Are You Consistent? - Mad World

Let’s do an experiment to see whether your preferences comply with traditional economic theories. 

 

There are two choices to make; neither affects the other in any way.

Choice 1:

	Payoff	Probability of getting Payoff (if not get nothing)
A	£5,000	100%
B	£7,000	60%

Which would you prefer, A or B?

Choice 2:

	Payoff	Probability of getting Payoff (if not get nothing)
C	£5,000	25%
D	£7,000	15%

Which would you prefer, C or D?

People commonly choose A and D (I did this too). However, this is inconsistent with traditional economic assumptions about how people behave.

This is because we can easily ‘scale-down’ Choice 1 to make it Choice 2 without changing the relative probabilities. 100 and 60 divided by 4 equal 25 and 15, respectively. Given that Choice 1 and Choice 2 are the same in relative terms economists say that to choose A and D is inconsistent .

It is assumed that any common components of gambles are irrelevant for preferences over the gambles. This is called The Common Ratio Effect (after Mr Common Ratio, presumably).

An important area of Behavioural Economics is discovering where we don’t comply with traditional assumptions about economic agents. The hard bit is incorporating our little foibles into the rest of economics.

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Recommended listening:

Mad World by Gary Jules