Justifying precautionary policies: Incommensurability and uncertainty

When decisions are taken in conditions of Keynesian or Knightian uncertainty, and when there is a threat of serious or irreversible environmental damage, the Precautionary Principle is often recommended to guide decision-making. However, the Precautionary Principle has been widely criticised. In response to these criticisms, a qualitative version of the Precautionary Principle is developed which draws its normative content from a blend of formal decision theory and political philosophy. It is argued that precautionary action can be justified by some flexible combination of uncertainty and incommensurability. The ‘greater’ the uncertainty, the ‘less’ incommensurability is required to justify precautionary action, and vice versa. Throughout the paper, the arguments are explored using the example of climate change decision problems.     

Irreversible investment and Knightian uncertainty

When firms make a decision about irreversible investment, they may not have complete confidence about their perceived probability measure describing future uncertainty. They may think other probability measures perturbed from the original one are also possible. Such uncertainty, characterized by not a single probability measure but a set of probability measures, is called “Knightian uncertainty.” The effect of Knightian uncertainty on the value of irreversible investment opportunity is shown to be drastically different from that of traditional uncertainty in the form of risk. Specifically, an increase in Knightian uncertainty decreases the value of investment opportunity while an increase in risk increases it.     

The uncertain foundations of the welfare state

The welfare state is often portrayed as provider of insurance against ‘uncertainties’, in Knight's (1921) sense of the term, which would be refused or underinsured on private markets. This image conflicts with the standard economic model of risk exchange founded on the subjective interpretation of probability, which predicts that all individual uncertainties will be insured by private markets. Our aim in this paper is to explain why this prediction fails and, building on contributions to decision theory that take seriously the idea of Knightian uncertainty, to show why social insurance may be justified.     

A Dynamic Characterization of Rawls's Maximin Principle: Theory and Implications

The purpose of this paper is to provide a reinterpretation of the maximin principle in Rawls's theory of justice. As we discuss the issue of social justice, we differentiate the point in time at which rectifying practices are discussed and the time intervals in which these practices are implemented; we explore the information content for people behind the veil of ignorance; and we distinguish the means and ends for social justice. With these points clarified, we interpret the veil of ignorance in Rawls's theory as a form of Knightian uncertainty, and show that Rawls's maximin criterion would be chosen by rational individuals behind the veil of ignorance.     

On pragmatic Philosophy and Knightian uncertainty

Knight indicates that his proposition of uncertainty is based on two important premises: (a) that the proposition of uncertainty is premised on a reevaluation of the theory of knowledge, and (b) that the primary theory of knowledge used in this re-evaluation may be the Pragmatic theory of knowledge. It is instructive to follow up on the hints that Knight gives, regarding the influences on his work, so as to clarify aspects of Knightian uncertainty for contemporary research. Accordingly, this work first analyzes the main insights of Pragmatic philosophy. Second, the connection between these insights and the definition of Knightian uncertainty is then outlined. Third, some conclusions as to the implications of this analysis are drawn.     

Knightian decision theory and econometric inferences

An uncertainty averse Knightian decision maker has a set of probability distributions over outcomes and chooses something other than the status quo only if the change increases the expected payoff according to all the distributions. It is possible to define a standardized degree of uncertainty aversion. To each such degree, there corresponds a set of prior distributions over the parameters of a Gaussian linear regression model, these priors being centered on a uniform prior. The set of posterior means corresponding to this set of priors has the same properties as a standard confidence region.     

Environmental Policy Theory Given Bounded Rationality and Other-regarding Preferences

Established environmental policy theory is based on the assumption of homo economicus. This means that people are seen as fully rational and acting in a self-regarding manner. In line with this, economics emphasizes efficient policy solutions and the associated advantages of price incentives. Behavioral economics offers alternative, more realistic views on individual behavior. In this paper we investigate opportunities to integrate bounded rationality and other-regarding preferences into environmental policy theory to arrive at recommendations for more effective policies. For this purpose, we will address decisions made under risk and uncertainty, intertemporal choice, decision heuristics, other-regarding preferences, heterogeneity, evolutionary selection of behaviors, and the role of happiness. Three aspects of environmental policy are considered in detail, namely sustainable consumption, environmental valuation and policy design. We pay special attention to the role of non-pecuniary, informative instruments and illustrate the implications for climate policy.     

Knowledge,coordination and the firm: Historical perspectives

Abstract

This paper illustrates the problems and processes of developing economic knowledge by a selective historical treatment of ideas about the firm. Coase thought it necessary to explain firms as organizations, but not as distinctive productive units; neither did he explain why markets exist. Chamberlin's attempt to introduce product differentiation and selling costs is compared with Allyn Young's process theory and Marshall's treatment of the firm, and inter-firm relations, as means of organizing the growth of knowledge. The firm is a decision-making system in a context of Knightian uncertainty, and Simon's concept of quasi-decomposability applies to human brains and human organizations.     

Knightian uncertainty and poverty trap in a model of economic growth

This paper explores how Knightian uncertainty affects dynamic properties in an economic growth model. The decision-making theory employed in the analysis is the theory of expected utility under a non-additive probability measure, i.e., the Choquet expected utility model of preference. We apply this decision-making theory to an overlapping generations model where producers face “uncertainty” in their technologies. When the producer is averse to uncertainty, the firm's profit function may not be differentiable. Therefore, the firm's decision to invest and hire labor becomes rigid for a certain measurable range of real interest rates. In dynamic equilibrium, the existence of firm-level rigidity causes discontinuity in the wage function; this makes multiple equilibria the more likely outcomes under the log utility and Cobb–Douglas production functions. In this paper, we show that even if aversion to uncertainty is small, the “poverty trap” can arise for a wide range of parameter values.     

UNCERTAINTY AVERSION AND PORTFOLIO INERTIA

In stock markets, we often observe portfolio inertia, i.e., a situation in which some stocks are not traded or not priced for a few minutes or longer. This is neither an exceptional situation in which some stock price soars too high to be priced, nor the one where some stock price plummets too much to be traded. By introducing the concept of ‘Knightian uncertainty’, Dow and Werlang (1992) account for the existence of portfolio inertia, which has not been accounted for under the concept of ‘risk’. This paper provides a characterization of the spread between buying and selling prices based on a parameter proposed by Ozaki and Streufert (1999, 2001) that enables us to estimate the attitude towards Knightian uncertainty, and shows that an increase (a decrease) in Knightian uncertainty expands (shrinks) the interval in which an investor never changes her initial position. Furthermore, we analyse the effect of an increase in Knightian uncertainty on portfolio inertia based on Epsilon‐contaminations.     

Knightian uncertainty and moral hazard

This paper presents a principal-agent model in which the agent has imprecise beliefs. We model this situation formally by assuming the agent?s preferences are incomplete as in Bewley (1986) [2]. In this setting, incentives must be robust to Knightian uncertainty. We study the implications of robustness for the form of the resulting optimal contracts. We give conditions under which there is a unique optimal contract, and show that it must have a simple flat payment plus bonus structure. That is, output levels are divided into two sets, and the optimal contract pays the same wage for all output levels in each set. We derive this result for the case in which the agent?s utility function is linear and then show it also holds if this utility function has some limited curvature.     

Self-Flagellation and Utility Maximization

Abstract

Economic models explain human behavior only to the degree that the underlying assumptions of the model are fulfilled. Consumer theory of rational choice has been applied to a wide array of situations. This paper examines the results of the model when a consumer considers bundles of goods, some of which may affect her self image. Under these conditions, wrong decisions are not easily corrected, but can more easily be reversed if the individual is able to forgive herself for having made the wrong decision.     

Knightian Uncertainty in Financial Markets: An Assessment

If information is too vague and imprecise to be summarized by a unique additive probability measure, an agent faces Knightian uncertainty or ambiguity rather than risk. Under Knightian uncertainty, an agent's beliefs may be represented by a capacity or a set of additive probabilities. It is proved that an agent's attitude towards ambiguity has a crucial role in asset price determination and portfolio choice. Knightian uncertainty attitude provides an alternative explanation of financial market failures and enables puzzles to be solved, such as market breakdowns, price indeterminacy and volatility, bid and ask spreads, portfolio inertia, violation of call and put parity.
(J.E.L.: D81, G11, G12).     

Riskiness for sets of gambles

Aumann–Serrano (J Polit Econ 116:810–836, 2008) and Foster–Hart (J Polit Econ 117:785–814, 2009) suggest two new riskiness measures, each of which enables one to elicit a complete and objective ranking of gambles according to their riskiness. These riskiness measures were created with a risky world in mind, but not an uncertain one. We apply similar arguments to models of decision under uncertainty and develop complete and objective rankings of sets of gambles, which arise naturally in many such models. Clearly, these results extend the previous riskiness measures, and they have a natural interpretation in terms of those measures even when uncertainty does play a significant role.     

Efficiency,incentives, and individual labor supply in the labor-managed firm

Parallels are drawn between the approach to the theory of individual labor supply used by Sen (“Labor Allocation in a Co-operative Enterprise.” Rev. Econ. Stud.33: 361–371, Oct. 1966) and approaches of more recent contributions. The paper considers questions of comparative statics in a general model and attempts to distinguish between behavior in labor-managed firms and profit-maximizing firms. Diagrammatic analysis is used for a simple case where income effects are absent. Questions of efficiency and comparative statics are studied in the short run (membership fixed) and in the medium term (membership variable). Finally an incentive scheme to promote efficiency is described.     

When do Heuristics Matter in Global Capital Markets? The Case of the BRIC Acronym

ABSTRACT

Several recent publications have argued that the use of heuristics by financial investors can distort global capital flows, but scholars have paid little attention to the scope conditions that determine when heuristics become influential (and when they don’t). Building on work in economic sociology and behavioural finance we suggest that the degree to which investment heuristics can bias aggregate capital flows depends on the levels of uncertainty and self-referentiality that structure the environments under which investment decisions are being made. Applying these insights to the two principal global markets for corporate investment, we argue that the institutional structure of markets for short-term portfolio equity investments (PEI) is far more conducive to trigger the mimetic adoption of a specific heuristic than in markets for long-term foreign direct investments (FDI). To test this hypothesis, we leverage the high level of arbitrariness of the selection of Brazil, Russia, India and China into the BRIC acronym and empirically examine the impact of its remarkable rise to prominence among communities of financial investors in the mid-2000s on global capital flows to emerging economies. In line with the theoretical argument, we find robust evidence of a strong BRIC-bias in markets for PEI but not FDI.     

Prior symmetry, similarity-based reasoning, and endogenous categorization

This paper presents a rational theory of categorization and similarity-based reasoning. I study a model of sequential learning in which the decision maker infers unknown properties of an object from information about other objects. The decision maker may use the following heuristics: divide objects into categories with similar properties and predict that a member of a category has a property if some other member of this category has this property. The environment is symmetric: the decision maker has no reason to believe that the objects and properties are a priori different. In symmetric environments, categorization is an optimal solution to an inductive inference problem. Any optimal solution looks as if the decision maker categorizes. Various experimental observations about similarity-based reasoning coincide with the optimal behavior in my model.     

Model uncertainty and liquidity

Extreme market outcomes are often followed by a lack of liquidity and a lack of trade. This market collapse seems particularly acute for markets where traders rely heavily on a specific empirical model such as in derivative markets like the market for mortgage backed securities or credit derivatives. Moreover, the observed behavior of traders and institutions that places a large emphasis on “worst-case scenarios” through the use of “stress testing” and “Value-at-Risk” seems different than Savage expected utility would suggest. In this paper, we capture model-uncertainty using an Epstein and Wang [Epstein, L.G., Wang, T., 1994. Intertemporal asset pricing under Knightian uncertainty. Econometrica 62, 283–322] uncertainty-averse utility function with an ambiguous underlying asset-returns distribution. To explore the connection of uncertainty with liquidity, we specify a simple market where a monopolist financial intermediary makes a market for a propriety derivative security. The market-maker chooses bid and ask prices for the derivative, then, conditional on trade in this market, chooses an optimal portfolio and consumption. We explore how uncertainty can increase the bid–ask spread and, hence, reduces liquidity. Our infinite-horizon example produces short, dramatic decreases in liquidity even though the underlying environment is stationary. We show how these liquidity crises are closely linked to the uncertainty aversion effect on the optimal portfolio. Effectively, the uncertainty aversion can, at times, limit the ability of the market-maker to hedge a position and thus reduces the desirability of trade, and hence, liquidity.