What do i choose? Gambling vs insurance: different decision models at stake

Before moving on to the analysis of the expected utility paradigm, there is another aspect that I would like to stress, that is, under which light what follows should be read. Confusion between positive and normative economics is somehow inevitable. Positive economics deals with ’what is’, not with ’what ought to be’, therefore it is in principle independent of any ethical position or normative judgments. Its task is to provide a system of generalizations that can be used to make correct predictions about the consequences of any change in circumstances and its performance has to be judged by the precision and conformity with experience of the predictions it yields.

Normative economics, on the other hand, cannot be independent of positive economics. Any policy conclusion necessarily rests on a prediction about the consequences of doing one thing rather than another, a prediction that must be based on positive economics.

In the end, the ultimate goal of a positive science is the development of a theory that yields valid and meaningful predictions about phenomena not yet observed. A theory asserts that certain forces are and others are not important in understanding a particular class of phenomena. This is so because, apart from being impossible, thinking of a theory which is entirely realistic is daunting. Hypotheses are important in that they are conceived for abstracting the common and crucial elements from the mass of complex and detailed circumstances surrounding the phenomena to be explained; this allows us to use these hypotheses, which embody the forces assumed to be important, to make predictions on the basis of them alone.

It should be clear, then, that claiming that a theory does not work because its assumptions are an inaccurate description of reality is not the right way of testing a theory. The relevant question is not whether the assumptions of a theory are realistic but whether they are a good approximation for the purpose. We have then to see whether a theory yields accurate predictions. In this sense, only factual evidence can show whether a theory is ’right’ or ’wrong’. It is also important to underline that factual evidence can never ’prove’ a theory; it can only fail to disprove it. It should be clear, then, that empirical evidence is vital at two different, though closely related, stages: in constructing theories and in testing their validity.

Thus, from this vantage point, the realism of the hypotheses is not important, what matters is whether the theory, in its capacity of an ’as if’ model, predicts behavior not used in the construction of the model. Therefore, it follows that, empirical findings of field studies and laboratory experiments are especially relevant.

I deem all this a very important and crucial point, which needs to be emphasized, over and over, in order to avoid misunderstanding. Indeed, confusion on the role of hypotheses have led many to suppose that hypotheses have not only implications but also assumptions, and that the conformity of these assumptions to reality is a test of the validity of the hypotheses, different from or additional to the test by implications. This widely held view is fundamentally wrong and productive of much mischief. Once again, the relevant question to ask about these alleged assumptions of a theory is not whether they are descriptively realistic, for they never are, but whether they are good approximations; and this question can be answered only by seeing whether the theory yields sufficiently accurate predictions.

In this new light, I claim that the expected utility theory do fails, but not because its assumptions are descriptively false, rather because it yields poor predictions.