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First-Order and Second-Order Ambiguity Aversion

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  • Matthias Lang

    (Department of Economics, Free University of Berlin, 14195 Berlin, Germany; Max Planck Institute for Research on Collective Goods, 53113 Bonn, Germany; CESifo, 81679 Munich, Germany)

Abstract

Different models of uncertainty aversion imply strikingly different economic behavior. The key to understanding these differences lies in the dichotomy between first-order and second-order ambiguity aversion, which I define here. My definition and its characterization are independent of specific representations of decisions under uncertainty. I show that with second-order ambiguity aversion, a positive exposure to ambiguity is optimal if and only if there is a subjective belief such that the act’s expected outcome is positive. With first-order ambiguity aversion, zero exposure to ambiguity can be optimal. Examples in finance, insurance, and contracting demonstrate the economic relevance of this dichotomy.

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  • Matthias Lang, 2017. "First-Order and Second-Order Ambiguity Aversion," Management Science, INFORMS, vol. 63(4), pages 1254-1269, April.
    • Handle: RePEc:inm:ormnsc:v:63:y:2017:i:4:p:1254-1269
    DOI: 10.1287/mnsc.2016.2443
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    Cited by:

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    2. Andrew J. Keith & Darryl K. Ahner, 2021. "A survey of decision making and optimization under uncertainty," Annals of Operations Research, Springer, vol. 300(2), pages 319-353, May.
    3. Jingyi Xue, 2020. "Preferences with changing ambiguity aversion," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 69(1), pages 1-60, February.
    4. Luigi Alberto Franzoni, 2022. "Efficient liability law when parties genuinely disagree," Working Papers wp1176, Dipartimento Scienze Economiche, Universita' di Bologna.
    5. Christoph Bühren & Fabian Meier & Marco Pleßner, 2023. "Ambiguity aversion: bibliometric analysis and literature review of the last 60 years," Management Review Quarterly, Springer, vol. 73(2), pages 495-525, June.
    6. Kräkel, Matthias, 2016. "Peer effects and incentives," Games and Economic Behavior, Elsevier, vol. 97(C), pages 120-127.
    7. Kellner, Christian & Le Quement, Mark T., 2018. "Endogenous ambiguity in cheap talk," Journal of Economic Theory, Elsevier, vol. 173(C), pages 1-17.
    8. Thomas Knispel & Roger J. A. Laeven & Gregor Svindland, 2021. "Asymptotic Analysis of Risk Premia Induced by Law-Invariant Risk Measures," Papers 2107.01730, arXiv.org.
    9. Soheil Ghili & Peter Klibanoff, 2021. "If It Is Surely Better, Do It More? Implications for Preferences Under Ambiguity," Management Science, INFORMS, vol. 67(12), pages 7619-7636, December.
    10. Bao, Xing & Diabat, Ali & Zheng, Zhongliang, 2020. "An ambiguous manager's disruption decisions with insufficient data in recovery phase," International Journal of Production Economics, Elsevier, vol. 221(C).
    11. Galanis, Spyros, 2018. "Financial complexity and trade," Games and Economic Behavior, Elsevier, vol. 112(C), pages 219-230.
    12. Christian Kellner, 2017. "The principal-agent problem with smooth ambiguity," Review of Economic Design, Springer;Society for Economic Design, vol. 21(2), pages 83-119, June.

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    More about this item

    Keywords

    ambiguity; uncertainty aversion; smooth ambiguity aversion; subjective beliefs; kinked preferences;
    All these keywords.

    JEL classification:

    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design
    • D01 - Microeconomics - - General - - - Microeconomic Behavior: Underlying Principles
    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions

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