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IAI Actuarial Core Principles · Economic Modelling · Rational choice theory and utility

Which observation is most directly a challenge to expected utility theory's independence axiom, as shown by the Allais paradox?

The Allais paradox challenges the independence axiom because preferences between two gambles reverse when a common consequence is changed in both. No expected utility function can reproduce that switch, so it shows actual choices departing from expected utility theory.

  1. APeople's choices between two gambles change when a common consequence is added to both, in a way no expected utility function can fitCorrect
  2. BPeople prefer higher expected wealth to lower expected wealth
  3. CPeople prefer more wealth to less wealth
  4. DPeople are risk averse when the utility function is concave
  5. People rank certain outcomes consistently on a transitive basis

Explanation

The Allais paradox shows preferences switching when a common consequence is altered in both lotteries, which violates independence. The other options are consistent with expected utility theory or are not violations of it.

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