Utility: Theories and Models

Abstract

The aim of this study is to look at utility theory from a broad perspective. The main hypothesis in the theory of decision is that the person who is in the position of deciding is entitled to the “economic man.” Also, the individual acts rationally. Thus, utility is the ability to satisfy (eliminate) human needs of goods and services. Utility is basically a psychological concept and also is the basis of economics and finance. Three types of utility take place in the economics and finance literature: marginal utility, total utility, and average utility. In addition, two main approaches fall within utility comparison: cardinal utility theory and ordinal utility theory. Furthermore, expected utility theory forms the basis of traditional finance. Expected benefit theory assumes that people choose risky or uncertain opportunities by comparing the expected benefits from them. Allais and Ellsberg paradoxes criticize expected utility theory. Tversky and Kahneman (Econometrica, 47: 263–291, 1979) present that the expected utility axioms are violated for more reasonable lottery alternatives than in the Allais paradox and put a link between finance and psychology. The prospect theory of Tversky and Kahneman forms the basis of behavioral finance