A rational decision maker should always choose the option that maximizes their “interest”. If we could quantify individuals’ “interest” in a decision-making activity, we could use simple optimization methods like calculus to find the best decision. This is where utility theory comes into play.
We use the concept of “utility” to measure the “interest” of a decision. Utility is a measure of the satisfaction or benefit that an individual derives from consuming goods and services.
In this section, we first introduce the utility function, which is a mathematical representation of this concept, assigning a numerical value to each possible outcome based on the individual’s preferences. We then explore the implications of risk aversion and how it affects decision-making under uncertainty. Finally, we discuss stochastic dominance, a method for comparing different risky prospects.
The utility optimization is closely related to the pricing models in finance. Since the price of any asset could considered as the wealth allocation of the overall “market” (the combination of all rational investors). We could further utilize this concept in mean-variance portfolio optimization, and comsumption-based asset pricing models.