Ambiguity aversion

In decision theory and economics, ambiguity aversion (also known as uncertainty aversion) is a preference for known risks over unknown risks. An ambiguity-averse individual would rather choose an alternative where the probability distribution of the outcomes is known over one where the probabilities are unknown. This behavior was first introduced through the Ellsberg paradox (people prefer to bet on the outcome of an urn with 50 red and 50 blue balls rather than to bet on one with 100 total balls but for which the number of blue or red balls is unknown).

There are two categories of imperfectly predictable events between which choices must be made: risky and ambiguous events. Risky events have a known probability distribution over outcomes while in ambiguous events the probability distribution is not known. The reaction is behavioral and still being formalized. Ambiguity aversion can be used to explain incomplete contracts, volatility in stock markets, and selective abstention in elections (Ghirardato & Marinacci, 2001).

The concept is expressed in the English proverb: "Better the devil you know than the devil you don't".

The distinction between ambiguity aversion and risk aversion is important but subtle. Risk aversion comes from a situation where a probability can be assigned to each possible outcome of a situation and it is defined by the preference between a risky alternative and its expected value. Ambiguity aversion applies to a situation when the probabilities of outcomes are unknown (Epstein 1999) and it is defined through the preference between risky and ambiguous alternatives, after controlling for preferences over risk.

Using the traditional two-urn Ellsberg choice, urn A contains 50 red balls and 50 blue balls while urn B contains 100 total balls (either red or blue) but the number of each is unknown. An individual that prefers a certain payoff strictly smaller than $10 over a bet that pays $20 if the color of a ball drawn from urn A is guessed correctly and $0 otherwise is said to be risk averse but nothing can be said about her preferences over ambiguity. On the other hand, an individual that strictly prefers that same bet if the ball is drawn from urn A over the case where the ball is drawn from urn B is said to be ambiguity averse but not necessarily risk averse.

A real world consequence of increased ambiguity aversion is the increased demand for insurance because the general public are averse to the unknown events that will affect their lives and property (Alary, Treich, and Gollier 2010).

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