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Loss Aversion – The Certainty Equivalent

The Certainty Equivalent by Jared Dillian, Mauldin Economics

One of my students met me in my office the other day. He is a ROTC cadet; that’s Reserve Officer Training Corps, in case you don’t know.

He knows I have military experience, and he wanted to pick my brain about how he could use his MBA while working for the government.

“Uh, you can’t, really,” I said.

So he asks me, “Should I stay in the government or get out?”

At this point I drew him a graph.

The x-axis is your ability, competence, IQ, whatever. The y-axis is how much you get paid.

So the government path is indicated by the dashed line. If you’re very smart, you can get paid a little more, but generally everyone gets paid the same no matter how competent or incompetent they are. That’s the government.

But it’s a lot more than what you would get paid in the private sector—unless, unless you are one of those savants like Zuckerberg or the Google Inc (NASDAQ:GOOG) guys or even a smart businessman or talented trader, in which case you can make a lot more in the private sector than working for the government.

But for 9 out of 10 people, no, you should not work in the private sector. You should work for the government.

So I asked him, “Are you one out of those 10 people?”

He said, “I think I am going to keep working for the government.”

Decision Theory

If you’ve ever taken a decision theory class (I have, and it was awesome), this is the first thing you learn.

You have a 50/50 chance of winning $10,000. You have P = 0.5 of getting $10,000 and P = 0.5 of getting 0.

Or you can choose not to play the game and get $3,000.

What do you do?

The answer is: it depends on who you are and what your risk preferences are.

Rationally, the number to get you to walk away should be $5,000. But most people will walk away for less. Sometimes much less. Sometimes people will walk away for $500 or $1,000. After all, it’s money they didn’t have before.

Anyone who accepts...


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