Examine the allais paradox and disappointment aversion

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Assignment:

In this problem, we will examine the Allais Paradox and disappointment aversion. Consider the following two decision problems A and B between lotteries p = (p1, P1; p2, P2; . . . ; pk, Pk), with probability pi for prize Pi, where

A: L1 = (1, 10000) vs. L2 = (.89, 40000; .1, 10000; .01, 0)

B: L3 = (.11, 10000; .89, 0) vs. L4 = (.10, 40000; .9, 0)

In lab experiments, subjects frequently choose L1 in problem A and L4 in problem B. See Kahneman and Tversky (1979)

(a) Show that the expected utility framework cannot accommodate choices observed in the lab. Which of the EU axioms is violated? Hint: L1 ? L2 implies something about L3 and L4.

(b) Show that the disappointment aversion framework by Gul (1991) accommodates the observed choices with the disappointment parameter β. Hint: What can you infer about the disappointment split from the choice in A?

Reference no: EM133611638

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