The Illusion of Irrationality

5 Pages Posted: 8 Dec 2009

Date Written: December 6, 2009

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.

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

JEL Classification: C91, D03, D81, D87

Suggested Citation

Kontek, Krzysztof, The Illusion of Irrationality (December 6, 2009). Available at SSRN: https://ssrn.com/abstract=1519496 or http://dx.doi.org/10.2139/ssrn.1519496

Krzysztof Kontek (Contact Author)

Warsaw School of Economics (SGH) ( email )

aleja Niepodleglosci 162
PL-Warsaw, 02-554
Poland

Register to save articles to
your library

Register

Paper statistics

Downloads
96
Abstract Views
527
rank
268,927
PlumX Metrics