The Microeconomics of Choice under Risk and Uncertainty: Where Are We?

Abstract

Financial decision-making is not straightforward, in part, because such decisions generally involve comparing financial assets the payoffs from which are subject to risk and uncertainty. Given that situation, two questions naturally arise: How do economic agents go about the business of making choices in the face of risk and uncertainty? And, how should economic agents make choices in the face of risk and uncertainty? This paper concentrates on the first of these questions and discusses some of the main attempts made by economic theory to understand how economic agents go about the business decision-making under conditions of risk and uncertainty. Theoretical possibilities considered in the context of decisions under conditions of risk include: Expected value maximization, Expected utility maximization, Rank dependent utility maximization, Prospect theory, and the Topology of fear approach to decision-making in the face of catastrophic risk. This paper also considers empirical tests of these theoretical possibilities and some of the anomalies and responses thrown up by those tests such as: Allais Paradox, Discovered Preference Hypothesis, and the choice behaviour of CEOs when faced with risk. The paper concludes with a brief excursion into choice under uncertainty where, unlike in risky choice situation, the existence of objective probabilities over states of the world cannot be relied on. In that context, the author briefly canvases the Subjective Expected Utility approach — which is unable in general to account for ambiguity aversion — Choquet utility, Wald's Multiple Priors, and the Case Based approach This paper highlights the fact that the rich and fascinating field of decision-making under risk and uncertainty is characterized by a constant interplay between theoretical conjecture, empirical testing, and theoretical refinement. Such interplay is mirrored by this paper and contributions in the Colloquium Section of this Issue, where the thoughts of practitioners and academics interact.

Strategic decision-making under ambiguity: a new problem space and a proposed optimization approach

“…The approach in the second camp is to model and describe individual-level DMUA behavior, most often by capturing observable ambiguity avoidance or decision-making inertia (Sautua 2017). This approach relates to two directions in the management literature-to understand how real managers deal with DMUA (e.g., by simplifying the problem- Hey et al 2010) and to provide a way to mathematically model the effect of ambiguity on subjective beliefs over those objectively unknowable probabilities (Bryant 2014;Galaabaatar and Karni 2013). In the latter, based on observed individual-level DMUA behavior, scholars construct a function, or a process description, consistent with the consensus outcomes about how much participants pay to avoid the choices that include ambiguous probabilities.…”