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Compound lottery A:
L1=(100,0,0) occurs with probability 1/3
L2=(100*1/4, 100* 3/8, 100*3/8) with probability 1/3
L3=(=(100*1/4, 100*3/8, 100*3/8) with probability 1/3
Compound lottery B:
L1=(100*1/2, 100*1/2, 0) with probability ½
L2=(100*1/2, 0, 100*1/2) with probability ½
Do you prefer A or B?
Since the consumer only cares about the distribution of final outcomes, he will be indifferent between to Compound Lotteries that deliver the same Reduced Lottery
Do you agree?
Concave utility function
Consider the following gamble
Do you accept this gamble?
Consider now these alternative gambles:
Which bet will you be willing to accept?
Source : M. Rabin and R.H.Thaler (2001), Anomalies- Risk Aversion, Journal of Economic Perspectives, pages 219-232