Unit - III

Decision Theory Paradoxes

Keynesian Beauty Context
• John Maynard Keynes considered professional
investment to be analogous to a beauty contest.
• Professional investment may be likened to those
newspaper competitions in which the competitors have to
pick out the six prettiest faces from a hundred
photographs the prize being awarded to the competitor
whose choice most nearly corresponds to the average
preferences of the competitors as a whole:
Keynesian Beauty Context
• So that each competitor has to pick, not those faces which he
himself finds prettiest, but those which he thinks likeliest to catch
the fancy of the other competitors, all of whom are looking at the
problem from the same point of view.
• It is not a case of choosing those which, to the best of one’s
judgment, are really the prettiest, nor even those which average
opinion genuinely thinks the prettiest.
• We have reached the third degree where we devote our
intelligences to anticipating what average opinion expects the
average opinion to be, and there are some, I believe, who
practice the fourth, fifth, and higher degree.
Keynesian Beauty Context
• The Keynes’ beauty contest analogy is an apt description
of how financial markets work and the key role played by
behavioural factors, though it may be a little difficult to get
it.
• To understand this analogy and its subtlety consider the
following contest.
• Guess a number from 0 to 100. Your goal should be to
make your guess as close as possible to two-thirds of the
average guess of all those who are participating in this
contest.
 Keynesian Beauty Context

• Let us look at how people at different levels of thinking would play this
game:
• A zero-level thinker: “I have no clue. This is a math problem and I don’t like
math. Let me just pick a number between 0 and 100 at random.”
• A first-level thinker: “Since most of the people don’t like to think, they will
randomly pick a number between 0 and 100, averaging 50. So, my guess
should be 33, two-thirds of 50.”
• A second-level thinker: “Most participants will be first-level thinkers, but think
that other participants are zero-level thinkers, and so they will guess 33.
Therefore, my guess should be 22.”
• A third-level thinker: “Most participants will be second-level thinkers and
guess 22. So, I should guess 15.”
Nash Equilibrium
• Clearly, there is no end to this train of thinking.
• Named after John Nash, a Nobel laureate in economics,
the Nash equilibrium is a number that if everyone
guessed it, no one would like to change their number.
• The Nash equilibrium for this game is 0.
• Hence, in economics, the “number guessing game” is
popularly referred to as the “beauty contest.”
Nash Equilibrium
• This “guess-a-number” experiment illustrates two
important themes in behavioural finance:
(a) People are prone to commit errors in the course of
decision making.
(b) The errors committed by people cause security prices to
be different from what they would have been in an error-
free environment.
Keynesian beauty contest
• The Keynesian beauty contest is a concept from
behavioral finance where participants gain by predicting
the majority's choice rather than making personal
judgments.
• Applied to stock markets, it suggests that investors profit
more by anticipating popular stocks, rather than those
with intrinsic value, leading to irrational price fluctuations.
The Prisoner's Dilemma
• It is a paradox in decision analysis in which two
individuals acting in their own self-interests do not
produce the optimal outcome.
• It was developed in 1950 by RAND Corporation
mathematicians Merrill Flood and Melvin Dresher during
the Cold War
The Prisoner's Dilemma
• Two bank robbers, Elizabeth and Henry, have been
arrested and are being interrogated in separate rooms.
• The authorities have no other witnesses, and can only
prove the case against them if they can convince at least
one of the robbers to betray their accomplice and testify
to the crime.
• Each bank robber is faced with the choice to cooperate
with their accomplice and remain silent or to
defect/confess from the gang and testify for the
prosecution.
The Prisoner's Dilemma
• If they both co-operate and remain silent, then the
authorities will only be able to convict them on a lesser
charge resulting in one year in jail for each (1 year for
Elizabeth + 1 year for Henry = 2 years total jail time).
• If one testifies and the other does not, then the one who
testifies will go free and the other will get five years (0
years for the one who defects/confess + 5 for the one
convicted = 5 years total).
The Prisoner's Dilemma
• However, if both testify against the other, each will get
three years in jail for being partly responsible for the
robbery (3 years for Elizabeth + 3 years for Henry = 6
years total jail time).
The Prisoner's Dilemma
• The paradox of the prisoner’s dilemma is this:
• both robbers can minimize the total jail time that the two
of them will do only if they both cooperate and stay silent
(two years total),
• but the incentives that they each face separately will
always drive them each to defect/confess and end up
doing the maximum total jail time between the two of them
of six years total.
The Prisoner's Dilemma
• The common thread is this:
• a situation where the incentives faced by each individual
decision-maker would induce them each to behave in a
way that makes them all collectively worse off.
• while individually avoiding choices that would make them
all collectively better off if all could somehow
cooperatively choose.
The Prisoner's Dilemma
• The financial market often represents a Prisoner's Dilemma
scenario, where market players can either cooperate for long-term
mutual benefits or defect to secure short-term individual gains,
potentially destabilizing the market.
• For instance, in a bullish market, traders could collectively
maintain the upward trend by holding onto their stocks
(cooperating).
• However, some might be tempted to sell (defect) to realize their
profits earlier, potentially triggering a sell-off.
The Monty Hall Paradox

• One of the most famous

television game shows
from the heyday of the
genre from the 1950s to
the 1980s was Let’s Make
a Deal.
• Its host, Monty Hall.

1 2 3
The Monty Hall Paradox
• A contestant is faced with three doors.
• Behind one of them is a sleek new car.
• Behind the other two are goats.
• The contestant picks a door, say Door 1.
• To build suspense, Monty opens one of the other two doors, say
Door 3, revealing a goat.
• To build the suspense still further, he gives the contestant an
opportunity either to stick with their original choice or to switch to
the unopened door.
• You are the contestant. What should you do?
The Monty Hall Paradox
• Almost everyone stays.
• They figure that since the car was placed behind one of the three
doors at random, and Door 3 has been eliminated, there is now a
fifty-fifty chance each that the car will be behind Door 1 or Door 2.
• Though there’s no harm in switching, they think, there’s no
benefit either.
• So they stick with their first choice out of inertia, pride, or
anticipation that their regret after an unlucky switch would be
more intense than their delight after a lucky one.
The Monty Hall Paradox
• Marilyn vos Savant, known at the time as “the world’s smartest
woman” because of her entry in the Guinness Book of World
Records for the highest score on an intelligence test.
• Vos Savant wrote that you should switch: the odds of the car
being behind Door 2 are two in three, compared with one in three
for Door 1.
• She gave the correct answer that you should switch doors to have
a 66% chance of winning.
The Monty Hall Paradox
The Monty Hall Paradox
• You pick the incorrect door by random chance. The prize is behind
one of the other two doors.
• Monty knows the prize location. He opens the only door available
to him that does not have the prize.
• By the process of elimination, the prize must be behind the door
that he does not open.
• Because this process occurs 66% of the time and because it
always ends with the prize behind the door that Monty allows you
to switch to, the “Switch To” door must have the prize 66% of the
time.
The St. Petersburg Paradox
• On the streets of St. Petersburg, Russia, and an old man
proposes the following game.
• He flips a coin, If it lands tails up then you lose and the
game is over.
• If the coin lands heads up then you win one ruble and the
game continues.
• The coin is tossed again. If it is tails, then the game ends.
If it is heads, then you win an additional two rubles.
The St. Petersburg Paradox
• The game continues in this fashion.
• For each successive head we double our winnings from
the previous round, but at the sign of the first tail, the
game is done.
• How much would you pay to play this game?
The St. Petersburg Paradox
• When we consider the expected value of this game, you
should jump at the chance, no matter what the cost is to
play.
• However, from the description above, you probably
wouldn’t be willing to pay much.
• After all, there is a 50% probability of winning nothing.
This is what is known as the St. Petersburg Paradox,
The St. Petersburg Paradox
• Some Probabilities
– The probability that a fair coin lands heads up is 1/2.
– The probability of two heads in a row is (1/2)) x (1/2) = 1/4.
– The probability of three heads in a row is
(1/2) x (1/2) x (1/2) = 1/8.
– To express the probability of n heads in a row, where n is a
positive whole number we use exponents to write 1/2 n.
The St. Petersburg Paradox
• Some Payouts
– If you have a head in the first round you win one ruble for that
round.
– If there is a head in the second round you win two rubles in that
round.
– If there is a head in the third round, then you win four rubles in
that round.
– If you have been lucky enough to make it all the way to the nth
round, then you will win 2n-1 rubles in that round.
 The St. Petersburg Paradox
• Expected Value of the Game
– To calculate the expected value, we multiply the value of the
winnings from each round with the probability of getting to this
round, and then add all of these products together.
– From the first round, you have probability 1/2 and winnings of 1
ruble: 1/2 x 1 = 1/2
– rom the second round, you have probability 1/4 and winnings
of 2 rubles: 1/4 x 2 = 1/2
– From the third round, you have probability 1/8 and winnings of
4 rubles: 1/8 x 4 = 1/2
– From the nth round, you have probability 1/2n and winnings of
2n-1 rubles: 1/2n x 2n-1 = 1/2
The St. Petersburg Paradox
• The Paradox - So what should you pay to play?
• How improbable it is to get something like 20 heads in a
row?
• So the price to play the St. Petersburg game should
probably not exceed a few dollars.
• If the man in St. Petersburg says that it will cost anything
more than a few rubles to play his game, you should
politely refuse and walk away.
• Rubles aren’t worth much anyway.
The St. Petersburg Paradox
• The paradox helped establish expected utility theory by
showing that making decisions based on expectation can
lead to unreasonable behavior.
• The paradox describes a situation where a simple game
of chance offers an infinite expected payoff, and yet any
reasonable investor will pay no more than a few dollars to
participate in the game.
The Ellsberg paradox
• In the 1970s, the economist Daniel Ellsberg theorized the
ambiguity aversion bias through the famous Ellsberg
paradox.
• The paradox is presented as a game, and it exists in a
number of different versions.
The Ellsberg paradox
• In the most famous version, participants were presented with
two fists full of marbles.
• The right fist contained 50% of red marbles and 50% of black
marbles.
• The left fist contained an unknown quantity of red marbles and
an unknown quantity of black marbles.
The Ellsberg paradox
• When given a choice of which fist they wanted to pick
either a red or a black marble?
The Ellsberg paradox
• Mostly people chose the right fist.
• On the surface, making the choice that offers a 50/50
chance seems obvious.
• In reality, one is just as likely to pick the correct-colored
marble from the left fist, with an unknown mix of marbles.
The Ellsberg paradox
• Applications to finance
 Ambiguity aversion affects our daily decisions and in particular
our financial decisions.
 We tend to avoid investing in something we do not understand
and whose probability of failure or success is hard to estimate.
 We are also more confident to invest in something we have the
impression to know better.
The Ellsberg paradox
• In finance, this can lead us to invest in domestic markets
or in sectors we are more familiar with.
• This specific behavior is called home bias and affect
professional as well as retail investors.
The Allais Paradox
• Suppose somebody offered you a choice between two
different vacations.
• Vacation number one gives you a 50 percent chance of
winning a three-week tour of England, France and Italy.
• Vacation number two offers you a one-week tour of
England for sure.
• Which one will you choose?
The Allais Paradox
• Not surprisingly, the vast majority of people (typically over
80 percent) prefer the one-week tour of England.
• We almost always choose certainty over risk, and are
willing to trade two weeks of vacation for the guarantee of
a one-week vacation.
• A sure thing just seems better than a gamble that might
leave us with nothing.
The Allais Paradox
• Vacation number one offers you a 5 percent chance of
winning a three week tour of England, France and Italy.
• Vacation number two gives you a 10 percent chance of
winning a one week tour of England.
• Which one will you choose?
The Allais Paradox
• In this case, most people choose the three-week trip.
• We figure both vacations are unlikely to happen, so we
might as well go for broke on the grand European tour.
The Allais Paradox
• Allais presciently realized that this very popular set of decisions -
almost everybody made them - violated the rational assumptions
of economics.
• Instead of making decisions that could be predicted by a few
mathematical equations, people acted with frustrating
inconsistency.
• After all, both questions involve 50 percent reductions in
probability (from 100 percent to 50 percent, and from 10 percent
to 5 percent), and yet generated completely opposite responses.
• Our choices seemed incoherent.
The Allais Paradox
• People hated losses.
• In fact, our dislike of losses was largely responsible for
our dislike of risk in general.
• We have come to realize that we are not nearly as
rational as we like to believe, that the brain is driven by all
sorts of inarticulate feelings and pre-programmed
instincts.