The Illusion of Irrationality

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

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
• 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 Decision-Making 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

References

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Kontek, K., (2009). Absolute vs Relative Notion of Wealth Changes. MPRA Paper http://mpra.ub.uni-muenchen.de/17336/, Available at SSRN: http://ssrn.com/abstract=1474229 .

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