The Allais paradox and expected utility theory

Diego F. Grijalva
January 17, 2019

1 Introduction
In class we discussed the Allais paradox and mentioned that only specific combina-
tions of choices are consistent with expected utility theory. The objective of this brief
document is to show that this is indeed the case.

2 Setup
The Allais paradox poses two choices, each one with two options as shown next:

• Choice 1:
Option A: 100% chance of winning USD 1 million
Option B: 10% chance of winning USD 5 million, 89% chance of winning USD 1
million and 1% chance of winning nothing

• Choice 2:
Option C: 11% chance of winning USD 1 million and 89% chance of winning
nothing
Option D: 10% chance of winning USD 5 million and 90% chance of winning
nothing

3 Results
The key result when Allais asked economists and statisticians to make a choice in each
one of these cases was that many of them chose A and D. We next show that these
decisions are inconsistent with expected utility theory.
Suppose that the individual has a utility function U (·) depending on the prize that
he gets. Thus for example the utility of getting USD 5 million is given by U (5). Then,
under expected utility theory the revealed preference A  B can be written as follows:

1
 U (1) > .1U (5) + .89U (1) + .01U (0) (1)
Without loss of generality we can further normalize U (0) = 0. After doing this and
collecting equal terms, equation (1) simplifies to:

U (1) > .1U (5) + .89U (1)

.11U (1) > .1U (5) (2)

Hence, choosing A implies that a consumer prefers USD 1 million with a probability
of 11% to USD 5 million with a probability of 10%. This already points at some
potential problems because this preference is not obvious for many people.
Consider next the choice of D over C. This can be written as:

.1U (5) + .90U (0) > .11U (1) + .89U (0) (3)
Again, normalizing U (0) = 0 equation (3) becomes:

.1U (5) > .11U (1) (4)

But this condition contradicts equation (2). The preference A  B thus implies
that C  D. As a consequence, an individual’s choice of A and D (or B and C) is
inconsistent with expected utility theory.