Ambiguity aversion in the small and in the large for weighted linear utility

Gordon B Hazen*, Jia Sheng Lee

*Corresponding author for this work

Research output: Contribution to journalArticle

5 Scopus citations

Abstract

The widely observed preference for lotteries involving precise rather than vague of ambiguous probabilities is called ambiguity aversion. Ambiguity aversion cannot be predicted or explained by conventional expected utility models. For the subjectively weighted linear utility (SWLU) model, we define both probability and payoff premiums for ambiguity, and introduce a local ambiguity aversion function a(u) that is proportional to these ambiguity premiums for small uncertainties. We show that one individual's ambiguity premiums are globally larger than another's if and only if his a(u) function is everywhere larger. Ambiguity aversion has been observed to increase 1) when the mean probability of gain increases and 2) when the mean probability of loss decreases. We show that such behavior is equivalent to a(u) increasing in both the gain and loss domains. Increasing ambiguity aversion also explains the observed excess of sellers' over buyers' prices for insurance against an ambiguous probability of loss.

Original languageEnglish (US)
Pages (from-to)177-212
Number of pages36
JournalJournal of Risk and Uncertainty
Volume4
Issue number2
DOIs
StatePublished - Apr 1 1991

Keywords

  • ambiguity
  • Ellsberg paradox
  • insurance prices
  • nonlinear utility
  • subjective probability

ASJC Scopus subject areas

  • Accounting
  • Finance
  • Economics and Econometrics

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