The Two Envelope Paradox and Using Variables Within the Expectation Formula
Graduate studies at Western
|Abstract||You are presented with a choice between two envelopes. You know one envelope contains twice as much money as the other, but you don't know which contains more. You arbitrarily choose one envelope -- call it Envelope A -- but don't open it. Call the amount of money in that envelope X. Since your choice was arbitrary, the other envelope (Envelope B) is 50% likely to be the envelope with more and 50% likely to be the envelope with less. But, strangely, that very fact might make Envelope B seem attractive: Wouldn't switching to Envelope B give you a 50% chance of doubling your money and a 50% chance of halving it? Since double or nothing is a fair bet, double or half is more than fair. Applying the standard expectation formula, you might calculate the expected value of switching to Envelope B as (.50)½X [50% chance it has less] + (.50)2X [50% chance it has more] = (1.25)X. So, it seems, you ought to switch to Envelope B: Your expected return -- your return on average, over the long run, if you did this many times -- would seem to be 25% more. But obviously that's absurd: A symmetrical calculation could persuade you to switch back to Envelope A. Hence the paradox|
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