLUENCED

BY IRRELEVANT

ALTERNATIVES

IRRATIONAL DECISION MAKING