Why expected utility theory is wrong

1 Mar, 2012 at 12:15 | Posted in Economics | 5 Comments

If a friend of yours offered you a gamble on the toss of a coin where you could lose €100 or win €200, would you accept it? Probably not. But if you were offered to make one hundred such bets, you would probably be willing to accept it, since most of us see that the aggregated gamble of one hundred 50–50 lose €100/gain €200 bets has an expected return of €5000 (and making our probabilistic calculations we find out that there is only a 0.04% risk of losing any money).

Unfortunately – at least if you want to adhere to the standard neoclassical expected utility maximization theory – you are then considered irrational! A neoclassical utility maximizer that rejects the single gamble should also reject the aggregate offer.

In Matthew Rabin’s and Richard Thaler’s modern classic Risk Aversion it is forcefully and convincingly shown that expected utility theory does not explain actual behaviour and choices.

What is still surprising, however, is that although the expected utility theory is obviously descriptively inadequate, colleagues and microeconomics textbook writers all over the world gladly continue to use it, as though its deficiencies were unknown or unheard of.

That cannot be the right attitude when facing scientific anomalies. When models are plainly wrong, you’d better replace them! Or as Rabin and Thaler have it:

It is time for economists to recognize that expected utility is an ex-hypothesis, so that we can concentrate our energies on the important task of developing better descriptive models of choice under uncertainty.