A theory of subjective compound lotteries

We develop a Savage-type model of choice under uncertainty in which agents identify uncertain prospects with subjective compound lotteries. Our theory permits issue preference; that is, agents may not be indifferent among gambles that yield the same probability distribution if they depend on differe...

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Bibliographic Details
Published in:Journal of economic theory 2009-05, Vol.144 (3), p.899-929
Main Authors: Ergin, Haluk, Gul, Faruk
Format: Article
Language:English
Subjects:
Agency theory
Compound lottery
Compound lottery Second-order probabilistic sophistication Uncertainty aversion Second-order risk aversion Issue preference Ellsberg paradox
Economic models
Economic theory
Ellsberg paradox
Issue preference
Lotteries
Preferences
Probability
Risk aversion
Second-order probabilistic sophistication
Second-order risk aversion
Studies
Subjectivity
Uncertainty
Uncertainty aversion
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Summary:We develop a Savage-type model of choice under uncertainty in which agents identify uncertain prospects with subjective compound lotteries. Our theory permits issue preference; that is, agents may not be indifferent among gambles that yield the same probability distribution if they depend on different issues. Hence, we establish subjective foundations for the Anscombe–Aumann framework and other models with two different types of probabilities. We define second-order risk as risk that resolves in the first stage of the compound lottery and show that uncertainty aversion implies aversion to second-order risk which implies issue preference and behavior consistent with the Ellsberg paradox.
ISSN:0022-0531
1095-7235
DOI:10.1016/j.jet.2008.08.003