Allais, Ellsberg, and preferences for hedging

Mark Dean, Pietro Ortoleva

Research output: Contribution to journalArticlepeer-review

22 Scopus citations

Abstract

Two of the most well known regularities observed in preferences under risk and uncertainty are ambiguity aversion and the Allais paradox. We study the behavior of an agent who can display both tendencies simultaneously. We introduce a novel notion of preference for hedging that applies to both objective lotteries and uncertain acts. We show that this axiom, together with other standard ones, is equivalent to a representation in which the agent (i) evaluates ambiguity using multiple priors, as in the model of Gilboa and Schmeidler, 1989, and (ii) evaluates objective lotteries by distorting probabilities, as in the rank dependent utility model, but using the worst from a set of distortions. We show that a preference for hedging is not sufficient to guarantee Ellsberg-like behavior if the agent violates expected utility for objective lotteries; we provide a novel axiom that characterizes this case, linking the distortions for objective and subjective bets.

Original languageEnglish (US)
Pages (from-to)377-424
Number of pages48
JournalTheoretical Economics
Volume12
Issue number1
DOIs
StatePublished - Jan 1 2017
Externally publishedYes

All Science Journal Classification (ASJC) codes

  • Economics, Econometrics and Finance(all)

Keywords

  • Allais paradox
  • Ambiguity aversion
  • Ellsberg paradox
  • hedging
  • multiple priors
  • probability weighting
  • rank dependent utility
  • subjective mixture

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