Kontek, Krzysztof (2009): The Illusion of Irrationality.

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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.
Item Type:  MPRA Paper 

Original Title:  The Illusion of Irrationality 
Language:  English 
Keywords:  Expected Utility Theory, Relative Utility Function, Allais Paradox, Common Ratio Effect, Prospect Theory 
Subjects:  D  Microeconomics > D0  General > D03  Behavioral Microeconomics: Underlying Principles D  Microeconomics > D8  Information, Knowledge, and Uncertainty > D81  Criteria for DecisionMaking under Risk and Uncertainty C  Mathematical and Quantitative Methods > C9  Design of Experiments > C91  Laboratory, Individual Behavior D  Microeconomics > D8  Information, Knowledge, and Uncertainty > D87  Neuroeconomics 
Item ID:  19044 
Depositing User:  Krzysztof Kontek 
Date Deposited:  08. Dec 2009 07:09 
Last Modified:  08. Mar 2015 23:23 
References:  Allais, M., (1953). Le comportement de l’homme rationnel devant le risque: critique des postulats etaxiomes de l’école Américaine. Econometrica 21, pp 503546. Kahneman, D., Tversky, A., (1979). Prospect theory: An analysis of decisions under risk. Econometrica, 47, pp 313327. Kahneman, D., Tversky, A., (1984). Choices, Values, and Frames. American Psychologist, Vol. 39, No. 4, pp 341350. Kontek, K., (2009). Absolute vs Relative Notion of Wealth Changes. MPRA Paper http://mpra.ub.unimuenchen.de/17336/, Available at SSRN: http://ssrn.com/abstract=1474229 . Markowitz H., (1952A). The Utility of Wealth. Journal of Political Economy, Vol. 60, pp 151158. von Neumann J., Morgenstern O., (1944). Theory of Games and Economic Behavior, Princeton University Press. Tversky A., Kahneman D., (1992). Advances in Prospect Theory: Cumulative Representation of Uncertainty. Journal of Risk and Uncertainty, vol. 5(4), October, pp 297323. 
URI:  http://mpra.ub.unimuenchen.de/id/eprint/19044 