Quantitative Economics: Mar, 2017, Volume 8, Issue 1

Testing ambiguity theories with a mean‐preserving design

Chun‐Lei Yang, Lan Yao

Prominent models such as maxmin expected utility/alpha‐multiprior (MEU/ α‐MP) and Klibanoff, Marinacci, and Mukerji (KMM) interpret ambiguity aversion as aversion against second‐order risks associated with ambiguous acts. We design an experiment where the decision maker draws twice with replacement in the typical Ellsberg two‐color urns, but with a different color winning each time. Given this set of mean‐preserving prospects, MEU/α‐MP, KMM, and Savage's subjective expected utility all predict unequivocally that risk‐averse decision makers (DMs) will avoid the 50–50 urn that exhibits the highest risk conceivable, while risk‐seeking DMs do the opposite. However, we observe a substantial number of violations in the experiments. It appears that the ambiguity premium is partially paid to avoid the ambiguity issue per se, which is distinct from notions of second‐order risk. This finding is robust even when there is only partial ambiguity, and is applicable to all models that satisfy a monotonicity condition.

Ambiguity Ellsberg paradox expected utility experiment mean preserving monotonicity partial ambiguity second‐order risk source premium C91 D81

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