First-Order and Second-Order Ambiguity Aversion
29 Pages Posted: 8 Oct 2015
Date Written: October 2015
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: Suggested Citation