Loss Aversion and the Utility of Wealth Theory

Total Posts:  5
Joined  14-01-2012
17 January 2012 10:09

Daniel Kahneman, believes that Matthew Rabin, a behavioral economist, disproved all attempts to explain loss aversion by the utility of wealth theory. (DANIEL KAHNEMAN, THINKING, FAST AND SLOW 285-86 (Farrar, Strauss & Girroux 2010). For example, given the accepted premise that most people reject the following gamble:

50% chance to lose $100 and a 50% chance to win $200.

Rabin demonstrates, according to the utility of wealth, then an individual who rejects the gamble above would also reject the following gamble:

50% chance to lose $200 and a 50% chance to win $20,000.

Kahneman believes the results to be absurd on their face. Thus, he concludes that Rabin has conclusively disproved attempts to explain loss aversion by the utility of wealth.

However, Rabin’s demonstration assumes not only that the brain is capable of cognizing the future benefits of superfluous amounts of paper money; i.e. that it is translatable to future wants and needs, but, also, this realization can take precedence over an immediate loss that may deprive one of life-sustaining necessities. In summary, his assumption negates the environmental dictates that evolutionarily constrained the brain’s ability to: 1) accurately access the relationship between superfluous sums of money and necessity; and 2) to conjecture this relationship into the distant future.

The is unable to cognize the value of superfluous of paper money into necessities in the distant future; such an ability was unnecessary in our evolutionary forbearers whose existence was largely day to day –thus, it is largely devoid in us.

Perhaps a different hypothetical would better demonstrate the assumptions of Rabin’s attempt to disprove utility theory’s application to loss aversion. Take for example a culture whose primary dietary staple is apples; the following gamble is proposed:

50% chance to lose 40 apples and a 50% chance to gain 1,000 apples.

Our evolutionary dictated brains cannot cognize the utility of 1,000 apples over the loss of 40 apples. The loss of forty apples is tied to the hunger pangs of an empty stomach, worse yet it could result in starvation –hence why our brain created the more urgent impulse of hunger pangs versus higher brain development which could properly conjecture as to the future utility of a present superfluity of apples. The irony is if Rabin’s evolutionary forbearers did not operate under the self-same paradigm he attempts to disprove, he would most likely not be here today.

Increased superfluity of present necessity requires increased conjecture of future necessity which, thereby, decreases the conjectured value of the necessity. In other words:

? superfluity of present necessity ==> ? conjecture of value of future necessity ==> ? value of the necessity.

In conclusion, it is difficult to calculate the future utility of 1,000 apples or $20,000; especially when weighed against the possibility of an immediate loss of a necessity.