12-03-2019, 12:39 AM

https://phys.org/news/2019-12-economic-t...hemes.html

Whether we decide to take out that insurance policy, buy Bitcoin, or switch jobs, many economic decisions boil down to a fundamental gamble about how to maximize our wealth over time. How we understand these decisions is the subject of a new perspective piece in Nature Physics that aims to correct a foundational mistake in economic theory.

According to author Ole Peters (London Mathematical Laboratory, Santa Fe Institute), people's real-world behavior often "deviates starkly" from what standard economic theory would recommend. Take the example of a simple coin toss: Most people would not gamble on a repeated coin toss where a heads would increase their net worth by 50%, but a tails would decrease it by 40%.

But early economists would have taken that gamble, at least in theory. In classical economics, the way to approach a decision is to consider all possible outcomes, then average across them. So the coin toss game seems worth playing because equal probability of a 50% gain and a 40% loss are no different from a 5% gain.

Why people don't choose to play the game, seemingly ignoring the opportunity to gain a steady 5%, has been explained psychologically— people, in the parlance of the field, are "risk averse". But according to Peters, these explanations don't really get to the root of the problem, which is that the classical "solution" lacks a fundamental understanding of the individual's unique trajectory over time.

Yeah, that doesn't sound like a very attractive game to me. Supposing I started with £100... then I got the median outcome of one heads and one tails. The first heads would put me up to £150, and then the tails would put me down to £90... so, the median outcome would result in a net loss of money. (Not to mention, the 'classical' solution of "averaging out the 50% gain and 40% loss" completely ignores utility... so, it never seemed to me like a very satisfactory solution to begin with )

Now, if it was a flat "£50 gain or £40 loss" on each turn, then I absolutely would play the heck out of that game... but somehow, I don't expect very many places would offer it !!!

Whether we decide to take out that insurance policy, buy Bitcoin, or switch jobs, many economic decisions boil down to a fundamental gamble about how to maximize our wealth over time. How we understand these decisions is the subject of a new perspective piece in Nature Physics that aims to correct a foundational mistake in economic theory.

According to author Ole Peters (London Mathematical Laboratory, Santa Fe Institute), people's real-world behavior often "deviates starkly" from what standard economic theory would recommend. Take the example of a simple coin toss: Most people would not gamble on a repeated coin toss where a heads would increase their net worth by 50%, but a tails would decrease it by 40%.

But early economists would have taken that gamble, at least in theory. In classical economics, the way to approach a decision is to consider all possible outcomes, then average across them. So the coin toss game seems worth playing because equal probability of a 50% gain and a 40% loss are no different from a 5% gain.

Why people don't choose to play the game, seemingly ignoring the opportunity to gain a steady 5%, has been explained psychologically— people, in the parlance of the field, are "risk averse". But according to Peters, these explanations don't really get to the root of the problem, which is that the classical "solution" lacks a fundamental understanding of the individual's unique trajectory over time.

Yeah, that doesn't sound like a very attractive game to me. Supposing I started with £100... then I got the median outcome of one heads and one tails. The first heads would put me up to £150, and then the tails would put me down to £90... so, the median outcome would result in a net loss of money. (Not to mention, the 'classical' solution of "averaging out the 50% gain and 40% loss" completely ignores utility... so, it never seemed to me like a very satisfactory solution to begin with )

Now, if it was a flat "£50 gain or £40 loss" on each turn, then I absolutely would play the heck out of that game... but somehow, I don't expect very many places would offer it !!!