RSM341H1 Lecture Notes - Lecture 8: Allais Paradox, Ellsberg Paradox, Utility
Document Summary
Experimenter offers subject two experiments with 2 choices. Subject chooses one of the choices for both experiments. Choosing first choice in experiment 1 and second choice in experiment 2 violates expected utility theory. Allais paradox may be due to how choices are presented rather than true eu violation. Key feature: events on which acts depend have objective (frequentist) probabilities unknown to decision maker. If decision maker adopts hybrid view, then he should assign personal (subjective) probability to that event. if randomly drawn ball is red or yellow. if randomly drawn ball is black or yellow. Data shows most people choose 1 for first experiment and 2 for second experiment. Probabilities are often perceived in a distorted way. Consequences are ranked and reference point/status quo is determined. Extra utility from gain is smaller than utility from loss. First, every probability p gets distorted into pseudoprobability (p) Acts are ranks using eu with distorted probabilities for small p.
