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The Allais paradox and its business application

The Allais paradox is a rather simple example of how people are different from the “rational man”, a foundation of  traditional economic theory. Consider two options:

Option A: A gamble that pays you $3500 with 33% probability, 3400 with 66% probability, or $0 with 1% probability.
Option B: A gamble that pays you $3400 for certain.

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Consider a second set of choices:

Option A2: A gamble that pays you $3500 with 33% probability or $0 with 67% probability.
Option B2: A gamble that pays you $3400 with 34% and $0 with 66% probability.

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If you are like the most people (and weren’t using a calculator) you would have chosen option B and option A2. But these two options are not consistent with each other! If you take a closer look, you can see that the second set of options is created by subtracting 3400 with 66% from the first set of options. If we subtract the same amount from both options why would it change your mind?

A “rational man” in this case would calculate an expected utility of each option by multiplying outcomes and their probabilities. The option with the highest expected utility would win. In our case these are options A and A2. But as can be seen in this example people don’t seem to use the expected utility as their decision model, they tend to gestimate and choose an option that “looks good”.

This tendency of choosing options that “look good” actually shows that people make irrational choices and serves as a foundation for the Prospect Theory. There is a lot of math involved. According to experimental results people tend to give more attention to small probabilities (like $0 with 1% probability) and give less weight to large probabilities (like $3400 with 66%). Further more people tend to like gains less than they hate losses, as such a game where you can win $101 dollar with a 50% chance and lose $100 with a 50% chance is not attractive to many.

So! How does this apply to business? Read about this next week!

Categories: Alex Tags: ,
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  1. September 20, 2012 at 11:48 pm

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