Perceived Repeated Risk and the Allais Paradox

27 Pages Posted: 9 Sep 2011

See all articles by Kenneth C. Lichtendahl

Kenneth C. Lichtendahl

University of Virginia - Darden School of Business

Yael Grushka-Cockayne

University of Virginia - Darden School of Business; Harvard University - Business School (HBS)

Date Written: September 8, 2011

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.

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

JEL Classification: A10, D81

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: https://ssrn.com/abstract=1924547 or http://dx.doi.org/10.2139/ssrn.1924547

Kenneth C. Lichtendahl (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 - Darden School of Business ( email )

P.O. Box 6550
Charlottesville, VA 22906-6550
United States

Harvard University - Business School (HBS) ( email )

Soldiers Field Road
Morgan 270C
Boston, MA 02163
United States

HOME PAGE: http://https://www.hbs.edu/faculty/Pages/profile.aspx?facId=263650

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