Sunday, October 24, 2010

Lessons from Allais Paradox - making right choices

DeLong refers us to a summary of the Allais paradox and its relationship to the 2002 Economics Nobel.

The bottom line is that humans fear losses more than they love gains. This leads to consistently illogical personal and business decisions. The 'rational economic animal' is an illusion.

Among other things, this explains we dislike recognizing sunk costs (see resolution 242). To recognize a sunk cost is to recognize loss.

How should we use this knowledge about the way our minds work?

First of all we should formally express the potential losses and gains of significant decisions, and recognize that our emotions will lead to consistently inferior economic choices.

Secondly we can also use this knowledge to bias decisions others make. For example:
... When asked whether they would choose surgery in a hypothetical medical emergency, twice as many people opted to go under the knife when the chance of survival was given as 80 percent than when the chance of death was given as 20 percent...
If you want a certain decision made, give the probability of the gain, not the probability of the loss.

Surprisingly, however, we may still want to make the "wrong" choice. We are not, after all, creatures of pure reason. If our goal is happiness, we will be happier if we experience fewer losses at the cost of smaller gains -- because that's the way we are built. The "right" choice depends on whether the goal of the decision is our personal happiness or economic success or maximal lifespan.

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