Expected Utility Theory and Allais Paradox

Module 2:Topic 3
Dr Sana Moid, ABSL

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 Session Outcome
• To understand and develop an understanding about the concept of
Expected Utility Theory.

• To identify and understand the meaning and applicability of Allais Paradox

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 Expected Utility Theory

• What is Expected Utility?

• Expected utility is an economic term summarizing the utility that an

entity or aggregate economy is expected to reach under any number of
circumstances. The expected utility is calculated by taking the weighted
average of all possible outcomes under certain circumstances, with the
weights being assigned by the likelihood, or probability, that any particular
event will occur.

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• Expected value

• Expected value is the probability-weighted average of a mathematical outcome.

• For example,
• A lottery ticket costs $20.
• The probability of winning the $2000 prize is 0.5%
• The likely value from having a lottery ticket will be the outcome x probability of the
event occurring.
• Therefore, expected value = 0.005 x 2000 = $10
• The expected value of owning a lottery ticket is $10. With an infinite number of
events, on average, this is the likely payout. Of course, we may be lucky or maybe
unlucky if we play only once.
• Since the ticket costs $20, it seems an illogical decision to buy – because the
expected value of buying a ticket is $10 – a smaller figure than the cost of
purchase $20.

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• Limitations of Expected Utility Theory

• The Allais Paradox – Fanning Out

• Maximizing Expected Utility is Impossible

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 Paradoxes

• Paradox in economics is the situation where the variables fail to follow the
generally laid principles and assumptions of the theory and behave in an
opposite fashion.

• Paradoxes are very common in economics. A few of them are Giffen's

Paradox, Leontief's Paradox and Paradox of Thrift.

• The demand curve of any commodity is generally downward sloping, but

Giffen's Paradox suggests that under certain situations Giffen goods have
an upward sloping demand curve.

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 The Allais Paradox

• The Allais paradox is a choice problem designed by Maurice Allais (1953)

to show an inconsistency of actual observed choices with the predictions
of expected utility theory.

• The Allais paradox arises when comparing participants' choices in two

different experiments, each of which consists of a choice between two
gambles, A and B. The payoffs for each gamble in each experiment are as:

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• When presented with a choice between 1A and 1B, most people would
choose 1A. Likewise, when presented with a choice between 2A and 2B,
most people would choose 2B. Allais further asserted that it was
reasonable to choose 1A alone or 2B alone.

• However, that the same person (who chose 1A alone or 2B alone) would
choose both 1A and 2B together is inconsistent with expected utility
theory. According to expected utility theory, the person should choose
either 1A and 2A or 1B and 2B.

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• The inconsistency stems from the fact that in expected utility theory,
equal outcomes (eg. $1 million for all gambles) added to each of the two
choices should have no effect on the relative desirability of one gamble
over the other; equal outcomes should "cancel out". In each experiment
the two gambles give the same outcome 89% of the time (starting from
the top row and moving down, both 1A and 1B give an outcome of $1
million with 89% probability, and both 2A and 2B give an outcome of
nothing with 89% probability). If this 89% ‘common consequence’ is
disregarded, then in each experiment the choice between gambles will be
the same – 11% chance of $1 million versus 10% chance of $5 million.

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• After re-writing the payoffs, and disregarding the 89% chance of
winning — equalising the outcome — then 1B is left offering a 1% chance
of winning nothing and a 10% chance of winning $5 million, while 2B is
also left offering a 1% chance of winning nothing and a 10% chance of
winning $5 million. Hence, choice 1B and 2B can be seen as the same
choice. In the same manner, 1A and 2A can also be seen as the same
choice, i.e

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• The main point Allais wished to make is that the independence axiom of expected utility
theory may not be a valid axiom. The independence axiom states that two identical outcomes
within a gamble should be treated as irrelevant to the analysis of the gamble as a whole.
However, this overlooks the notion of complementarities, the fact your choice in one part of a
gamble may depend on the possible outcome in the other part of the gamble. In the above
choice, 1B, there is a 1% chance of getting nothing. However, this 1% chance of getting
nothing also carries with it a great sense of disappointment if you were to pick that gamble
and lose, knowing you could have won with 100% certainty if you had chosen 1A. This feeling
of disappointment, however, is contingent on the outcome in the other portion of the gamble
(i.e. the feeling of certainty). Hence, Allais argues that it is not possible to evaluate portions
of gambles or choices independently of the other choices presented, as the independence
axiom requires, and thus is a poor judge of our rational action (1B cannot be valued
independently of 1A as the independence or sure thing principle requires of us).

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 Summary
• Conventional Financial Theory does not account for all situations that
happen in the real world.

• As a wise investor one should try to exploit the stock market anomalies
and make profit out of that.

• It dosen’t mean that conventional theory is not valuable but addition of

Behavioral Finance can further clarify how market works

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 Suggested Readings and References

• http://finance.wharton.upenn.edu/~keim/research/
NewPalgraveAnomalies(May302006).pdf

• https://www.nber.org/papers/w9512.pdf

• https://www.nber.org/papers/w4369.pdf

• https://www.jstor.org/preview-page/10.2307/222535?seq=1

• https://escholarship.org/content/qt731230f8/qt731230f8.pdf

• http://www.econ.yale.edu/~shiller/behfin/2000-05/ikenberry.pdf

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• https://www.jstor.org/stable/2526866?seq=1

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