Policonomics » LPsection » Risk and uncertainty I: Uncertainty

Risk and uncertainty I: Uncertainty

Summary

Everyone has to make decisions, but it is not always clear to us what outcomes can derive from these decisions. When this happens, we say we are making decisions in situations under risk or uncertainty. In this LP we learn about risk and uncertainty. We see how risk can be analysed by using expected utility instead of expected value, and how different kind of people will behave differently when facing risk.

Risk and uncertainty:

Risk
Uncertainty

Expected utility:

Risk aversion analysis:

The theory of consumer choice under situations of risk and uncertainty belongs to the field of microeconomics. Risk and uncertainty are sometimes interchangeable terms but their meaning is easily misunderstood. Frank Knight in his “Risk, Uncertainty and Profit” 1921, treated this subject and posed a fundamental distinction between the two, formulating the definition that, ever since, became the most widely used.

In a situation that involves uncertainty the outcome is unknown and agents cannot (or will not) assign probabilities to each outcome. Sometimes it is said that uncertainty is an unknown-unknown, while risk is a known-unknown, since agents assign probabilities to each outcome.

Consumer choice under uncertainty is studied mainly in game theory, while risk is usually analysed using the expected utility theory approach.

Now that we know exactly what the difference between risk and uncertainty is, let’s see how to deal with risk. We’ll start by learning how Daniel Bernoulli came up with a solution to the Saint Petersburg paradox.

Risk and uncertainty I: Risk Risk and uncertainty I: St. Petersburg paradox