St. Petersburg paradox

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The St. Petersburg paradox or St. Petersburg lottery is a paradox related to probability and decision theory in economics. It is based on a particular (theoretical) lottery game that leads to a random variable with infinite expected value (i.e., infinite expected payoff) but nevertheless seems to be worth only a very small amount to the participants. The St. Petersburg paradox is a situation where a naive decision criterion which takes only the expected value into account predicts a course of action that presumably no actual person would be willing to take. Several resolutions are possible.

The paradox takes its name from its resolution by Daniel Bernoulli, one-time resident of the eponymous Russian city, who published his arguments in the Commentaries of the Imperial Academy of Science of Saint Petersburg (Bernoulli 1738). However, the problem was invented by Daniel's cousin, Nicolas Bernoulli, who first stated it in a letter to Pierre Raymond de Montmort on September 9, 1713 (de Montmort 1713).

Video St. Petersburg paradox

The paradox

A casino offers a game of chance for a single player in which a fair coin is tossed at each stage. The initial stake starts at 2 dollars and is doubled every time heads appears. The first time tails appears, the game ends and the player wins whatever is in the pot. Thus the player wins 2 dollars if tails appears on the first toss, 4 dollars if heads appears on the first toss and tails on the second, 8 dollars if heads appears on the first two tosses and tails on the third, and so on. Mathematically, the player wins 2^k dollars, where k equals number of tosses (k must be a whole number and greater than zero). What would be a fair price to pay the casino for entering the game?

To answer this, one needs to consider what would be the average payout: with probability 1/2, the player wins 2 dollars; with probability 1/4 the player wins 4 dollars; with probability 1/8 the player wins 8 dollars, and so on. The expected value is thus

${\displaystyle {\begin{aligned}E&={\frac {1}{2}}\cdot 2+{\frac {1}{4}}\cdot 4+{\frac {1}{8}}\cdot 8+{\frac {1}{16}}\cdot 16+\cdots \\&=1+1+1+1+\cdots \\&=\infty \,.\end{aligned}}}$

Assuming the game can continue as long as the coin toss results in heads and in particular that the casino has unlimited resources, this sum grows without bound and so the expected win for repeated play is an infinite amount of money. Considering nothing but the expected value of the net change in one's monetary wealth, one should therefore play the game at any price if offered the opportunity. Yet, in published descriptions of the game, many people expressed disbelief in the result. Martin Robert quotes Ian Hacking as saying "few of us would pay even $25 to enter such a game" and says most commentators would agree. The paradox is the discrepancy between what people seem willing to pay to enter the game and the infinite expected value.

Maps St. Petersburg paradox

Solutions

Several approaches have been proposed for solving the paradox.

Expected utility theory

The classical resolution of the paradox involved the explicit introduction of a utility function, an expected utility hypothesis, and the presumption of diminishing marginal utility of money.

In Daniel Bernoulli's own words:

The determination of the value of an item must not be based on the price, but rather on the utility it yields.... There is no doubt that a gain of one thousand ducats is more significant to the pauper than to a rich man though both gain the same amount.

A common utility model, suggested by Bernoulli himself, is the logarithmic function U(w) = ln(w) (known as "log utility"). It is a function of the gambler's total wealth w, and the concept of diminishing marginal utility of money is built into it. The expected utility hypothesis posits that a utility function exists the sign of whose expected net change from accepting the gamble is a good criterion for real people's behavior. For each possible event, the change in utility ln(wealth after the event) - ln(wealth before the event) will be weighted by the probability of that event occurring. Let c be the cost charged to enter the game. The expected incremental utility of the lottery now converges to a finite value:

${\displaystyle \Delta E(U)=\sum _{k=1}^{\infty }{\frac {1}{2^{k}}}\left[\ln(w+2^{k}-c)-\ln(w)\right]<\infty \,.}$

This formula gives an implicit relationship between the gambler's wealth and how much he should be willing to pay to play (specifically, any c that gives a positive change in expected utility). For example, with natural log utility, a millionaire ($1,000,000) should be willing to pay up to $20.88, a person with $1,000 should pay up to $10.95, a person with $2 should borrow $1.35 and pay up to $3.35.

Before Daniel Bernoulli published, in 1728, a mathematician from Geneva, Gabriel Cramer, had already found parts of this idea (also motivated by the St. Petersburg Paradox) in stating that

the mathematicians estimate money in proportion to its quantity, and men of good sense in proportion to the usage that they may make of it.

He demonstrated in a letter to Nicolas Bernoulli that a square root function describing the diminishing marginal benefit of gains can resolve the problem. However, unlike Daniel Bernoulli, he did not consider the total wealth of a person, but only the gain by the lottery.

A commonly held incorrect belief is that the lottery can easily be changed such that the paradox reappears in Bernoulli's treatment. The argument is due to Menger (Menger 1934) and was endorsed by Samuelson (Samuelson 1977) as a "quantum jump in analysis". Menger had claimed that the (even larger) payoff e^2k would again make the game worth an infinite amount, and that more generally, one can find a lottery that allows for a variant of the St. Petersburg paradox for every unbounded utility function. Substituting the corresponding parameters in the equation for ${\displaystyle \Delta E(U)}$ above immediately shows that this is not correct: the expression becomes negative at a finite value of ${\displaystyle c}$ (Peters & Gell-Mann 2016).

Recently, expected utility theory has been extended to arrive at more behavioral decision models. In some of these new theories, as in cumulative prospect theory, the St. Petersburg paradox again appears in certain cases, even when the utility function is concave, but not if it is bounded (Rieger & Wang 2006).

Probability weighting

Nicolas Bernoulli himself proposed an alternative idea for solving the paradox. He conjectured that people will neglect unlikely events (de Montmort 1713). Since in the St. Petersburg lottery only unlikely events yield the high prizes that lead to an infinite expected value, this could resolve the paradox. The idea of probability weighting resurfaced much later in the work on prospect theory by Daniel Kahneman and Amos Tversky.

Cumulative prospect theory is one popular generalization of expected utility theory that can predict many behavioral regularities (Tversky & Kahneman 1992). However, the overweighting of small probability events introduced in cumulative prospect theory may restore the St. Petersburg paradox. Cumulative prospect theory avoids the St. Petersburg paradox only when the power coefficient of the utility function is lower than the power coefficient of the probability weighting function (Blavatskyy 2005). Intuitively, the utility function must not simply be concave, but it must be concave relative to the probability weighting function to avoid the St. Petersburg paradox.

Rejection of mathematical expectation

Various authors, including Jean le Rond d'Alembert and John Maynard Keynes, have rejected maximization of expectation (even of utility) as a proper rule of conduct. Keynes, in particular, insisted that the relative risk of an alternative could be sufficiently high to reject it even if its expectation were enormous.

Finite St. Petersburg lotteries

The classical St. Petersburg lottery assumes that the casino has infinite resources. This assumption is unrealistic, particularly in connection with the paradox, which involves the reactions of ordinary people to the lottery. Of course, the resources of an actual casino (or any other potential backer of the lottery) are finite. More importantly, the expected value of the lottery only grows logarithmically with the resources of the casino. As a result, the expected value of the lottery, even when played against a casino with the largest resources realistically conceivable, is quite modest. If the total resources (or total maximum jackpot) of the casino are W dollars, then L = floor(log₂(W)) is the maximum number of times the casino can play before it no longer fully covers the next bet. The expected value E of the lottery then becomes:

${\displaystyle {\begin{aligned}E&=\sum _{k=1}^{L}{\frac {1}{2^{k}}}\cdot 2^{k}~+~2{\frac {W}{2^{L+1}}}\\&={L}~+~{\frac {W}{2^{L}}}\,\,.\end{aligned}}}$

The following table shows the expected value E of the game with various potential bankers and their bankroll W (with the assumption that if you win more than the bankroll you will be paid what the bank has):

A rational person might not find the lottery worth even the modest amounts in the above table, suggesting that the naive decision model of the expected return causes essentially the same problems as for the infinite lottery. Even so, the possible discrepancy between theory and reality is far less dramatic.

The premise of infinite resources produces a variety of paradoxes in economics. In the martingale betting system, a gambler betting on a tossed coin doubles his bet after every loss, so that an eventual win would cover all losses; this system fails with any finite bankroll. The gambler's ruin concept shows a persistent gambler will go broke, even if the game provides a positive expected value, and no betting system can avoid this inevitability.

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Recent discussions

Although this paradox is three centuries old, new arguments are still being introduced.

Feller

One mathematically correct solution is sampling by William Feller. In order to understand Feller's answer correctly, sufficient knowledge about probability theory and statistics is necessary, but it can be understood intuitively as "to perform this game with a large number of people and to calculate the expected value from the sample extraction". In this method, when infinite games are possible, the expected value diverges to infinite, and in the case of finite, the expected value converges to a much smaller value.

Samuelson

Samuelson resolves the paradox by arguing that, even if an entity had infinite resources, the game would never be offered. If the lottery represents an infinite expected gain to the player, then it also represents an infinite expected loss to the host. No one could be observed paying to play the game because it would never be offered. As Paul Samuelson describes the argument:

"Paul will never be willing to give as much as Peter will demand for such a contract; and hence the indicated activity will take place at the equilibrium level of zero intensity." (Samuelson 1960)

Peters

Ole Peters thinks that the St. Petersburg paradox can be solved by using concepts and ideas from ergodic theory (Peters 2011a). In statistical mechanics it is a central problem to understand whether time averages resulting from a long observation of a single system are equivalent to expectation values. This is the case only for a very limited class of systems that are called "ergodic." For non-ergodic systems there is no general reason why expectation values should have any relevance.

Peters points out that computing the naive expected payout is mathematically equivalent to considering multiple outcomes of the same lottery in parallel universes. This is irrelevant to the individual considering whether to buy a ticket since he exists in only one universe and is unable to exchange resources with the others. It is therefore unclear why expected wealth should be a quantity whose maximization should lead to a sound decision theory. Indeed, the St. Petersburg paradox is only a paradox if one accepts the premise that rational actors seek to maximize their expected wealth. The classical resolution is to apply a utility function to the wealth, which reflects the notion that the "usefulness" of an amount of money depends on how much of it one already has, and then to maximise the expectation of this. The choice of utility function is often framed in terms of the individual's risk preferences and may vary between individuals: it therefore provides a somewhat arbitrary framework for the treatment of the problem.

An alternative premise, which is less arbitrary and makes fewer assumptions, is that the performance over time of an investment better characterises an investor's prospects and, therefore, better informs his investment decision. In this case, the passage of time is incorporated by identifying as the quantity of interest the average rate of exponential growth of the player's wealth in a single round of the lottery,

${\displaystyle {\bar {g}}(w,c)=\sum _{k=1}^{\infty }p_{k}\ln \left({\frac {w-c+D_{k}}{w}}\right)}$

per round, where D_k is the kth (positive finite) payout, p_k is the (non-zero) probability of receiving it, w is the wealth of the player, and c is the cost of a ticket. In the standard St. Petersburg lottery, D_k = 2^{k - 1} and p_k = 2^-k.

Although this is an expectation value of a growth rate, and may therefore be thought of in one sense as an average over parallel universes, it is in fact equivalent to the time average growth rate that would be obtained if repeated lotteries were played over time (Peters 2011a). While g is identical to the rate of change of the expected logarithmic utility, it has been obtained without making any assumptions about the player's risk preferences or behaviour, other than that he is interested in the rate of growth of his wealth.

Under this paradigm, an individual with wealth w should buy a ticket at a price c provided

${\displaystyle {\bar {g}}(w,c)>0.}$

This strategy counsels against paying any amount of money for a ticket that admits the possibility of bankruptcy, i.e.

${\displaystyle w-c+D_{k}=0,}$

for any k, since this generates a negatively divergent logarithm in the sum for g which can be shown to dominate all other terms in the sum and guarantee that g < 0. If we assume the smallest payout is D₁, then the individual will always be advised to decline the ticket at any price greater than

${\displaystyle c_{\mathrm {max} }=w+D_{1},}$

regardless of the payout structure of the lottery. The ticket price for which the expected growth rate falls to zero will be less than c_max but may be greater than w, indicating that borrowing money to purchase a ticket for more than one's wealth can be a sound decision. This would be the case, for example, where the smallest payout exceeds the player's current wealth, as it does in Menger's game.

It should also be noted in the above treatment that, contrary to Menger's analysis, no higher-paying lottery can generate a paradox which the time resolution - or, equivalently, Bernoulli's or Laplace's logarithmic resolutions - fail to resolve, since there is always a price at which the lottery should not be entered, even though for especially favourable lotteries this may be greater than one's worth.

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Further discussions

The St. Petersburg paradox and the theory of marginal utility have been highly disputed in the past. For a discussion from the point of view of a philosopher, see (Martin 2004).

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See also

• Ellsberg paradox
• Exponential growth
• Gambler's ruin
• Kelly criterion
• Martingale (betting system)
• Pascal's mugging
• Two envelopes problem
• Zeno's paradoxes

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Notes and references

Citations

Works cited

• Arrow, Kenneth J. (February 1974). "The use of unbounded utility functions in expected-utility maximization: Response" (PDF). Quarterly Journal of Economics. The MIT Press. 88 (1): 136-138. doi:10.2307/1881800. JSTOR 1881800. Handle: RePEc:tpr:qjecon:v:88:y:1974:i:1:p:136-38. 

• Bernoulli, Daniel; originally published in 1738; translated by Dr. Louise Sommer (January 1954). "Exposition of a New Theory on the Measurement of Risk". Econometrica. The Econometric Society. 22 (1): 22-36. doi:10.2307/1909829. JSTOR 1909829. Retrieved 2006-05-30. 
• Blavatskyy, Pavlo (April 2005). "Back to the St. Petersburg Paradox?". Management Science. 51 (4): 677-678. doi:10.1287/mnsc.1040.0352. 

• de Montmort, Pierre Remond (1713). Essay d'analyse sur les jeux de hazard [Essays on the analysis of games of chance] (Reprinted in 2006) (in French) (Second ed.). Providence, Rhode Island: American Mathematical Society. ISBN 978-0-8218-3781-8.  as translated and posted at Pulskamp, Richard J. "Correspondence of Nicolas Bernoulli concerning the St. Petersburg Game" (pdf). Retrieved July 22, 2010. 

• Laplace, Pierre Simon (1814). Théorie analytique des probabilités [Analytical theory of probabilities] (in French) (Second ed.). Paris: Ve. Courcier. 

• Martin, Robert (2004). "The St. Petersburg Paradox". In Edward N. Zalta. The Stanford Encyclopedia of Philosophy (Fall 2004 ed.). Stanford, California: Stanford University. ISSN 1095-5054. Retrieved 2006-05-30. 

• Menger, Karl (August 1934). "Das Unsicherheitsmoment in der Wertlehre Betrachtungen im Anschluß an das sogenannte Petersburger Spiel". Zeitschrift für Nationalökonomie. 5 (4): 459-485. doi:10.1007/BF01311578. ISSN 0931-8658. (Paper) (Online). 

• Peters, Ole (October 2011b). "Menger 1934 revisited". arXiv:1110.1578 . 

• Peters, Ole (2011a). "The time resolution of the St Petersburg paradox" (PDF). Philosophical Transactions of the Royal Society. 369: 4913-4931. arXiv:1011.4404 . Bibcode:2011RSPTA.369.4913P. doi:10.1098/rsta.2011.0065. 

• Peters, Ole; Gell-Mann, Murray (2016). "Evaluating gambles using dynamics". Chaos. 26: 023103. arXiv:1405.0585 . Bibcode:2016Chaos..26b3103P. doi:10.1063/1.4940236. 

• Pianca, Paolo (September 2007). "The St. Petersburg Paradox: Historical Exposition, an Application to Growth Stocks and Some Simulation Approaches" (PDF). Quaderni Di Didattica, Department of Applied Mathematics, University of Venice. 24: 1-15. 

• Rieger, Marc Oliver; Wang, Mei (August 2006). "Cumulative prospect theory and the St. Petersburg paradox". Economic Theory. 28 (3): 665-679. doi:10.1007/s00199-005-0641-6. ISSN 0938-2259. (Paper) (Online).  (Publicly accessible, older version.)

• Samuelson, Paul (January 1960). "The St. Petersburg Paradox as a Divergent Double Limit". International Economic Review. Blackwell Publishing. 1 (1): 31-37. doi:10.2307/2525406. JSTOR 2525406. 

• Samuelson, Paul (March 1977). "St. Petersburg Paradoxes: Defanged, Dissected, and Historically Described". Journal of Economic Literature. American Economic Association. 15 (1): 24-55. JSTOR 2722712. 

• Todhunter, Isaac (1865). A history of the mathematical theory of probabilities. Macmillan & Co. 

• Tversky, Amos; Kahneman (1992). "Advances in prospect theory: Cumulative representation of uncertainty". Journal of Risk and Uncertainty. 5: 297-323. doi:10.1007/bf00122574. 

Bibliography

• Aumann, Robert J. (April 1977). "The St. Petersburg paradox: A discussion of some recent comments". Journal of Economic Theory. 14 (2): 443-445. doi:10.1016/0022-0531(77)90143-0. 
• Feller, William. An Introduction to Probability Theory and its Applications Volume I, II. 
• Durand, David (September 1957). "Growth Stocks and the Petersburg Paradox". The Journal of Finance. American Finance Association. 12 (3): 348-363. doi:10.2307/2976852. JSTOR 2976852. 

• "Bernoulli and the St. Petersburg Paradox". The History of Economic Thought. The New School for Social Research, New York. Archived from the original on June 18, 2006. Retrieved May 30, 2006. 

• Haigh, John (1999). Taking Chances. Oxford, UK: Oxford University Press. p. 330. ISBN 0198526636. (Chapter 4)

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External links

• Online simulation of the St. Petersburg lottery

Source of the article : Wikipedia