Policonomics » LPsection » Risk and uncertainty II: Uncertainty

Risk and uncertainty II: Uncertainty

Summary

In this LP we learn a bit more about risk, but also about uncertainty. We start by seeing again how risk is analysed using Morgenstern and von Neumann’s expected utility theory. We also learn about alternative approaches, such as the Friedman-Savage and Markowitz perspectives, but especially Daniel Kahneman’s prospect theory. We end our study of risk and uncertainty by learning how game theory can help when analysing uncertainty.

Risk:

EUT and other approaches:

Uncertainty:

Uncertainty
Game theory

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.

In order to analyse uncertain situations, we must use a complete different framework: game theory.

Risk and uncertainty II: Prospect theory Risk and uncertainty II: Game theory