The Markowitz model of utility supplemented with a small degree of probability distortion as an explanation of outcomes of Allais experiments over large and small payoffs and gambling on unlikely outcomes

Abstract

We show that in principal only a small degree of probability distortion is necessary for agents to exhibit the Allais paradox. We also show that the choices observed in the Allais experiments employing small real payoffs cannot be explained by Cumulative Prospect Theory without the assumption of low degrees of probability distortion that rule out gambling at unfair odds on all but the most extreme longshots in CPT. Given these points we show that the Markowitz model of utility supplemented by a small degree of probability distortion can explain the majority choices involved Allais experiments and other experiments as well as gambling at actuarially unfair odds.

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