The Illusion of Irrationality
AbstractThis 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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Bibliographic InfoPaper provided by University Library of Munich, Germany in its series MPRA Paper with number 19044.
Date of creation: 06 Dec 2009
Date of revision:
Expected Utility Theory; Relative Utility Function; Allais Paradox; Common Ratio Effect; Prospect Theory;
Find related papers by JEL classification:
- D03 - Microeconomics - - General - - - Behavioral Microeconomics; Underlying Principles
- D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
- C91 - Mathematical and Quantitative Methods - - Design of Experiments - - - Laboratory, Individual Behavior
- D87 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Neuroeconomics
This paper has been announced in the following NEP Reports:
- NEP-ALL-2009-12-19 (All new papers)
- NEP-EVO-2009-12-19 (Evolutionary Economics)
- NEP-NEU-2009-12-19 (Neuroeconomics)
- NEP-UPT-2009-12-19 (Utility Models & Prospect Theory)
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
- Harry Markowitz, 1952. "The Utility of Wealth," Journal of Political Economy, University of Chicago Press, vol. 60, pages 151.
- Kontek, Krzysztof, 2009. "Absolute vs. Relative Notion of Wealth Changes," MPRA Paper 17336, University Library of Munich, Germany.
- Amos Tversky & Daniel Kahneman, 1979.
"Prospect Theory: An Analysis of Decision under Risk,"
Levine's Working Paper Archive
7656, David K. Levine.
- Kahneman, Daniel & Tversky, Amos, 1979. "Prospect Theory: An Analysis of Decision under Risk," Econometrica, Econometric Society, vol. 47(2), pages 263-91, March.
- 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.
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