The Illusion of Irrationality

Krzysztof Kontek ()

MPRA Paper from University Library of Munich, Germany

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 (search for similar items in EconPapers)
JEL-codes: C91 D03 D81 D87 (search for similar items in EconPapers)
Date: 2009-12-06
New Economics Papers: this item is included in nep-evo, nep-neu and nep-upt
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Persistent link: https://EconPapers.repec.org/RePEc:pra:mprapa:19044

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