You are given a choice between lottery 1 and lottery 2. You are also given a choice between lottery 3 and lottery 4.
Lottery 1: |
A sure gain of $240 |
Lottery 2: |
25% chance to gain $1,000 and 75% chance to gain nothing |
Lottery 3: |
A sure loss of $750 |
Lottery 4: |
A 75% chance to lose $1,000 and a 25% chance of losing nothing |
84% of all people prefer lottery 1 over lottery 2, and 87% choose lottery 4 over lottery 3.
a Explain why the choice of lottery 1 over lottery 2 and lottery 4 over lottery 3 contradicts expected utility maximization. (Hint: Compare lottery 1 + lottery 4 to lottery 2 + lottery 3.)
b Can you explain this anomalous behavior?