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The Illusion of Irrationality

Author

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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.

Suggested Citation

  • Kontek, Krzysztof, 2009. "The Illusion of Irrationality," MPRA Paper 19044, University Library of Munich, Germany.
  • Handle: RePEc:pra:mprapa:19044
    as

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    File URL: https://mpra.ub.uni-muenchen.de/19044/1/MPRA_paper_19044.pdf
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    References listed on IDEAS

    as
    1. Kahneman, Daniel & Tversky, Amos, 1979. "Prospect Theory: An Analysis of Decision under Risk," Econometrica, Econometric Society, vol. 47(2), pages 263-291, March.
    2. 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.
    3. Harry Markowitz, 1952. "The Utility of Wealth," Journal of Political Economy, University of Chicago Press, vol. 60, pages 151-151.
    4. Kontek, Krzysztof, 2009. "Absolute vs. Relative Notion of Wealth Changes," MPRA Paper 17336, University Library of Munich, Germany.
    Full references (including those not matched with items on IDEAS)

    More about this item

    Keywords

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

    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

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