Dynamic Consistency and Expected Utility with State Ambiguity

Abstract

While models of ambiguity are reputed to generate a basic tension between dynamic consistency and the Ellsberg choices, this paper identifies a third implicit ingredient of this tension, namely the parsimony rule, which enforces each state of nature to encode a well-defined unique observation. This paper then develops nonparsimonious interpretations of the state space to make the Ellsberg choices compatible with both expected utility and dynamic consistency. The state space may contain nonobservable states: a state is allowed to encode more than one observation, a pattern called state ambiguity. The presence of such ambiguous states motivates an explicit distinction between the decision-maker and the theory-maker, the latter designing the state space and eliciting the former's preferences.

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