Puzzles and Paradoxes: The Consistent Role of Ambiguity Aversion

By

Fred Viole
OVVO Financial Systems
fred.viole@gmail.com

And

David Nawrocki
Villanova University
Villanova School of Business
800 Lancaster Avenue
Villanova, PA 19085 USA
610-519-4323
david.nawrocki@villanova.edu
 Puzzles and Paradoxes: The Consistent Role of Ambiguity Aversion

Abstract

Historical puzzles and paradoxes have been accepted by practitioners and researchers as evidence of
irrationality on the part of the individual. However, when classifying these anomalies into similar
structural ambiguities we note the consistency of individuals' distaste for ambiguity. Asymmetrical
payout structures offer compensation for accepting some level of ambiguity. When viewed through the
lens of ambiguity aversion, the individual's actions are quite rational.
“Ah, people asking questions lost in confusion
Well I tell them there's no problem, only solutions...”
John Lennon

I. Introduction

When examining historical paradoxes and deviations from expected utility theory, we find the
commonality of ambiguity aversion. Ambiguity aversion can and does exist autonomously from loss-
aversion. Daniel Ellsberg (1961) offers a definition,

“Ambiguity is a subjective variable, but it should be possible to identify ‘objectively’

some situations likely to present high ambiguity, by noting situations where available
information is scanty or obviously unreliable or highly conflicting; or where expressed
expectations of different individuals differ wildly; or where expressed confidence in
estimates tends to be low.”

When comparing similar expected values of different gambles, we can isolate the ambiguity aversion in
reaction to structural uncertainties via the premiums to expected values offered. People who purchase
lottery tickets and insurance policies for instance, have clearly come to some loss acceptance level. In
the relatively precisely defined expected values of lottery and insurance endeavors, the individual
realizes they will not likely win the lottery nor collect on the insurance policy. However, the
asymmetry of the payoff compensates for this loss acceptance. For lotteries, it is the opportunity to
catapult themselves to a greater level of wealth and eclipse their Personal Consumption Satiation (PCS)
point identified in Viole and Nawrocki (2011a, 2013). With insurance, it is the “break-even effect” of a
zero return analyzed in Viole and Nawrocki (2013). Both outcomes are positive utility generators for
the individual.

This paper aims to classify historical paradoxes and puzzles into categories based on various
certainty in defining probabilities and expected values. When properly contextualized, the paradoxes
and puzzles are consistent with individual preferences to avoid ambiguity.

II. HISTORICAL PARADOXES

a. St. Petersburg Paradox

The St. Petersburg Paradox is a lottery with an infinite expected value payoff. The paradox
stems from individuals' reluctance to offer an amount of money commensurate with an infinite
expected value. From Camerer (2005),

“Consider the classic St. Petersburg gamble: A fair memoryless coin is flipped until a
“heads” turns up. If the head is flipped on the n-th trial, the gamble pays $2n. The
gamble therefore pays $2 with probability .5 (a head comes up right away), $4 with
probability .25 (a tail, then the fateful head), $8 with probability .125, and so on. The
expected value of the gamble is 1+1+1+.., repeated infinitely, so its expected value is
infinite. But when asked how much they would pay to buy such a gamble, people
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 routinely report sums around $20. (As Hacking (1980) wrote, "few of us would pay
even $25 to enter such a game."). Bernoulli concluded from this (based on
introspection) that the infinite sum of expected utilities of money outcomes could be
finite—and reconcilable with a low buying price—if utility was sufficiently concave
(i.e., u’’(x)<0).”

b. Ellsberg Paradox

Another example of individuals exhibiting ambiguity aversion is when uncertainty is compared

in alternative choices. The paradox is as follows as presented in Chow and Sarin (2001):

There are two bags, labeled as Bag A and Bag B on the table. Bag A is filled with
exactly 50 yellow balls and 50 white balls. Bag B is filled with 100 balls that are yellow
and white but you do not know their relative proportion.

Bag A Bag B
50 yellow balls ? yellow balls
50 white balls ? white balls
100 total balls 100 total balls

First, you are to guess a color (white or yellow). Next, without looking, you are to draw
a ball from either Bag A or Bag B. If you draw the ball matching the color you guessed,
then you will win $100; otherwise you win nothing. What is the smallest amount of
money that you would accept rather than play this game with Bag A? with Bag B?

The paradox arises from individuals’ preference to bet on the outcome of Bag A rather than Bag B due
to Bag B’s unknown proportion of yellow and white balls.

Andrew Lo, in an interesting recorded lecture, informally recreates the paradox with his audience,
noting the reluctance to pay for a gamble due to the uncertainty injected into the second set of
gambles.1

c. Allais' Paradox

Allais' (1953) paradox was the first violation of expected utility theory documented. The
paradox involves a participant accepting less than expected value for alternative choices containing a
certain outcome. When no certain alternative is presented, individuals maximize the expected value.
The paradox is as follows:

EXPERIMENT 1 (Most participants choose A)

SITUATION A SITUATION B
$1m with certainty 89% chance of $1m; 10% chance of $5m; 1% chance of nothing

1.00U($1 M) > 0.89U($1 M) + 0.01U($0 M) + 0.1U($5 M)

1 http://mitworld.mit.edu/video/794
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EXPERIMENT 2 (Most participants choose B)
SITUATION A SITUATION B
89% chance of nothing; 11%chance of $1m 90% chance of nothing; 10% chance of $5m

1.00U($1 M) < 0.89U($1 M) + 0.01U($0 M) + 0.1U($5 M)

d. Equity Premium Puzzle

The Equity Premium Puzzle is a manifestation of Allais' paradox. It was introduced in 1985 by
Mehra and Prescott in order to describe investor behavior creating the premium of equities to their
certain alternative, US Treasuries. When ambiguity aversion is properly compensated for in the overall
loss-aversion coefficient α, the equity premium puzzle and corresponding risk free rate puzzle as
presented in Mehra and Prescott (1985) is solved. Viole and Nawrocki (2011b) offer supporting
evidence to Fisher Black's (1981) solution with Allais' paradox; and Mankiw and Zeldes' (1991)
solution via Deal or No Deal evidence originally described in Post et al. (2008).

e. Insurance and Lotteries

Individuals' behavior to participate in both insurance and lotteries has confounded economists
for decades. The acts are thought to represent the opposite spectrum of risk aversion and simultaneous
participation, inexplicable. However, when deconstructed, insurance and lotteries are both highly
defined asymmetrical outcome events individuals pay a premium to expected value for. Both outcomes
are also positive utility generators. Winning the lottery has an obvious positive utility connotation,
with the possibility of eclipsing the individual's PCS or upside target for aggregate wealth. The odds,
however remote, are clearly defined. This certainty of the odds supports the premium to expected
value for lotteries.

Insurance also represents a positive utility to the individual in the form of a break-even effect.
While calculating the probabilities of a natural disaster or some other exogenous event are not as
discrete as the lottery example, the asymmetrical payout structure for such an event is equally defined.
This certainty in payouts supports the premium to expected value for insurance policies.2

The additive nature of certainty may also help explain the popularity of derivatives, notably the
ability to satisfy the role of a lottery and insurance for an investor by defining specific payouts to
underlying positions.

f. Deal or No Deal

Post, van den Assem, Baltussen and Thaler (2008) analyze the contestant behavior in the game
show “Deal or No Deal” to illustrate the path-dependence nature of risky decisions under uncertainty.
The game is as follows:

2 CDS contracts which represent default insurance on an underlying debt obligation is the largest speculative market in the
world. The asymmetry of payouts is responsible for this, regardless of the negative event required for payment.
5|Page
 “The game show we use in this study, “Deal or No Deal”, has such desirable features that
it almost appears to be designed to be an economics experiment rather than a TV show.
Here is the essence of the game. A contestant is shown 26 briefcases which each contain
a hidden amount of money, ranging from €0.01 to €5,000,000 (in the Dutch edition). The
contestant picks one of the briefcases and then owns its unknown contents. Next, she
selects 6 of the other 25 briefcases to open. Each opened briefcase reveals one of the 26
prizes that are not in her own briefcase. The contestant is then presented a “bank offer” –
the opportunity to walk away with a sure amount of money – and asked the simple
question: “Deal or No Deal?” If she says “No Deal”, she has to open five more
briefcases, followed by a new bank offer. The game continues in this fashion until the
contestant either accepts a bank offer, or rejects all offers and receives the contents of her
own briefcase. The bank offers depend on the value of the unopened briefcases; if, for
example, the contestant opens high-value briefcases, the bank offer falls.

This game show seems well-suited for analyzing risky choice. The stakes are very high
and wide-ranging: contestants can go home as multimillionaires or practically empty-
handed. Unlike other game shows, “Deal or No Deal” involves only simple stop-go
decisions (“Deal” or “No Deal”) that require minimal skill, knowledge or strategy, and
the probability distribution is simple and known with near-certainty (the bank offers are
highly predictable, as discussed later). Finally, the game show involves multiple game
rounds, and consequently seems particularly interesting for analyzing path-dependence,
or the role of earlier outcomes.” Post et al. (2008).

Viole and Nawrocki (2011a) provide an expanded analysis of the Deal or No Deal data
presented by Post et al. (2008), supporting Allais' certainty equivalence observations.

“This discount to expected value within a solely positive utility (no losses involved) of
68.28% ($51,209 certain consumption divided by the expected value $75,000) Mankiw
and Zeldes (1991) identify is in the realm of the 76.3% bank offer accepted in the Dutch
version of Deal or No Deal, and clearly not off by an order of magnitude. Viewed
differently, the 4.8% certain consumption level Mankiw and Zeldes (1991) identify
($1,209 premium to the certain minimum divided by the expected value difference from
the certain minimum of $25,000) is also consistent with the percentages provided by Post
et al. (2008); where their path dependent model implied certainty coefficient for the
neutral group of Dutch contestants implies indifference at 3.2% of expected value for
large prizes.”

III. Possible Explanations for the St. Petersburg Paradox

a. Concavity – Logarithmic Utility Function

Bernoulli's solution: a concave utility function and thus a diminishing marginal utility of money,
is not a practical solution to the St. Petersburg Paradox.3 Viole and Nawrocki (2011a, 2013) identify a

3 Markowitz (1952) notes, “To avoid the famous St. Petersburg Paradox, or its generalization by Cramer, I assume that the utility function is bounded
from above. For analogous reasons I assume it to be bounded from below.”
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twofold concave-convex utility for gains based on Markowitz Stochastic Dominance reverse-S utility
curves (Levy and Levy (2002)) more aptly noticed with philanthropy and other intangible utilities
associated with money. The difference in utility between $1 billion and $100 billion in wealth is not a
fraction of a util as Bernoulli would contend in his St. Petersburg Paradox solution. The risk averse
logarithmic utility function has some desirable qualities such as preventing all in gambles when $0
terminal wealth is a remote possibility. However, generalized concavity as a means of defining loss-
aversion is a blunt construct. The desirable downside protections are easily rectified in alternative
utility functions with the concave loss section having a steeper curve than the corresponding convexity
of gains.

b. Multiple Prize Lotteries

The discrete lottery odds and insurance policies payoffs is lacking in the St. Petersburg Paradox,
rendering the infinite expected value meaningless.

“A statistical fact is that if you pay $20, the most likely outcome is that a head will come
up quickly and you’ll lose money net of the price you paid (with probability
.5+.25+.125+.0625=.9375; you have only a 7% chance of winning, though of course if
you win, you might win big).” Camerer (2005).

Upon further inspection, the St. Petersburg Paradox appears to be a multiple prize lottery which
Markowitz notes (1952) and offers a proof against (2010); whereby expected utility maximizers would
not willingly engage. Appendix A offers an expanded explanation regarding agent assumptions.

c. Overweighting of Small Probabilities

The field of behavioral finance has come into existence in order to explain these anomalies with
expected utility theory. Cumulative prospect theory as presented by Kahneman and Tversky (1992)
suggests the overweighting of small probabilities as a reason for these observed behaviors...

“a nonlinear transformation of the probability scale, which overweights small

probabilities and underweights moderate and high probabilities. In an important later
development (Quiggin, 1982; Schmeidler, 1989; Yaari, 1987; Weymark, 1981) have
advanced a new representation, called the rank-dependent or the cumulative functional,
that transforms cumulative rather than individual probabilities. This article presents a
new version of prospect theory that incorporates the cumulative functional and extends
the theory to uncertain as well as risky prospects with any number of outcomes.”

Shouldn't the overweighting of small probabilities, such as lottery participation or insuring an asset,
lead to larger sums offered to play the lottery or St. Petersburg Paradox?

There is a 0.000000512% chance of winning the average powerball jackpot of $141 million.4,5 There is
a 0.000000745% chance of winning $134 million (227) playing the St. Petersburg Paradox. There is a

4 http://www.powerball.com/powerball/pb_prizes.asp
5 http://www.powerball.com/pb_contact.asp
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45% greater chance to win a similar amount with the St. Petersburg Paradox.

“In the evaluation of uncertainty, there are two natural boundaries – certainty and
impossibility – that correspond to the endpoints of the certainty scale. Diminishing
sensitivity entails that the impact of a given change in probability diminishes with its
distance from the boundary. For example, an increase of .1 in the probability of
winning a given prize has more impact when it changes the probability of winning from
.9 to 1.0 or from 0 to .1, than when it changes the probability of winning from .3 to .4
or from .6 to .7. Diminishing sensitivity, therefore, gives rise to a weighting function
that is concave near 0 and convex near 1. For uncertain prospects, this principle yields
subadditivity for very unlikely events and superadditivity near certainty. However, the
function is not well-behaved near the endpoints, and very small probabilities can be
either greatly overweighted or neglected altogether.” Kahneman and Tversky (1992)6

The aforementioned odds would “certainly” be considered impossible, the lower endpoint mentioned.
So either individuals who offer the $20 to play the St. Petersburg Paradox are overweighting the 45%
greater odds or are neglecting them altogether (offering simultaneous inverse explanations seems to be
an effective hedge against the unknown). Perhaps the individual's ambiguity aversion is playing a
prominent part in this decision of uncertainty. Viole and Nawrocki (2011b) illustrate that those
questioned by Allais exhibit a loss-aversion 39 times the certain alternative. There is a certainty when
playing the St. Petersburg Paradox that the jackpot, however weighted, is solely the contestant's.
Multiple winners negates that certainty with the lottery, thus somewhat lessening the vaulted certain
status as with its probabilities. This premium for similar statistical gambles is consistent with the
ambiguity aversion noted with Allais' subjects and completely inconsistent with the findings originally
presented in prospect theory.

Is the overweighting of small probabilities referred to by Kahneman and Tversky relevant in this
instance? Not likely. Problem 8 presented in prospect theory asks if the respondent would prefer a
0.1% chance of 6000 else nothing; or a 0.2% chance of 3000 else nothing.

“In Problem 8, there is a possibility of winning, although the probabilities of winning are
miniscule (.002 and .001) in both prospects. In this situation where winning is possible
but not probable, most people choose the prospect that offers the larger gain. Similar
results have been reported by MacCrimmon and Larson (1979).” Kahneman and Tversky
(1979)

This does not bode well for the above reference of subadditivity for very unlikely events (such as the
lottery or SPP), and would likely be defended with “endpoints are neglected” in this instance. This
violation of the violation of expected utility theory argues for the consideration that, perhaps, prospect
theory in not a sufficient autonomous explanation of decisions under uncertainty.

d. Sum over Histories

One glaring question remains, why only $20 for an infinite expected value, why not $100,
$1000, etc? Sum over histories and the inability to view the game as a whole may prevent the

6
Emphasis ours.
8|Page
individual from being able to properly compute an expected value for the St. Petersburg Paradox and
other multiple prize lotteries. The myopic view of each outcome may be at fault, diminishing from the
additive nature of the outcomes.

“A striking fact about the loss-aversion in our savings experiment is that each subject
made 29 periodic consumption decisions, over 7 lifetimes. So their earnings were
determined by 203 different piecemeal decisions. They could easily afford to absorb
point losses on many decisions and still end up ahead. The fact that they are reluctant to
do so (judging from Figure 1) means they are not only loss-averse (on an arbitrary
utility scale)—they are myopically loss-averse to each of about 200 separate periods.”
Camerer (2005).

Viole and Nawrocki (2011a) normatively present a sum over histories path-dependent utility model
whereby local investment utilities are aggregated into a total wealth function. This supports the
myopic findings of Camerer as well as the observation by Markowitz (2010) “It does not violate the
expected-utility hypothesis to assume that an agent's utility function changes with time.”

Furthermore, if the agent is myopic to the extent illustrated, then they likely have placed a
subjective finite positive benchmark on the gamble at the time of deciding to play the St. Petersburg
gamble. This subjective expected value may factor into their offering of a specific amount as
postulated in the next section.

e. Behavioral

If we work under the assumption that an individual must reach an equilibrium in order to
engage in a wager, then this axiom would be represented by equation 1,

𝐸(𝑥)
𝑃𝑀𝑇𝑥𝑚𝑎𝑥 = (1)
𝛼

where 𝑃𝑀𝑇𝑥𝑚𝑎𝑥 is the maximum payment for a gamble x, 𝐸(𝑥) is the expected value of the gamble, and
𝛼 is the overall risk aversion coefficient. However, risk is not solely loss aversion and Ellsberg (1961)
identifies ambiguity as an autonomous variable per our introductory quote. Ellsberg (1961) then offers
a decision rule compensating ambiguity,

[𝜌. 𝑦 0 + (1 − 𝜌)𝑦𝑥𝑚𝑖𝑛 ](𝑥) (2)

where 𝜌 is the degree of confidence, 𝑦 0 is the estimated probability vector, 𝑦𝑥𝑚𝑖𝑛 the probability vector
in 𝑌0 corresponding to minx for action x and (X) is the vector of payoffs for action x. (𝑌0, 𝑦0, X and 𝜌
are all subjective data to be inferred by an observer or supplied by the individual, depending on
whether the criterion is being used descriptively or for convenient decision-making).

Using Ellsberg’s definition of a situation of high ambiguity,

“Let us imagine a situation in which so many of the probability judgments an individual

can bring to bear upon a particular problem are either “vague” or “unsure” that his
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 confidence in a particular assignment of probabilities, as opposed to some other of a set
of “reasonable” distributions, is very low. We may define this as a situation of high
ambiguity.”

and factoring the subjective nature of ambiguity we can redefine α as

(1+𝜎20 )
𝜆 𝑦
𝛼=( ) (3)
𝜌

where λ is the loss-aversion parameter, 𝜌 is the degree of confidence, and 𝜎𝑦20 is the variance of the
estimated probability vector.

We can now demonstrate the effects of ambiguity on the equilibrium an individual must achieve in
order to participate in the gamble.

𝜌↓ → 𝛼 ↑ → 𝐸(𝑥)↑ 𝑜𝑟 𝑃𝑀𝑇𝑥𝑚𝑎𝑥 ↓

𝜌↑ → 𝛼 ↓ → 𝐸(𝑥)↓ 𝑜𝑟 𝑃𝑀𝑇𝑥𝑚𝑎𝑥 ↑

Then the effects of the variance of the estimated probability vector (𝜎𝑦20 ),

𝜎𝑦20 ↓ → 𝛼 ↓ → 𝐸(𝑥)↓ 𝑜𝑟 𝑃𝑀𝑇𝑥𝑚𝑎𝑥 ↑

𝜎𝑦20 ↑ → 𝛼 ↑ → 𝐸(𝑥)↑ 𝑜𝑟 𝑃𝑀𝑇𝑥𝑚𝑎𝑥 ↓

Alternatively, we can see the isolated effects of loss-aversion on the equilibrium equation:

𝜆↓ → 𝛼 ↓ → 𝐸(𝑥)↓ 𝑜𝑟 𝑃𝑀𝑇𝑥𝑚𝑎𝑥 ↑

𝜆↑ → 𝛼 ↑ → 𝐸(𝑥)↑ 𝑜𝑟 𝑃𝑀𝑇𝑥𝑚𝑎𝑥 ↓

10 | P a g e
 IV. Conclusions

When categorizing paradoxes and puzzles into payment versus expected value or accepted
payment versus expected value, we note the consistency of ambiguity aversion. Individuals are
consistently rational on their asymmetrical payout structures as a compensation for various
uncertainties. Ellsberg (1961) also notes the rational behavior of such actions,

“It would seem incautious to rule peremptorily that the people in question should not
allow their perception of ambiguity, their unease with their best estimates of probability,
to influence their decision: or to assert that the manner in which they respond to it is
against their long-run interest and that they would be in some sense better off if they
should go against their deep felt preferences. If their rationale for their decision behavior
is not uniquely compelling (and recent discussions with T. Schelling have raised
questions in my mind about it), neither, it seems to me, are the counterarguments.
Indeed, it seems out of the question to summarily judge their behavior as irrational: I am
included among them.”

Offering a Discount to Expected Value

Ellsberg Paradox (Low 𝜌)
St. Petersburg Paradox (Low 𝜌, Undefined 𝜎𝑦20 )

Accepting a Discount to Expected Value

Allais' Paradox (Certain Alternative)
Equity Premium Puzzle (Certain Alternative)
Deal or No Deal (Certain Alternative)

Offering a Premium to Expected Value

Lotteries (High 𝜌)
Insurance (High 𝜌)

Anecdotally, we are witnessing these paradoxes being manifested into tangible current observations.
The current housing crisis has enjoined uncertainty into the homeowner's expected value calculations.
Those homeowners currently underwater are paying a premium to the current value of their home.
This is inconsistent with the noted asymmetry individuals demand for various uncertainties.

“The couple spoke with financial advisers and considered a strategic default.
"It's not about not having money," says Shelby, a purchasing manager for a shoe
company. "It's about not throwing money away."
In the end, they opted for a short sale, an agreement with a lender to sell the house for
less than what is owed.”7

7 http://www.usatoday.com/money/economy/housing/2010-03-25-underwater25_ST_N.htm
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 "Strategic default can be a financially sophisticated thing to do," said Mark Fleming,
chief economist for CoreLogic, the financial analytics company. "And it makes sense
that more financially savvy people do it. They may treat their mortgages like they
would their investment portfolios -- in a financially ruthless manner."8

According to historical paradox and puzzle analysis, what is required to pay a premium to expected
value (increased 𝑃𝑀𝑇𝑥𝑚𝑎𝑥 versus a static (𝑥)) ? A decreased 𝛼 via certainty in the probabilities (an
increased 𝜌 – lotteries and insurance) of a highly asymmetrical payout - of which the current housing
market fails to offer.

8 http://money.cnn.com/2011/06/07/real_estate/walk_away_mortgage/index.htm
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References

Black, F. (1981) Private communication with R.Mehra (2006).

Camerer, C. (2005). “Three Cheers – Phychological, Theoretical, Empirical – for Loss Aversion.”
Journal of Marketing Research, 42 (2). 129 – 133.

Chow, C.C., and Sarin, R.K. (2001). “Comparitive Ignorance and the Ellsberg Paradox.” The Journal
of Risk and Uncertainty, 22:2, 129-139.

Cramer, G. (1728). http://en.wikipedia.org/wiki/Gabriel_Cramer

Ellsberg, D. (1961). “Risk, Ambiguity, and the Savage Axioms.” Quarterly Journal of Economics, 75
(4), 643-669.

Hacking, I. (1980). “Strange Expectations.” Philosophy of Science 47, 562-567.

Kahneman, D., and Tversky, A., (1992). “Advances in Prospect Theory: Cumulative Representation of
Uncertainty.” Journal of Risk and Uncertainty, 5:297 – 323.

Levy M., and Levy H. (2002). “Prospect Theory: Much Ado About Nothing?” Management Science,
v48(10), 1334-1349.

MacCrimmon, K. R., and Larsson, S., (1979). “Utility Theory: Axioms versus Paradoxes.” In M.
Allais and O. Hagen (eds.), Expected Utility Hypotheses and the Allais Paradox, Boston, Reidel.

Mankiw, N. Gregory, and Zeldes, S.P. (1991). “The Consumption of Stockholders and
Nonstockholders.” Journal of Financial Economics, 29, 97-112.

Markowitz, H. (1952). “The Utility of Wealth.” Journal of Political Economy, 60, 151-158.

Markowitz, H. (2010). “Portfolio Theory as I see it Still.” Annual Review of Financial Economics,
V2, 1-41.

Mehra, R. (2006). "The Equity Premium Puzzle: A Review", Foundations and Trends in Finance, Vol.
2, No. 1, 1-81.

Mehra, R., and E.C. Prescott. (1985). “The Equity Premium: A Puzzle.” Journal of Monetary
Economics, vol. 15, no. 2, (March):145–161.

Post, T., Van den Assem, M., Baltussen, G., and Thaler, R. (2008). “Deal or No Deal? Decision Making
under Risk in a Large-Payoff Game Show.” American Economic Review, March 2008, (98:1), 38-71.

Quiggin, J. (1982). “A Theory of Anticipated Utility.” Journal of Economic Behavior and

Organization, 3, 323-343.

Schmeidler, D. (1989). “Subjective Probability and Expected Utility without Additivity.”

Econometrica, 57, 571-587.
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Viole, Fred, and Nawrocki David, (2011a). “The Utility of Wealth in an Upper and Lower Partial
Moment Fabric.” Journal of Investing, Summer 2011, Vol. 20, No. 2, 58-85.

Viole, Fred, and Nawrocki David, (2011b). “The Equity Premium Puzzle: Defining a Robust Risk
Aversion Coefficient.” Working Paper.

Viole, Fred, and Nawrocki David, (2013). “An Analysis of Heterogeneous Utility Benchmarks in A
Zero Return Environment.” Forthcoming, International Review of Financial Analysis.

Weymark, J.A. (1981). “Generalized Gini Inequality Indices.” Mathematical Social Sciences, 1, 409-
430.

Yaari, M.E. (1987). “The Dual Theory of Choice Under Risk.” Econometrica, 55, 95-115.

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Appendix A – Multiple Prize Lotteries

From Markowitz (1952),

Even now we are aware of one class of commonly observed phenomena which seems
inconsistent with the hypothesis introduced in this paper, as well as the hypothesis which
this one was intended to supersede. The existence of multiple lottery prizes may
contradict the theory presented. If we are forced to concede that the individual (lottery-
ticket) buyer prefers, say, a fair multiple prize lottery to say all other fair lotteries, then
my hypothesis cannot explain this fact. Nor can any other hypothesis considered in this
paper explain a preference for different sized lottery prizes. Nor can any hypothesis
which assumes that people maximize expected utility. Even now we must seek
hypotheses which explain what our current hypotheses explain, avoid the contradictions
with observation to which they are subject, and perhaps explain still other phenomena.

From Markowitz (2010), one of two proofs against multiple-prize lotteries.

Theorem 1
Suppose that an agent can design its own “gamble” by choosing probabilities

𝑝1 , 𝑝2 , … , 𝑝n that the gamble will have dollar outcomes 𝑑1 , 𝑑2 , … , 𝑑n . His choice is

subject to two constraints: (a) the 𝑝𝑖 must be probabilities, therefore

∑ 𝑝𝑖 = 1 (16a)
𝑖=1

𝑝𝑖 ≥ 0 𝑖 = 1, … , 𝑛 (16b)
and (b) the game has a given expected loss or gain, i.e.,

∑ 𝑝𝑖 𝑑𝑖 = 𝑘 (17)
𝑖=1

In particular, if 𝑘 = 0, then the lottery is required to be a “fair” game. Define a “possible

outcome” of the lottery as a 𝑑𝑖 with 𝑝𝑖 > 0 If the decision maker maximizes expected

utility

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 𝑛

𝐸𝑈 = ∑ 𝑝𝑖 𝑢𝑖 (18)
𝑖=1

for some given utility vector 𝑢1 , 𝑢2 , … , 𝑢n then the agent will never prefer a gamble with

three or more possible outcomes to all gambles with only one or two possible outcomes.

Proof
The maximization of the linear function, Equation 18, subject to the two linear

constraints, Equations 16a and 17, in nonnegative variables, Constraints 16b. This is a

2  n linear programming problem. Dantzig’s (1963) simplex algorithm is based on a

theorem concerning any 𝑚 𝑥 𝑛 linear program to the effect that if an optimum solution

exists then one exists with 𝑋𝑖 = 0 for 𝑛 − 𝑚 variables. (One or more of the m “basis”

variables of the solution may also be zero “accidentally.”) For our 2 𝑥 𝑛 linear program,

the fact that the constraint set is closed and bounded implies that an optimum solution

exists; therefore, an optimum solution exists with all but one or two of the 𝑝𝑖 equal to

zero. QED

Markowitz's proof does indeed note ambiguity aversion. If we look at equation 16a, his assumption is
that the sum of the probabilities from 𝑖 = 1, … , 𝑛 equal 1. That is not possible under the St. Petersburg
gamble. The cumulative probability approaches 1 but never reaches it under the infinitely iterated
game. Table 1 illustrates the cumulative probability for the St. Petersburg gamble with probability 0.5n
for n=30.

16 | P a g e
 Table 1. Cumulative probabilities for the St. Petersburg Paradox

N= Cumulative Probabilty
1 0.50000000000000000000
2 0.75000000000000000000
3 0.87500000000000000000
4 0.93750000000000000000
5 0.96875000000000000000
6 0.98437500000000000000
7 0.99218750000000000000
8 0.99609375000000000000
9 0.99804687500000000000
10 0.99902343750000000000
11 0.99951171875000000000
12 0.99975585937500000000
13 0.99987792968750000000
14 0.99993896484375000000
15 0.99996948242187500000
16 0.99998474121093800000
17 0.99999237060546900000
18 0.99999618530273400000
19 0.99999809265136700000
20 0.99999904632568400000
21 0.99999952316284200000
22 0.99999976158142100000
23 0.99999988079071000000
24 0.99999994039535500000
25 0.99999997019767800000
26 0.99999998509883900000
27 0.99999999254941900000
28 0.99999999627471000000
29 0.99999999813735500000
30 0.99999999906867700000

This constraint that the sum of probabilities equal 1 addresses individual's distaste for ambiguity. The
St. Petersburg Paradox and other like gambles would fail Markowitz's agent's requirement and may
offer some insight as to why no substantial amount is offered to play such a game.

17 | P a g e