First-Order and Second-Order Ambiguity Aversion

29 Pages Posted: 8 Oct 2015

See all articles by Matthias Lang

Matthias Lang

Ludwig Maximilian University of Munich (LMU) - Faculty of Economics; Max Planck Society for the Advancement of the Sciences - Max Planck Institute for Research on Collective Goods; CESifo (Center for Economic Studies and Ifo Institute)

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Date Written: October 2015

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: Uncertainty Aversion, Ambiguity, Smooth Ambiguity Aversion, Subjective Beliefs, Kinked preferences

JEL Classification: D82, D01, D81, G11

Suggested Citation

Lang, Matthias, First-Order and Second-Order Ambiguity Aversion (October 2015). MPI Collective Goods Preprint, No. 2015/13. Available at SSRN: https://ssrn.com/abstract=2670427 or http://dx.doi.org/10.2139/ssrn.2670427

Matthias Lang (Contact Author)

Ludwig Maximilian University of Munich (LMU) - Faculty of Economics ( email )

Ludwigstrasse 28
Munich, D-80539
Germany

Max Planck Society for the Advancement of the Sciences - Max Planck Institute for Research on Collective Goods ( email )

Kurt-Schumacher-Str. 10
Bonn
Germany

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

Poschinger Str. 5
Munich, DE-81679
Germany

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