Choice under Uncertainty; ‘Allais Paradox’ and its Paradoxical Implication

‘Allais Paradox’ and its Paradoxical Implication

Abstract

Human attitude towards risk is mixed. However, looking at the persuasive
argument of diminishing marginal utility of wealth, academia has adopted
risk aversion as the norm. Inculcating risk aversion, expected utility
hypothesis (EUH) is used to rank risky options. ‘Allais paradox’
contradicted EUH but promoted the conviction of risk aversion intuitively on
the basis of certainty effect. Most of the later studies also did not test risk
aversion in strict statistical terms. Consequently the confusion initiated by
‘Allais paradox’ persists. This research has investigated three possible
reasons for this paradoxical implication. One, Allais study put up such
option-pairs which were not testable for risk aversion statistically. Two, by
posing similar option-pairs, later researchers confirmed ‘Allais paradox’
and found even more systematic violations of EUH which further discredited
EUH as an analytical tool. However, a few of these studies tested risk
aversion directly. Three, analogy of the argument of diminishing utility of
wealth and law of diminishing utility of a commodity holds if probability
distributions in competing options are symmetric, otherwise it may or may
not hold. Since all options in Allais study had asymmetric distributions,
therefore violation of EUH should not have promoted the conviction of risk
aversion intuitively. To clear this confusion, this paper recommends
simultaneous testing of EUH and risk aversion and equal emphasis on the
certainty and the big amount effects which tilt human attitude towards risk
aversion and risk-seeking respectively