Ambiguity aversion: the explanatory power of indeterminate probabilities

Daniel Ellsberg presented in Ellsberg (The Quarterly Journal of Economics 75: 643-669, 1961) various examples questioning the thesis that decision making under uncertainty can be reduced to decision making under risk. These examples constitute one of the main challenges to the received view on the foundations of decision theory offered by Leonard Savage in Savage (1972). Craig Fox and Amos Tversky have, nevertheless, offered an indirect defense of Savage. They provided in Fox and Tversky (1995) an explanation of Ellsberg's two-color problem in terms of a psychological effect: ambiguity aversion. The 'comparative ignorance' hypothesis articulates how this effect works and explains why it is important to an understanding of the typical pattern of responses associated with Ellsberg's two-color problem. In the first part of this article we challenge Fox and Tversky's explanation. We present first an experiment that extends Ellsberg's two-color problem where certain predictions of the comparative ignorance hypothesis are not confirmed. In addition the hypothesis seems unable to explain how the subjects resolve trade-offs between security and expected pay-off when vagueness is present. Ellsberg offered an explanation of the typical behavior elicited by his examples in terms of these trade-offs and in section three we offer a model of Ellsberg's trade-offs. The model takes seriously the role of imprecise probabilities in explaining Ellsberg's phenomenon. The so-called three-color problem was also considered in Fox and Tversky (1995). We argue that Fox and Tversky's analysis of this case breaks a symmetry with their analysis of the two-color problem. We propose a unified treatment of both problems and we present a experiment that confirms our hypothesis.