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Behavioural Models of Ambiguity

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Behavioural Models of Ambiguity

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Behavioural Models of Ambiguity

Introduction

Ambiguity in decision-making refers to situations where the probabilities of outcomes are


unknown. Unlike risk, where probabilities are known and quantifiable, ambiguity involves uncertainty
without clear probabilities. Behavioural models of ambiguity seek to explain how individuals make
decisions under such uncertain conditions, diverging from the traditional expected utility theory.

Traditional Expected Utility Theory

Before delving into behavioural models, it is essential to understand the limitations of


traditional expected utility theory (EUT) when dealing with ambiguity. EUT assumes that individuals
have well-defined probabilities for all possible outcomes and make decisions by maximizing their
expected utility. However, real-world scenarios often involve ambiguity, where probabilities are
unknown or imprecise, leading to deviations from EUT predictions.

Ambiguity Aversion

Ambiguity aversion is a common phenomenon where individuals prefer known risks over unknown
risks. This behaviour contradicts the EUT, which does not differentiate between risk and ambiguity.
Ambiguity aversion was first highlighted by the Ellsberg Paradox, where people consistently choose
known probabilities over ambiguous ones, even when the expected values are identical.

Key Behavioural Models of Ambiguity

1. Maximin Expected Utility (MEU)

2. Smooth Ambiguity Model (SAM)

3. Choquet Expected Utility (CEU)

4. Multiple Priors Model (MPM)

5. Prospect Theory and Ambiguity

1. Maximin Expected Utility (MEU)

The Maximin Expected Utility model, proposed by Gilboa and Schmeidler (1989), addresses
ambiguity by assuming that individuals maximize the minimum expected utility over a set of possible
probability distributions.

Mathematical Formulation:
• P is a set of possible probability distributions.

• P(s) is the probability of state S.

• 𝑢(𝑥𝑠) is the utility of outcome 𝑥𝑠.

Example: Consider a decision maker choosing between two investments: one with a known return
distribution and another with an unknown distribution. The MEU model predicts that the decision maker
will evaluate the worst-case scenario for the unknown distribution and compare it with the known
distribution, often preferring the latter due to ambiguity aversion.

2. Smooth Ambiguity Model (SAM)

The Smooth Ambiguity Model, developed by Klibanoff, Marinacci, and Mukerji (2005), incorporates
ambiguity into the utility function by introducing a second-order probability distribution over the first-
order subjective probabilities.

Mathematical Formulation:

Where:

• Δ represents the set of probability distributions.

• μ is a second-order distribution over Δ.

• v is a function that captures ambiguity aversion.

Example: In choosing between two job offers, one with a clear salary structure and another with
potential bonuses but unclear probabilities, the SAM model predicts that the individual will evaluate
the expected utilities of each job offer and adjust for ambiguity aversion, potentially favouring the job
with the clear salary structure.

3. Choquet Expected Utility (CEU)

The Choquet Expected Utility model, proposed by Schmeidler (1989), uses non-additive probabilities
(capacities) to represent ambiguity. This model allows for a more flexible representation of uncertainty
by relaxing the additivity requirement of probabilities.

Mathematical Formulation:

Where:
• ϕ is a capacity, a non-additive measure representing ambiguity.

• The integral is taken in the sense of Choquet, which integrates utility over the capacity.

Example: When choosing between medical treatments, one with well-documented success rates and
another with less clear data but potential higher benefits, the CEU model predicts that individuals will
use non-additive measures to weigh the potential outcomes, often leading to a preference for the
treatment with clearer success rates.

4. Multiple Priors Model (MPM)

The Multiple Priors Model, also known as the Gilboa-Schmeidler model, assumes that decision makers
consider multiple plausible probability distributions and evaluate the worst-case expected utility among
them.

Mathematical Formulation:

Where:

• P is a set of plausible probability distributions.

• is the expected utility under distribution P.

Example: In financial planning, when facing multiple economic forecasts, the MPM predicts that an
investor will consider the worst-case scenario among the forecasts to make conservative investment
decisions.

5. Prospect Theory and Ambiguity

Prospect Theory, developed by Kahneman and Tversky (1979), primarily addresses decision making
under risk but has been extended to incorporate ambiguity. The model emphasizes the importance of
reference points and the differing treatment of gains and losses.

Mathematical Formulation:

Where:

• 𝜋(𝑝𝑖) is a probability weighting function that can be adjusted to account for ambiguity.

• 𝑣(𝑥𝑖) is the value function.


Example: In consumer choices, such as selecting a product with known and unknown features, Prospect
Theory predicts that consumers will weigh the known features more heavily and may overvalue or
undervalue ambiguous features depending on their risk preferences.

Empirical Studies and Applications

1. Ellsberg Paradox:

• Study: Ellsberg (1961) demonstrated that people prefer bets with known probabilities
over those with unknown probabilities, highlighting ambiguity aversion.

• Findings: Participants consistently chose options with known risks over ambiguous
ones, contradicting the predictions of EUT.

2. Investment Decisions:

• Study: Garlappi, Uppal, and Wang (2007) explored ambiguity in portfolio choice,
showing that ambiguity-averse investors prefer portfolios with more predictable
outcomes.

• Findings: Investors' preferences for less ambiguous assets were consistent with the
predictions of models like MEU and MPM.

3. Medical Decision Making:

• Study: Curley, Yates, and Abrams (1986) examined how ambiguity affects medical
decisions, finding that patients and doctors prefer treatments with clearer probabilities
of success.

• Findings: The preference for less ambiguous treatments supports the application of
SAM and CEU in healthcare contexts.

Behavioural models of ambiguity provide a more nuanced understanding of decision making


under uncertainty compared to traditional expected utility theory. Models such as Maximin Expected
Utility, Smooth Ambiguity Model, Choquet Expected Utility, Multiple Priors Model, and extensions of
Prospect Theory incorporate ambiguity aversion and offer insights into real-world decision-making
behaviour. Empirical studies support these models, demonstrating how ambiguity influences choices in
various domains, from finance to healthcare. By integrating psychological factors and relaxing some of
the strict assumptions of EUT, these models offer a richer framework for analysing decisions under
uncertainty.

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