Thursday, December 10, 2009

Economic Thinking

Even apparently irrational human choices can make sense in terms of our inner logic

Much economic thinking rests on the assumption that individuals know what they want and that they make rational decisions to achieve it. Such behavior requires that they be able to rank the possible outcomes of their actions, also known as putting a value on things.

The value of a decision’s outcome is often not the same as its nominal dollar value. Say you are offered a fair bet: you have the same chance of doubling your $1 wager as you have of losing it. Purely rational individuals would be indifferent to the choice between playing or not playing: if they play such a bet every day, on average they will be no better or no worse off. But as Captain Kirk might tell Mr. Spock, reality often trumps logic. Or as Swiss mathematician Gabriel Cramer wrote in a 1728 letter to his colleague Nicolas Bernoulli, “The mathematicians estimate money in proportion to its quantity, and men of good sense in proportion to the usage that they may make of it.” Indeed, many people are “risk-averse”: they will forfeit their chance of winning $1 to be guaranteed of keeping the $1 they have, especially if it is their only one. They assign more value to the outcome of not playing than to the outcome of potentially losing. A risk-oriented person, on the other hand, will go for the thrill.

Cramer’s idea was later formalized by Bernoulli’s statistician cousin Daniel into the concept of expected utility, which is an implicit value given to the possible outcomes of a decision, as revealed by comparing them with the outcomes of a bet. Risk-averse and risk-oriented persons are not irrational; rather they make rational decisions based on their own expected utility.

Economists generally assume that most people are rational most of the time, meaning that they know which decisions will maximize the expected utility of their choices. (Of course, doing so requires knowing how to evaluate risk wisely, which people do not always do well. AIG, anyone?) Some experiments, however, have shown that people are occasionally unable to rank outcomes in a consistent way. In 1953 American mathematician Kenneth May conducted an experiment in which college students were asked to evaluate three hypothetical marriage candidates, each of whom excelled in a different quality. The students picked intelligence over looks, looks over wealth and wealth over intelligence.

Source of Information : Scientific American September 2009

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