Wednesday, March 17, 2010

The Allais Paradox

The more I think about this statement the more it makes me laugh...

Shachar Kariv: "I just wonder what is really going through people's heads when they are given these choices in an experiment. My mother would start crying."

(For the non-economists who might wonder what the Allais paradox is, keep reading...)

Suppose you're given the choice between two lotteries:
Lottery A: Win $1 million for sure.
Lottery B: Win $1 million with 89% probability, $5 million with 10% probability, get nothing with 1% probability.

Most people will choose Lottery A.

Now suppose you're given the choice between the lotteries:
Lottery A': Get nothing with 89% probability, $1 million with 11% probability.
Lottery B': Get nothing with 90% probability, $5 million with 10% probability.

Most people will choose Lottery B'.

But, if you choose lottery A, you SHOULD choose lottery A' as well. The difference between the first choice and second choice is that an 89% probability of $1 is taken away from both choices. So the relative value does not change.

The point is that people overvalue certainty.