ABSTRACT
The concepts of risk and risk aversion are cornerstones of a broad range of models in economics and finance. In contrast, relatively little attention is paid in formal models to the phenomenon of uncertainty that is arguably more prevalent than risk. The distinction between them is roughly that risk refers to situations where the perceived likelihoods of events of interest can be represented by probabilities, whereas uncertainty refers to situations where the information available to the decision-maker is too imprecise to be summarized by a probability measure. Thus the terms “vagueness” or “ambiguity” can serve as close substitutes. Ellsberg, in his famous experiment, has demonstrated that such a distinction is meaningful empirically, but it cannot be accommodated within the subjective expected utility (SEU) model.
