Home > Uncategorized > Expected utility theory — an ex-parrot

Expected utility theory — an ex-parrot

from Lars Syll

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? Many of us probably wouldn’t. 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 mainstream expected utility theory – you are then considered irrational! A mainstream utility maximizer that rejects the single gamble should also reject the aggregate offer.

Expected utility theory does not explain actual behaviour and choices. But still — although the theory is obviously descriptively inadequate — economists and microeconomics textbook writers 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 Matthew Rabin and Richard 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.

Yes indeed — expected utility theory is an ‘ex-hypothesis.’ Or as Monty Python has it:

ex-ParrotThis parrot is no more! He has ceased to be! ‘E’s expired and gone to meet ‘is maker! ‘E’s a stiff! Bereft of life, ‘e rests in peace! If you hadn’t nailed ‘im to the perch ‘e’d be pushing up the daisies! ‘Is metabolic processes are now ‘istory! ‘E’s off the twig! ‘E’s kicked the bucket, ‘e’s shuffled off ‘is mortal coil, run down the curtain and joined the bleedin’ choir invisible!! THIS IS AN EX-PARROT!!

An ex-parrot that transmogrifies truth shouldn’t just be marginally mended. It should be replaced!

  1. John Doyle
    September 21, 2020 at 5:54 am

    I was wondering how relevant the “Dunning – Kruger” effect is in economics? Do you have an opinion? It sure looks like it does. Then there’s the Peter Principle rampant in academia today.

  2. David Sinclair
    September 21, 2020 at 11:35 am

    Agree entirely, Lars!

    But it shouldn’t be a surprise. Much in orthodox/neoclassical economic theory (and its variants and descendants) relies on a distorted version of an “Idealist” approach to knowledge (but not really Kant, nor Hegel – both would groan…). Intended or not, it’s evident in Friedman’s 1950s essay on economic methodology – (the F-Twist, “assumptions don’t matter” essay), as well as in various defences of the “as if” assumption.

    The neoclassical theory, to paraphrase Friedman, is perfect and necessarily true, irrespective of, and unaffected by, empirical observation, which is necessarily imperfect and unreliable. Theory is projected onto “reality” and observations (which is part of what econometrics does). If empirical observation doesn’t confirm theory, it’s the observation which must be in error, not theory. “Facts” can’t disprove ideals or theory, but can only be accepted by economists if they support theory. Discrepancies can be assumed away because the ideal model assumptions aren’t open to testing. Thus says Milton…. Understanding this is essential to being an economist. If you are trained in the sciences it should be astonishing and worrying that neoclassical theory (and Friedman’s F-twist in particular, surely the nadir of what passes for thought in economics) continues to be taken seriously, when it is in the category of “not even wrong”.

    This is, of course, antithetical to the natural or social sciences, and one of key reasons that neoclassical economics (and its variants and descendants) is NOT and CANNOT be science. There is no ontologically or epistemologically plausible pathway from the sciences to orthodox economic theory, nor to the economic practice derived from it. The most that mainstream economists can do is attempt to co-opt science to prop up necrotic theory (which is what behavioural economics attempts to do). Removing market imperfections or ensuring symmetrical perfect information or nudging people towards economics’ bizarre concept of “rationality” can’t solve the problem of the disparity between theory and the actual economy in the real world.

    Ecological economics is one of the few areas in economics where science is taken seriously, but even there, many ecological economists I’ve met struggle with trying to reconcile what they’ve been taught with the biophysical and social sciences. It can’t be done.

  3. September 21, 2020 at 1:07 pm

    utility hypothesis doesn’t clarify real conduct and decisions. Yet at the same time — in spite of the fact that the hypothesis is clearly engagingly insufficient

  4. Grayce
    September 24, 2020 at 2:36 pm

    In Physics, this is where it says, “Assume a frictionless surface.”

  5. Ken Zimmerman
    October 11, 2020 at 5:30 pm

    Even a frictionless surface, a frictionless universe can be a useful assumption. We could in theory compute the magnitude and directions of certain vectors in this frictionless world which could in turn help us compute what friction might be involved and what its effects on the vectors might be. Building knowledge one small observation at a time. However, I am not certain this is what Friedman had in mind. He seems more interested in setting out assumptions but never confronting them with observational data of any sort. I can not see this work as being useful. I have read Friedman’s ‘Essays in Positive Economics’ and Paul Samuelson’s critiques. Nothing seems to fit for me. Am I missing something?

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