Inconsistency in Risk Preferences: A Psychophysical Anomaly

There is a fundamental problem with the conceptualization of the individual agent in economics and public policy. At the heart of both domains is the notion that people should be able to make stable tradeoffs between different goods and quantities. For example, people might have to choose between the benefit gained investing money in a pension fund or in joining a gym to improve their health; or they may need to trade-off risk and return when choosing a pension fund. Should policy makers help people make the right choices when faced with such difficult decisions? More pertinently, policy makers themselves frequently need to arbitrate between dissimilar options. For example, a minister may be forced to decide to fund hospitals rather than schools, and in doing so trade-off the health and education level of the population. Recent theoretical and empirical work suggests, however, that people cannot make stable tradeoffs, i.e., independent of other available choice options or the context. This inability seems to reflect a basic property of human cognition that applies right across psychology, from the basic psychophysics of sound perception right through to highlevel cognitive processes in judgment and decision making. This cognitive limitation has implications for economics and public policy where it raises important questions for the central methodologies used to measure and derive human preferences. Popular methods like functional measurement (Anderson and Zalinski, 1988) and conjoint analysis (Louviere, 1988; Green and Srinivasan, 1990) measure tradeoffs by asking respondents for attractiveness ratings of options (e.g., policies) consisting of pairs of attributes (e.g., a reduction of x% in the annual risk of death for £y). Ratings of this sort are useful if the tradeoffs are independent of other available options (e.g., “rationally irrelevant” factors like the range of values on each attribute). If a change from 30 to 60 min is worth a change from £10 to £20, then this should be true regardless of whether the range of available monetary options is from £10 to £20 or from £1 to £200. Utility of each option should depend on its consequences, not on what other options are considered; yet, such independence is often not found (Baron, 1997).