An economics term, exponential utility comes from the utility function theory. Utility function is typically a measure of consumer satisfaction with a purchase; the consumption of goods and services are an essential part of this function. Exponential utility adds risk to the equation, looking to define how consumers will avoid risk. This utility theory often falls under decision analysis techniques. In this process, consumers look to avoid risk altogether for major purchases or decide to pay a premium in order to select an option with less risk.
Utility maximization is a guide that defines the use of scarce resources. For example, a consumer only has a limited amount of income. He or she must use income, however, on multiple items in order to maintain a standard of living. With money as a scarce resource, each purchase must maximize the utility — or use — derived from each item purchased. While utility analysis is a common consideration of economists, exponential utility theory adds the assumption of risk to purchasing.
Most consumers are risk adverse, meaning they prefer options that offer maximum utility without the potential for wasted resources. The exponential utility formula describes this relationship. The addition of a positive constant to the formula indicates the degree of risk aversion from consumers. It is difficult to determine an average consumer degree of risk aversion because consumers are often individual in their economic choices. Taking information about a group as a whole, however, can help economists translate standard group figures to the average individual, using the homo economicus model.
It is usually impossible to avoid all risk in an economic transaction or in an economy. Therefore, consumers may have the ability to pay a premium for avoiding risk. In finance and economic terms, a premium represents additional money paid for an item. The higher price means lower risk is present while maintaining the expected utility. Essentially, exponential utility simply adds another piece to standard economic utility functions.
Typically, decision analysis is a process individuals go through when making major purchases, including investments. Businesses can also use the exponential utility formula for the same reasons: utility maximization from consumption or investments. Investments such as stocks often carry risk, and decision analysis is necessary to find the greatest financial return on the lowest cost. Using economic formulas such as the exponential utility function allow for a quantitative analysis process.
