First-Order and Second-Order Ambiguity Aversion

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.

Keywords: Ambiguity, Uncertainty Aversion, Smooth Ambiguity Aversion, Subjective Beliefs, Kinked Preferences

JEL Classification: D01, D81, D82, G11