The Allais Paradox and Misunderstanding Probability and Randomness

June 4, 2011

The Allais Paradox:

Suppose you are given two gambles to choose from, 1A and 1B:

1A: 1 million with 100% certainty
1B: 89% chance of 1 million, 1% chance of nothing, and 10% chance of 5 million

Later, you are given two more gambles to choose from, this time 2A and 2B:

2A: 1 million with 11% probability, nothing with 89% probability
2B: 5 million with 10% probability, nothing with 90% probability.

Which combination do you choose? The “paradox” is not logical but rather just highlights a quirk in human reasoning. Most people, for some reason, choose the combination 1A-2B. I can see why. I really have to fight the inner urge not to, but this is completely inconsistent.

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