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.

Number of Pages in PDF File: 5

Keywords: Expected Utility Theory, Relative Utility Function, Allais Paradox, Common Ratio Effect, Prospect Theory

JEL Classification: C91, D03, D81, D87

working papers series