Abstract

http://ssrn.com/abstract=1924547
 
 

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Perceived Repeated Risk and the Allais Paradox


Kenneth C. Lichtendahl Jr.


University of Virginia - Darden School of Business

Yael Grushka-Cockayne


University of Virginia - Darden School of Business

September 8, 2011

Darden Business School Working Paper No. 1924547

Abstract:     
Empirical evidence on the common ratio effect, a version of the Allais paradox, indicates that people are nonlinearly sensitive to probabilities. The leading explanation of this effect is prospect theory and its nonlinear weights applied to probabilities. We propose an alternative explanation: expected utility under the perception that one-shot risks will be repeated. We follow a stream of literature which suggests that evolutionary forces have shaped human tendencies to choose actions which are adapted to recurrent situations. We show that expected utility under perceived repeated risk can explain the common ratio effect and give rise to nonlinear sensitivity to probabilities. We provide several classes of utilities that can satisfy conditions that are necessary and sufficient for the existence of a common ratio effect. These utility functions have context-dependent inflection points: a zero inflection point that resets itself in each choice frame and other non-zero inflection points around which an individual is increasingly absolute risk averse. We argue that such inflection points may arise from frequent social comparison of the outcomes from one-shot risks.

Number of Pages in PDF File: 27

Keywords: expected utility theory, prospect theory, common ratio effect, nonlinear sensitivity to probabilities

JEL Classification: A10, D81

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Date posted: September 9, 2011  

Suggested Citation

Lichtendahl, Kenneth C. and Grushka-Cockayne, Yael, Perceived Repeated Risk and the Allais Paradox (September 8, 2011). Darden Business School Working Paper No. 1924547. Available at SSRN: http://ssrn.com/abstract=1924547 or http://dx.doi.org/10.2139/ssrn.1924547

Contact Information

Kenneth C. Lichtendahl Jr. (Contact Author)
University of Virginia - Darden School of Business ( email )
P.O. Box 6550
Charlottesville, VA 22906-6550
United States
Yael Grushka-Cockayne
University of Virginia (UVA) - Darden School of Business ( email )
P.O. Box 6550
Charlottesville, VA 22906-6550
United States
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