The Topology of Fear
10 Pages Posted: 5 Feb 2010
Date Written: February 24, 2007
Abstract
For many years experimental observations have raised questions about the rationality of economic agents – for example, the Allais Paradox or the Equity Premium Puzzle. The problem is a narrow notion of rationality that disregards fear. This article extends the notion of rationality with new axioms of choice under uncertainty and the decision criteria they imply (Chichilnisky, G., 1996a. Anaxiomatic approach to sustainable development. Social Choice and Welfare 13, 257-321; Chichilnisky, G., 2000. An axiomatic approach to choice under uncertainty with Catastrophic risks. Resource and Energy Economics; Chichilnisky, G., 2002. Catastrophical Risk. Encyclopedia of Environmetrics, Vol.1. John Wiley & Sons, Ltd., Chicester). In the absence of catastrophes, the old and the new approach coincide, and both lead to standard expected utility. A sharp difference emerges when facing rare events with important consequences, or catastrophes. Theorem 1 establishes that a classic axiom of choice under uncertainty – Arrow’s Monotone Continuity axiom, or its relatives introduced by De Groot, Villegas, Hernsteinand Milnor – postulate rational behavior that is ‘insensitive’ to rare events as defined in (Chichilnisky, G., 1996a. Anaxiomatic approach to sustainable development. Social Choice and Welfare13, 257-321; Chichilnisky, G., 2000. An axiomatic approach to choice under uncertainty with Catastrophic risks. Resource and Energy Economics; Chichilnisky, G., 2002. Catastrophical Risk. Encyclopedia of Environmetrics, vol. 1. John Wiley & Sons, Ltd., Chicester).Theorem 2 replaces this axiom with another that allows extreme responses to extreme events, and characterizes the implied decision criteria as a combination of expected utility with extremal responses. Theorems 1 and 2 offer a new understanding of rationality consistent with previously unexplained observations about decisions involving rare and catastrophic events, decisions involving fear, the Equity Premium Puzzle, ‘jump diffusion’ processes and ‘heavy tails’, and it agrees with (Debreu, G., 1953. Valuation equilibrium and Pare to optimum. Proceedings of the National Academy of Sciences, 40, 588-592) formulation of market behavior and his pro of of Adam Smith’s Invisible Hand theorem.
Suggested Citation: Suggested Citation
Do you have negative results from your research you’d like to share?
Recommended Papers
-
General Equilibrium with Endogenous Uncertainty and Default
By Graciela Chichilnisky and Ho-mou Wu
-
Catastrophic Risks: The Need for New Tools, Financial Instruments and Institutions
-
Trade Regimes and Gatt: Resource Intensive vs. Knowledge-Intensive Growth
-
Traditional Comparative Advantages Vs. Economies of Scale: NAFTA and GATT
-
Traditional Comparative Advantage Vs. Increasing Returns to Scale: NAFTA and the GATT