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The Illusion of Irrationality

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  • Kontek, Krzysztof

Abstract

This short paper shows that the Allais Paradox and the Common Ratio Effect regarded as classic examples of the violation of the Expected Utility Theory Axioms – may be easily explained by assuming that changes in wealth (i.e. gains and losses) are perceived in relative terms. The preference reversal observed in experiments is therefore predictable and the choices shall consequently be assumed to be rational. By contrast, the assumption that wealth changes are perceived in absolute terms leads to the conclusion that the choices violate the axioms underlying Expected Utility Theory, and are therefore irrational. This state of affairs is called the illusion of irrationality.

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File URL: http://mpra.ub.uni-muenchen.de/19044/
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Bibliographic Info

Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 19044.

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Date of creation: 06 Dec 2009
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Handle: RePEc:pra:mprapa:19044

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Keywords: Expected Utility Theory; Relative Utility Function; Allais Paradox; Common Ratio Effect; Prospect Theory;

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  1. Kahneman, Daniel & Tversky, Amos, 1979. "Prospect Theory: An Analysis of Decision under Risk," Econometrica, Econometric Society, vol. 47(2), pages 263-91, March.
  2. Harry Markowitz, 1952. "The Utility of Wealth," Journal of Political Economy, University of Chicago Press, vol. 60, pages 151.
  3. Tversky, Amos & Kahneman, Daniel, 1992. " Advances in Prospect Theory: Cumulative Representation of Uncertainty," Journal of Risk and Uncertainty, Springer, vol. 5(4), pages 297-323, October.
  4. Kontek, Krzysztof, 2009. "Absolute vs. Relative Notion of Wealth Changes," MPRA Paper 17336, University Library of Munich, Germany.
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