Ambiguity Aversion: Avoidance of the Unknown

If you are familiar with the idea of risk aversion, our innate preference for a sure outcome over a gamble that would result in an equivalent or higher expected value, the concept of ambiguity aversion is very similar. It claims that people show a preference for known risks over unknown risks. Ambiguity aversion differs from risk aversion because it applies to situations in which probabilities of outcomes are unknown, while risk aversion is based on scenarios where a probability can be assigned to each possible outcome.

The famous experiment used to describe this idea, the Ellsberg paradox, begins by presenting an urn with 50 red and 50 black balls, and another urn that has 100 balls with an unknown color ratio of red to black. Suppose you have one chance to draw a ball at random and you receive $100 for drawing a red and nothing for drawing a black, which urn do you chose to draw from? A significantly larger amount of people said they would draw from the urn of known proportions, but will this yield a higher expected value?

In the first case we know that the urn contains black and red balls in equal proportions, and in the second case this proportion is unknown meaning that each ball is as likely to be black as red. This means that the probability of drawing a red ball from both urns is ½. Due to the strong preference for the known probability urn, experimentalists were able to come to the conclusion that people’s willingness to act in the presence of uncertainty doesn’t only depend on the perceived probability of the event in question, but also on its vagueness or ambiguity.

An example of this principle put to use is by Hyundai’s marketing team, who in 2010 used it to sell cars. They played on the decision many people searching for a car make- buy a new or used car? They were able to eliminate the uncertainty or the size of the drop in value that their new car will experience once it is driven out of the lot, and compare it to that of a used car. By switching an unknown risk for an absolute certainty, companies like Hyundai are able to use the principal of ambiguity aversion to increase their sales and use empirical data to eliminate common uncertainties that their potential buyers hold.

One Reply to “Ambiguity Aversion: Avoidance of the Unknown”

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