Economics, 3rd Edition

Expected Utility Theory and Framing Effects

In our analysis of the SEM we noted that indifference curves implied that consumers can rank preferences 

from best to worst (or vice versa). This is referred to as 

expected utility theory

.

expected utility theory 

the idea that preferences can and will be ranked by buyers

Expected utility theory is important because consumers have to make decisions based on ranking pref-

erences on a regular basis. Imagine you are faced with buying your first car. You have limited income and so 

have to go to second-hand dealers. You are wary of the potential problems inherent in buying a second-hand 

car – you know that if the car develops a mechanical fault it often costs more to repair than to replace, so you 

go to the dealers with this in mind. You find two cars that you like and are faced with the following choice:

Choice (a)

 

●

Car X is priced at 

€500 and its age suggests that it has a 50 per cent chance of breaking down in the 

first year.

 

●

Car Y is priced at 

€900 but only has a 20 per cent chance of breaking down in the first year.

---

CHAPTER 5  BACKGROUND TO DEMAND: THE THEORY OF CONSUMER CHOICE  129

Which do you choose?

Expected utility theory says that consumers can rank the preference between these two options. We 

assumed that if the car breaks down it is more expensive to repair than to replace so our calculations are 

based on replacing the car rather than repairing it (we are talking rational human beings after all here). Look 

at the following choice:

The expected replacement cost of the first car would be the price we paid (

€500) × the probability of  

it breaking down (50 per cent) which works out as 

€500 × 0.50 = €250. The expected replacement cost  

of the second car is 0.2

× 900 = €180. The rational choice, therefore, would be to purchase the more 

expensive car. The problem is that the way in which such choices are presented can affect our judgements 

and the rational decision is violated.

Whilst expected utility theory has been a part of the SEM, research has suggested that there are 

also flaws in this model. Research into this area is extensive and persuasive. Essentially, choices can be 

affected by the way in which they are framed. Consider the choice below:

Choice (b)

 

●

Car T has an 80 per cent chance of losing 

€720 in a year’s time.

 

●

Car Z has a 50 per cent chance of losing 

€250 after a year.

Which would you now choose?

Choice option (b) is exactly the same as choice option (a) but just presented differently – it has been 

framed differently (the information relating to Car T is the same to that in Car Y in choice (a) and the inform-

ation relating to Car Z is the same to that in Car X in choice (a). The risks now appear different.

Firms are careful to frame the way they present products and information to consumers to try to influ-

ence purchasing decisions and exploit these differences in perception. For example, firms selling insur-

ance know that people make judgements about the extent to which they are exposed to risk in deciding 

whether to take out insurance and how much cover they need. Adverts and marketing, therefore, may be 

framed to give the impression to consumers that they face increased risk.