Welfare-Improving Ambiguity

Abstract:     
Existing papers on ambiguity predict that the arrival of ambiguity-increasing information leads to a fall in welfare. In this paper, we consider a model of competitive insurance markets involving both asymmetric information and Knightian uncertainty (ambiguity) about the accident probability. We establish necessary and sufficient conditions for ambiguity-increasing information to lead to a Pareto improvement. Higher ambiguity relaxes the high-risk insurees’ incentive compatibility constraint and allows low risks to buy more insurance. Higher ambiguity for low risks also deteriorates their expected utility from holding an uncertain prospect. If the former effect dominates, the expected utility of low risks increases and given that the high risks’ utility remains unaffected, the increase in ambiguity implies a Pareto improvement.

Number of Pages in PDF File: 20

Keywords: ambiguity aversion, asymmetric information, value of ambiguous information

JEL Classification: D82, G22

working papers series