In economics, rational actors are assumed to maximise their utility. However, the fact that world is uncertain means that you can't always know what would maximise your utility, so this is instead amended to expected utility. This means: a rational actor makes the decision that on average produces the highest utility. Many people then take a step further and move from utility to money: rational individuals make decisions that maximise their expected worth.
This assumption also feeds through into a lot of financial modelling and optimisation. For example, valuations using methods such as dynamic programming typically assume that decision making maximises expected utility and nothing else.
But... does this make any sense? To see why it might not, consider what you would do if a billionaire offered you a choice. If you accept, he will flip fair coin. If it comes up heads, he will give you a million pounds, and if it comes up tails you will give him all your assets. Now let's consider the expected value here. If your assets have value A, and you take the bet, then your expected financial worth after the bet is:
0.5 x (A + 1,000,000) + 0.5 x 0 = 0.5 x A + 500,000
Obviously, if you don't take the bet then your assets will continue to be worth A. Therefore, the expected improvement in your financial position if you take the bet is:
(0.5 x A + 500,000) - A = 500,000 - 0.5 x A
So if your assets are worth less than 1,000,000 then you should take the bet if you are maximising your expected worth. What's more, the less your assets are worth, the stronger the expected benefit of the bet, and therefore the more "rational" it would be to take it as an maximiser of the expected.
But do people behave this way? And should they? This bet would mean, for a middle income home owner, that they have a 50% chance of becoming a millionaire, and a 50% chance of becoming a homeless pauper. I think a significant proportion of people would not risk becoming homeless even for the chance of becoming a millionaire. It has been demonstrated experimentally that people are strongly averse to losing what they have, even when there are significant rewards to taking the risk.
As to whether they should... well, despite the fact that many economists equate rational with maximising the mean, it does not seem irrational at all to decide not to risk homelessness. In fact, it seems pretty rational to protect your access to necessities before trying to get the nice-to-haves. But this kind of maximising the minimum, rather than the mean, behaviour is too often ignored.
Agricultural modernisation
The same phenomenon crops up in traditional agriculture. New high yield varieties of major crops have slowly spread through the world, but in traditional communities there was a lot of resistance to their use. Why? Don't those peasants want to improve their lives? Modern agricultural experts tended, I think, to see peasants in poor countries as backwards, since the new high yield varieties would make them more money.
But it is seeing yield from a commercial perspective that makes you miss why standardisation on high yield varieties was resisted. From the point of view of the subsistence peasant, the product of agriculture is not just food to sell, but survival into the next year. For this reason, an extremely high value was place on reliability, and the ability to reliably produce enough to survive. The natural consequence of this was:
1. to grow crops that could tolerate tough conditions and still produce something
2. to grow diverse crops so that if one failed there would be another source of food
In other words, the backwards peasant was making the perfectly rational decision to maximise the minimum yield instead of to maximise the average yield. Peasants and subsistence farmers are conservative because their system, while it might leave them hungry, at least minimises the risk of widespread starvation. Any change is risk, and risk is what they are trying to minimise.
The book below, which I would like to read from cover to cover one day, discusses some of these issues in more detail:
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| A book partially about how peasants maximise the minimum |
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