Utility, Probability, and Human Decision-Making
B.M.S. van Praag
University of Amsterdam - Faculty of Economics and Business (FEB); IZA Institute of Labor Economics; Tinbergen Institute in Amsterdam; CESifo (Center for Economic Studies and Ifo Institute)
In this paper the consumer problem is considered as a decision problem. At first consumer behaviour is described by the usual standard model, well-known in economic theory.
The main criticism of this model is that it presumes a consumer acting rationally in the sense that he can choose simultaneously from a multitude of commodities, whereas ordinary intuition tells us that even the choice from a small set of alternatives is very difficult. Things are becoming even more difficult if goods available at different times are considered as different options, and when randomness is introduced in terms of 'contingent claims'. We call this the assumption of 'irrational rationality'. Things become more natural if the ordinal utility concept is replaced by a cardinal concept. This is introduced as a normed measure W on the service space of commodities Ω. Then it becomes possible to fragment consumer behaviour into several consecutive stages. At the first stage the consumer decides on how much is consumed and how much is saved, at the second stage a broad distribution is made over a few subgroups of expenditures, while in later stages money is gradually 'differentiated' up to the point where it is actually spend and transformed into purchases. If the consumer acts in this way, he most probably will reach a suboptimal solution when compared to the 'master plan' where everything is planned in one stroke. However, it is the more realistic description, since it is rational for the consumer to consider one decision at a time. We call this feature 'rational irrationality'. Probability and time preference are introduced by introducing new coordinate spaces. The Cartesian product of the state space S, the commodity space Ω and the time space T, with their corresponding marginal measures P, W, T, becomes the natural space to describe consumer behaviour.
Number of Pages in PDF File: 18
Date posted: May 17, 2006