The Illusion of Irrationality
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.
|Date of creation:||06 Dec 2009|
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- 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.
- Harry Markowitz, 1952. "The Utility of Wealth," Journal of Political Economy, University of Chicago Press, vol. 60, pages 151-151.
- Kahneman, Daniel & Tversky, Amos, 1979.
"Prospect Theory: An Analysis of Decision under Risk,"
Econometric Society, vol. 47(2), pages 263-291, March.
- Amos Tversky & Daniel Kahneman, 1979. "Prospect Theory: An Analysis of Decision under Risk," Levine's Working Paper Archive 7656, David K. Levine.
- 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)
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