Economic Rationality: Investigating the Links between Uncertainty, Complexity, and Sophistication

Abstract

We report on a laboratory experiment measuring the preferences of a unique pool of risk professionals over various sources of uncertainty that entail different degrees of complexity. We then compare these preferences with those of a control group composed of social science students to obtain a deeper understanding of the mechanisms driving behaviors under risk and ambiguity. We find that (1) ambiguity aversion is robust to subjects’ degree of sophistication in probabilistic reasoning and background. (2) An association exists between attitudes toward ambiguity and compound risk for students/less sophisticated subjects, and is mainly explained by their attitudes toward complexity. Such an association does not exist for risk professionals/more sophisticated subjects. (3) The failure to reduce compound risk emerges as a sufficent, but not necessary, condition for ambiguity non-neutrality. These findings suggest that decision making under ambiguity cannot be reduced to decision making under risk. Keywords: Ambiguity aversion, reduction of compound lotteries, non-expected utility, model uncertainty, model misspecification JEL Codes: D81

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