Common Paradoxes in Decision-Making

• Option A: A 100% chance of winning 1 million, a 10% chance of winning 1 million and an 89% chance of winning nothing.
• Option D: A 10% chance of winning 2^1 = 2^2 = 2^3 = 2) + (1/4 * 8) + … EV = 1 + 100 feels more painful than the pleasure of gaining $100. This asymmetry in our response to gains and losses is a central pillar of the theory.

The Prospect Theory Value Function: Prospect theory is often visualized with a value function that is S-shaped. It’s steeper for losses than for gains, illustrating loss aversion. This function is also concave for gains (explaining risk aversion when dealing with gains) and convex for losses (explaining risk-seeking behavior when dealing with losses).

6. The Endowment Effect

The endowment effect is a bias where people place a disproportionately higher value on an item simply because they own it. This contradicts the Coase Theorem in economics, which suggests that in the absence of transaction costs, an item’s value should be independent of who owns it.

The Setup:

• Group 1 (Sellers): Given a coffee mug and asked the minimum price they would sell it for.
• Group 2 (Buyers): Not given a mug and asked the maximum price they would pay for it.

The Paradox: Studies consistently show that the sellers demand a much higher price for the mug than the buyers are willing to pay. The mere fact of owning the mug “endows” it with a higher perceived value. This is a direct consequence of loss aversion from prospect theory: the sellers see giving up the mug as a loss, which feels more significant than the buyers’ potential gain of acquiring it.

These concepts and biases, alongside the classic paradoxes, have profoundly influenced behavioral economics and finance.

They provide a more realistic and psychologically grounded understanding of how people make decisions, revealing that our choices are often shaped by cognitive shortcuts, emotions, and the way information is presented, rather than by pure, objective rationality.

Decision-making paradoxes are situations where an individual’s choices appear to be inconsistent or irrational when judged against the principles of classical economic theories, like expected utility theory.

These paradoxes highlight how human behavior often deviates from the predictions of traditional models, revealing the influence of cognitive biases and psychological factors.

Here are some of the most common paradoxes:

1. Allais Paradox

The Allais paradox demonstrates that people’s choices can violate the independence axiom of expected utility theory. This axiom suggests that if you add an identical outcome to two different lotteries, the preference between the two lotteries should not change. The paradox shows this isn’t always true, as people often place a disproportionately high value on a certain outcome, a phenomenon known as the certainty effect.

The Setup: Participants are presented with two pairs of choices.

• Choice 1:
  • Option A: A 100% chance of winning 1 million, a 10% chance of winning 1 million and an 89% chance of winning nothing.
  • Option D: A 10% chance of winning 2^1 = 2^2 = 2^3 = 2) + (1/4 * 8) + … EV = 1 + 100 feels more painful than the pleasure of gaining $100. This asymmetry in our response to gains and losses is a central pillar of the theory.

  The Prospect Theory Value Function: Prospect theory is often visualized with a value function that is S-shaped. It’s steeper for losses than for gains, illustrating loss aversion. This function is also concave for gains (explaining risk aversion when dealing with gains) and convex for losses (explaining risk-seeking behavior when dealing with losses).

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  6. The Endowment Effect

  The endowment effect is a bias where people place a disproportionately higher value on an item simply because they own it. This contradicts the Coase Theorem in economics, which suggests that in the absence of transaction costs, an item’s value should be independent of who owns it.

  The Setup:

  • Group 1 (Sellers): Given a coffee mug and asked the minimum price they would sell it for.
  • Group 2 (Buyers): Not given a mug and asked the maximum price they would pay for it.

  The Paradox: Studies consistently show that the sellers demand a much higher price for the mug than the buyers are willing to pay. The mere fact of owning the mug “endows” it with a higher perceived value. This is a direct consequence of loss aversion from prospect theory: the sellers see giving up the mug as a loss, which feels more significant than the buyers’ potential gain of acquiring it.

  These concepts and biases, alongside the classic paradoxes, have profoundly influenced behavioral economics and finance.

  They provide a more realistic and psychologically grounded understanding of how people make decisions, revealing that our choices are often shaped by cognitive shortcuts, emotions, and the way information is presented, rather than by pure, objective rationality.