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A Bayesian Model of Knightian Uncertainty

  • Al-Najjar, Nabil I.

    (Department of Managerial Economics and Decision Sciences, Kellog School of Management, Northwestern University Evanston, USA)

  • Weinstein, Jonathan

    (Department of Managerial Economics and Decision Sciences, Kellog School of Management, Northwestern University Evanston, USA)

Registered author(s):

    A long tradition suggests a fundamental distinction between situations of risk, where true objective probabilities are known, and unmeasurable uncertainties where no such probabilities are given. This distinction can be captured in a Bayesian model where uncertainty is represented by the agent's subjective belief over the parameter governing future income streams. Whether uncertainty reduces to ordinary risk depends on the agent's ability to smooth consumption. Uncertainty can have a major behavioral and economic impact, including precautionary behavior that may appear overly conservative to an outside observer. We argue that one of the main characteristics of uncertain beliefs is that they are not empirical, in the sense that they cannot be objectively tested to determine whether they are right or wrong. This can confound empirical methods that assume rational expectations.

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    File URL: http://www.ihs.ac.at/publications/eco/es-300.pdf
    File Function: First version, 2013
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    Paper provided by Institute for Advanced Studies in its series Economics Series with number 300.

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    Length: 28 pages
    Date of creation: Jul 2013
    Date of revision:
    Handle: RePEc:ihs:ihsesp:300
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    1. Yoram Halevy & Vincent Feltkamp, 2005. "A Bayesian Approach to Uncertainty Aversion," Review of Economic Studies, Oxford University Press, vol. 72(2), pages 449-466.
    2. LeRoy, Stephen F & Singell, Larry D, Jr, 1987. "Knight on Risk and Uncertainty," Journal of Political Economy, University of Chicago Press, vol. 95(2), pages 394-406, April.
    3. Caballero, Ricardo J., 1990. "Consumption puzzles and precautionary savings," Journal of Monetary Economics, Elsevier, vol. 25(1), pages 113-136, January.
    4. Gilboa, Itzhak & Schmeidler, David, 1989. "Maxmin expected utility with non-unique prior," Journal of Mathematical Economics, Elsevier, vol. 18(2), pages 141-153, April.
    5. Martin L. Weitzman, 2007. "Subjective Expectations and Asset-Return Puzzles," American Economic Review, American Economic Association, vol. 97(4), pages 1102-1130, September.
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