The Flaw of Averages: Why We Underestimate Risk in the Face of Uncertainty

CHAPTER 7

Mindle 1: Uncertainty Versus Risk

Do you skydive? Or perhaps, instead, you check your morning oatmeal for razor blades that slipped in at the factory? You probably don’t do both. The branch of economics known as UTILITY THEORY (our first Red Word), describes an individual’s willingness to incur risk in the quest for reward. I will use the name “risk attitude” instead and define it no further than to point out that we all have one and that it ranges from going for broke at one extreme, to covering our butts at the other.

The tension introduced during the popular TV game show, Deal or No Deal, is based on the contrasts between the risk attitudes of members of the audience and that of the live contestant. Imagine that you are the contestant. An idealized event on the show might go as follows. You are presented with two closed briefcases, each attended by an attractive model in a brief outfit. One case is known to contain $100, and the other is empty, but you don’t know which is which. You must choose a briefcase to remove from the game, thereby keeping the contents of the other. This provides a 50/50 chance of zero or $100, for an average outcome of $50.

Before you choose, the host makes you an offer: $30 in cash to walk away and leave both briefcases behind. Is it a deal or no deal? I expect many readers would go for the gamble and incur the risk of coming home emptyhanded for the 50/50 chance of winning $100. But suppose you were a penniless wino on skid row. Given the ...