First-Order and Second-Order Ambiguity Aversion

Management Science, 63(4), 1254-1269, 2017, doi: 10.1287/mnsc.2016.2443

Posted: 10 Aug 2012 Last revised: 30 Oct 2018

See all articles by Matthias Lang

Matthias Lang

Ludwig Maximilian University of Munich (LMU); CESifo (Center for Economic Studies and Ifo Institute)

Multiple version iconThere are 2 versions of this paper

Date Written: April 1, 2017

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

Suggested Citation

Lang, Matthias, First-Order and Second-Order Ambiguity Aversion (April 1, 2017). Management Science, 63(4), 1254-1269, 2017, doi: 10.1287/mnsc.2016.2443, Available at SSRN: https://ssrn.com/abstract=1970261 or http://dx.doi.org/10.2139/ssrn.1970261

Matthias Lang (Contact Author)

Ludwig Maximilian University of Munich (LMU) ( email )

Geschwister-Scholl-Platz 1
Munich, DE Bavaria 80539
Germany

CESifo (Center for Economic Studies and Ifo Institute) ( email )

Poschinger Str. 5
Munich, DE-81679
Germany

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