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Wednesday, March 07, 2007

Mangled Utility Economics

From security expert Bruce Schneier:
" * Alternative A: A sure gain of $500.
" * Alternative B: A 50% chance of gaining $1,000.

"The other group was given the choice of:
" * Alternative C: A sure loss of $500.
" * Alternative D: A 50% chance of losing $1,000.

"These two trade-offs aren't the same, but they're very similar. And traditional economics predicts that the difference doesn't make a difference.

"Traditional economics is based on something called "utility theory," which predicts that people make trade-offs based on a straightforward calculation of relative gains and losses. Alternatives A and B have the same expected utility: +$500. And alternatives C and D have the same expected utility: -$500. Utility theory predicts that people choose alternatives A and C with the same probability and alternatives B and D with the same probability. Basically, some people prefer sure things and others prefer to take chances. The fact that one is gains and the other is losses doesn't affect the mathematics, and therefore shouldn't affect the results.

"But experimental results contradict this. When faced with a gain, most people (84%) chose Alternative A (the sure gain) of $500 over Alternative B (the risky gain). But when faced with a loss, most people (70%) chose Alternative D (the risky loss) over Alternative C (the sure loss)...

"The authors of this study explained this difference by developing something called "prospect theory." Unlike utility theory, prospect theory recognizes that people have subjective values for gains and losses..."

This is no "traditional economics" with which I'm familiar! Neoclassical economics:
1) Does not hold that utility is measurable;
2) Recognizes that valuation is subjective;
3) Certainly never does anything so crude as equate utility with dollars in such a straightforward manner; and
4) Recognizes that different units of the same good certainly do not have the same value placed on them.

Where did this bizarre interpretation of utility theory come from?

4 comments:

  1. Yeah this guy doesn't seem to know what he's talking about. I remember doing a problem for homework in grad school my first year, and it was something like, "Show that for a concave utility function over wealth, a person would always be willing to take an actuarially advantageous bet at a small enough size of the wager."

    Note that it's 11:30 pm right now so I might be getting something wrong. But the point is, the magnitude of the bet clearly matters, even in baseline mainstream models. I don't think the standard models imply the type of "consistency" this author believes.

    On the other hand, I know that sharp neoclassicals think that prospect theory explains experimental results that the standard models can't, so probably this author is just motivating it a little inaccurately.

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  2. Well this guys is also an security expert and a cryptographer, not an economist.

    If he is wrong, just point it out to him.

    ReplyDelete
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