Individual Rationality, Market Rationality, and Value Estimation

Abstract

Direct experimental tests of expected utility theory (EUT), in which subjects are asked to choose among alternative gambles or to make judgments as to their willingness-to-pay (WTP) and/or willingness-to-accept (WTA) payment for a gamble, have not been kind to EUT. As noted in the survey by Slovic and Lichtenstein (1983), the results of these interrogations are remarkably consistent in a wide variety of contexts and are robust under examinations designed to determine the effect of monetary incentives, experience, and other factors that might have accounted for the discrepancy between subject responses and the predictions of EUT. On the other hand, experimental studies of individual and market behavior based upon EUT models of market decision making have yielded results showing high consistency with the predictions of these models (see the references in Smith, 1982). Are individual revealed preferences in some market contexts more likely to be “rational” (consistent with EUT) than individual responses to choices among alternative prospects? Several studies designed to solicit WTP and WTA responses for a variety of goods have found a wide disparity between the “buying price” and “selling price” measures of individual value (see the study and the citations therein by Knetsch and Sinden, 1984; hereafter K-S).Values of WTA obtained in this way are frequently an order of magnitude greater than values of WTP although theoretically WTP and WTA “should” differ by no more than a presumed “small” income effect. These results should not be dismissed by economists on the grounds of poor subject motivation because the experiments include some (see those in K-S) that have carefully introduced actual monetary payments and cash compensations and have not relied on hypothetical choices.

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