The Allais Paradox refers to a classic hypothetical choice problem in behavioral economics that exposes human irrationality. Daniel Kahneman offered a simplified version of the puzzle in his seminal book, Thinking, Fast and Slow1:
Problem A: 61% chance to win $520,000 OR 63% chance to win $500,000
Problem B: 98% chance to win $520,000 OR 100% chance to win $500,000
If you haven’t already, take a moment to consider your own preferences for each problem… The majority of people choose the left-hand option for Problem A and the right-hand option for Problem B. As Kahneman put it: “If these were your preferences, you have just committed a logical sin and violated the rules of rational choice.” The irrationality stems from the willingness to take on an additional 2% risk in exchange for an extra $20,000 in potential winnings for one problem but not the other. Put differently, we are risk-seeking and choose the option with a greater expected value for Problem A but are risk-averse and choose the option with a lower expected value for Problem B, despite the possible outcomes being of equal value for both problems.