3.1 Risk and Uncertainty

Economists attach a precise meaning to the words risk and uncertainty. Pandora makes a decision under risk if unambiguous probabilities can be assigned to the states of the world in her belief space B. Otherwise, she decides under uncertainty. The importance of distinguishing decision problems in which unambiguous probabilities are available from those in which they aren’t was first brought to the attention of the world by Frank Knight (1921). For this reason, people often speak of Knightian uncertainty to emphasize that they are using the word in its technical sense.

The archetypal case of risk is playing roulette in a casino. The archetypal case of uncertainty is betting at the race track. Who knows what the ...

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