Ambiguity and Second-Order Belief Kyoungwon Seo May 19, 2009

Abstract Anscombe and Aumann (1963) is a classic characterization of subjective expected utility theory. This paper employs the same domain for preference and a closely related (but weaker) set of axioms to characterize preferences that use second-order beliefs (beliefs over probability measures). Such preferences are of interest because they accommodate Ellsberg-type behavior. Keywords: ambiguity, Ellsberg Paradox, second-order belief.

1

Introduction

The Ellsberg (1961) Paradox has raised questions about the subjective expected utility model and has stimulated development of a number of more general theories. In one version of the paradox (Ellsberg (2001, p.151)), there is an urn known to contain 200 balls of 4 colors – RI , BI , RII and BII . RI and RII denote two di¤erent shades of red; similarly, BI and BII denote two di¤erent shades of blue. The urn is known to contain 50 RII balls and 50 BII Department of Managerial Economics and Decision Sciences, Kellogg School of Management, Northwestern University, [email protected]. I am indebted to Larry G. Epstein for his illuminating guidance and invaluable advice. I thank D. Ahn, P. Barelli, P. Ghirardato, F. Gul, I. Kopylov, B. Lipman, M. Marinacci, K. Nehring, B. Polak and P. Wakker for helpful discussions and suggestions. I also thank audiences at the University of Rochester, Boston University, the University of Chicago, Washington University in St. Louis, Rice University, Yale University, Northwestern University, the Canadian Economic Theory Conference, the RUD’06 Workshop on Risk, Utility and Decision, and the 2006 NBER/NSF/CEME Conference on General Equilibrium. Finally, the detailed comments of the editor and the referees were extremely valuable.

1

balls. But the number of RI (or BI ) balls is unknown. One ball is to be drawn from the urn. Consider the following 6 bets on the color of the ball that is drawn.

A B C D AB CD

100 50 50 RI BI RII BII $100 $0 $0 $0 $0 $100 $0 $0 $0 $0 $100 $0 $0 $0 $0 $100 $100 $100 $0 $0 $0 $0 $100 $100

Bet A gives $100 if the drawn ball is RI and $0 otherwise. The other bets are interpreted similarly. Many subjects rank C D A B and AB CD. Subjective Expected Utility (SEU) cannot accommodate this behavior. One explanation of this behavior is that the agent has in mind a second-order belief, or a probability measure on probability measures. The agent forms a belief on the proportion of the RI balls, or the type of the urn, and then translates bets into two-stage lotteries. Segal (1987) adopts this approach to accommodate the above ranking. He uses anticipated utility theory (see Quiggin (1982) for example). However he is well aware that ‘modelling the Ellsberg paradox as a two-stage lottery does not depend on anticipated utility theory’but on nonreduction of two-stage lotteries. Klibano¤, Marinacci and Mukerji (2005) (henceforth KMM) propose and axiomatize a utility representation of preference involving the standard expectations of utilities, where nonreduction of a second-order belief is key to accommodating the Ellsberg paradox. Nau (2006) and Ergin and Gul (2004) characterize utility representations that, at least in special cases of their models, can be interpreted similarly to that of KMM. This paper provides a new axiomatization for a model of preference involving a secondorder belief. An important di¤erence from the cited models lies in what is assumed about the domain of preference. Models of preference typically model the ranking not only of bets, but also of all other acts – an act over a state space S is a (measurable) function from S into the set of outcomes. In the Ellsberg case, the natural state space is SE = fRI ; BI ; RII ; BII g and bets are binary acts over SE . I now use the Ellsberg setting to highlight the noted di¤erence in assumptions about the domain. 2

KMM assume two subdomains and two corresponding preferences. One consists of acts on SE and a preference is given over this set of acts. For the other subdomain, they introduce another state space (SE ), the set of all probability measures over SE . Each probability measure over SE corresponds to a particular number of RI balls in the Ellsberg urn. KMM call an act over (SE ) a second-order act. They assume that the preference over secondorder acts is an SEU preference, which leads immediately to second-order belief.1 Ergin and Gul permit issue preference, called source dependence in Nau.2 They assume two issues and their state space is a product space. In the Ellsberg context, one issue is which ball is drawn and the other is what color is each ball. The second issue determines the type of the urn and hence a probability measure over SE . Given preference on acts over the product state space, they prove a representation involving a …rst-order belief over the product state space, that can be interpreted as a second-order belief over the …rst issue. Therefore, KMM, Nau and Ergin-Gul assume state spaces bigger than SE . They presume that the analyst can observe more than just the ranking of acts over the color of the drawn ball –the ranking of acts over the “type of the urn”must also be observable. Similar remarks apply to their model in general (not only Ellsbergian) settings. The importance of the domain assumption can be illustrated in the context of an asset market. Consider a simple model where the asset price may go up (H) or go down (L). In this setting, a bet on H corresponds to buying the asset and a bet on L to selling the asset –decisions that are observed in many data sets. On the other hand, a second-order act (or a bet on the second issue) is a bet on the true nature of the market – the probability that the price goes up. But we do not observe bets on the true probability; that is, the payo¤s of real-world securities depend on realizations of prices, and not separately on the mechanism that generates these realizations. This paper adopts a domain consisting of lotteries over acts de…ned over a basic state space –which is SE in the Ellsberg case. Arguably, this domain is closer to the set of choices involved in the Ellsberg Paradox than are the domains of KMM and Ergin-Gul. Besides, the domain in this paper is the same as that in Anscombe and Aumann (1963), one of the classic papers on SEU. Frequently, “the Anscombe-Aumann domain” is taken to be the set of all acts whose prizes are lotteries (see Kreps (1988), for example). Note, however, that in their paper, Anscombe-Aumann use the set of all lotteries over such acts. Thus, the choice objects in this paper and Anscombe-Aumann have three stages. 1

See Section 6 for further discussion of the relation between the KMM representation result and the main theorem in this paper. 2 Nau allows also state dependence.

3

The model in this paper, referred to as Second Order Subjective Expected Utility (SOSEU), has the following representation:3 Z Z Z v u(f )d dm( ); V (P ) = U (f )dP (f ) and U (f ) = (S)

S

where P is a lottery over acts, f is an act and m is a second-order belief (a probability measure on (S)). Degenerate lotteries can be identi…ed with acts and thus V induces the utility function U over acts. When v is linear V collapses to Anscombe-Aumann’s SEU. SOSEU has di¤erent axiomatic foundations from SEU. In their characterization of SEU, Anscombe and Aumann assume Order, Continuity, Independence, Reversal of Order and Dominance. I drop Reversal of Order and modify Dominance to characterize SOSEU. The functions u and v in SOSEU are cardinally unique. Thus it is possible to discuss connections bewteen the properties of the functions and preference. In particular, v captures ambiguity attitude –if v is concave, then preference exhibits Ellsbergian behavior. As usual, u characterizes attitude toward risk. The interpretations of u and v are considered in detail in KMM; Nau and Ergin-Gul have related results and discussions. The domain in this paper makes it possible to analyze attitudes toward ambiguity and two-stage lotteries at the same time. Speci…cally, SOSEU has the property that if the agent reduces two-stage lotteries into one-stage lotteries in the usual way, then he does not exhibit Ellsberg-type behavior. This prediction is con…rmed in the experiment by Halevy (2007). He claims that a descriptive theory of ambiguity aversion “should account - at the same time - for violation of reduction of compound objective lotteries.” The paper is organized as follows: Section 2 introduces the setup. In Section 3, Anscombe and Aumann’s axioms and theorem are presented. Section 4 motivates dropping their axiom Reversal of Order, and modifying Dominance. This leads to the SOSEU representation theorem. Section 5 examines the connection between nonindi¤erence to ambiguity and violation of reduction of two-stage lotteries. Section 6 discusses related literature. Proofs are contained in appendices.

2

The Setup

For any topological space X, let (X) be the set of all Borel probability measures on X, and let Cb (X) be the set of all bounded continuous functionals on X. Endow (X) with 3

Technical details are provided later.

4

R R the weak convergence topology, i.e., for n ; 2 (X), n ! if d n! d for every 2 Cb (X). If X is a separable metric space, so is (X). (See Aliprantis and Border (1999, p.482); these authors are henceforth AB.) Let BX denote the Borel -algebra on X and denote by x 2 (X) a point mass on X, de…ned by x (A) = 0 if x 2 = A and x (A) = 1 if x 2 A. Let S = fs1 ; s2 ; :::; sjSj g be a …nite set of states. Let Z denote a set of outcomes or prizes, where Z is a separable metric space. An act f is a function from S into (Z). Let H be the set of all acts endowed with the product topology. Preference is de…ned on (H). I refer to an element in (Z) as a one-stage lottery and to an element in ( (Z)) as a two-stage lottery (or a compound lottery). A constant act (an act taking the same value for every s 2 S) is viewed also as a one-stage lottery. Moreover, any act f is identi…ed with f . Then, it is immediate that (Z) H (H) and hence ( (Z)) (H). Therefore the preference induces rankings on H, (Z) and ( (Z)). Typical elements in (H) are denoted by P , Q and R. I use f , g and h for elements in H. In addition, P , Q and R are typical elements for ( (Z)) and, p, q and r for (Z). Denote by (x1 ; 1 ; :::; xn ; n ) a lottery that gives x1 with probability 1 and so on, where x1 ; x2 ; :::; xn can be outcomes, lotteries or acts. A typical object P in (H) is depicted in Fig. 1.

3

The Anscombe-Aumann Model

Preferences having an SEU form on (H) are characterized by Anscombe and Aumann (1963) (henceforth AA). Using the notations and de…nitions of this paper, AA’s axioms and theorem can be restated.4

Axiom 1 (Order)

is complete and transitive.

Axiom 2 (Continuity)

is continuous.

4

Actually, they don’t state the …rst 4 axioms - Order, Continuity, Second-Stage Independence and FirstStage Independence. Instead, they assumed expected utility functions on (H) and (Z), respectively.

5

s1

α

s2

P 1−α

s1

s2

a1 1 − a1 a2 1 − a2 b1 1 − b1 b2 1 − b2

Objective prob.

z1 z2 z3 z4 z5 z6 z7 z8

Objective prob.

Figure 1: A typical element in (H). The …rst and the last nodes are governed by objective probabilities ; a1 ; a2 ; b1 and b2 . The second node is selected according to the realized state s1 or s2 .

De…nition 1 For f; g 2 H and 2 [0; 1], f (1 )g 2 H is a component-wise mixture, i.e., for every s 2 S and every B 2 BZ , ( f (1 )g) (s)(B) = f (s)(B)+(1 )g(s)(B). This operation is referred to as a second-stage mixture. Axiom 3 (Second-Stage Independence) For any (Z), p (1 )r q (1

2 (0; 1] and one-stage lotteries p; q; r 2 )r () p

q.

Consider two lotteries p (1 )r and q (1 )r. Both give the same prize r with probability (1 ). The two lotteries di¤er only in the -probability event. So it is intuitive that the agent’s ranking between them depends only on the ranking between p and q, regardless of the common prize r. De…nition 2 For P; Q 2 (H) and 2 [0; 1], P + (1 )Q 2 (H) is a lottery such that ( P + (1 )Q)(B) = P (B) + (1 )Q(B) for B 2 BH . This operation is called a …rst-stage mixture. For simplicity, I write f + (1 ) g instead of f + (1 ) g for any act f and g. 6

f

prob. 1

s1 s2

prob. 1

prob. 1

$ 100

g prob. 1

s2

$0 α

α f ⊕ (1 − α ) g

s1

s1

prob. 1

1−α

α

s2

1−α

prob. 1

s1 α

α f + (1 − α ) g

prob. 1

$0 $ 100

$ 100 $0 $0 $ 100 $ 100

s2

prob. 1

s1

prob. 1 $ 0

s2

prob. 1

1−α

prob. 1

$0

$ 100

Figure 2: Examples of mixture operations: f 2 H gives $100 if s1 is realized, and $0 if s2 is realized; g 2 H gives $0 for s1 and $100 for s2 . The second-stage mixture f (1 )g 2 H is an act that gives the lottery ($100; ; $0; 1 ) for s1 and the lottery ($0; ; $100; 1 ) for s2 . The …rst-stage mixture f + (1 )g 2 (H) is the lottery (f; ; g; 1 ). Axiom 4 (First-Stage Independence) For any P + (1

)R

Q + (1

2 (0; 1] and lotteries P; Q; R 2 )R () P

(H),

Q:

First-Stage Independence can be interpreted in a way similar to Second-Stage Independence.

Axiom 5 (Reversal of Order) For every f; g 2 H and f (1 )g f + (1 )g.

7

2 [0; 1],

Reversal of Order assumes that the agent is not concerned about whether the mixture operation is taken before or after the realization of the state. Later, I will discuss an argument against this axiom. Axiom 6 (AA-Dominance) Let f; g 2 H and s 2 S. If f (s0 ) = g(s0 ) for all s0 6= s and f (s) g(s), then f g.

This axiom says that when two acts give the identical prizes except in one state s, the prizes in state s determine the agent’s ranking between the two acts.

De…nition 3 An SEU representation is a bounded continuous mixture linear function u : (Z) ! R and a probability measure 2 (S) such that V AA represents on (H), where Z Z AA AA AA u(f )d : U (f )dP (f ) and U (f ) = V (P ) = S

H

AA’s theorem can be restated.5

Theorem 3.1 (AA (1963)) Preference on (H) satis…es Order, Continuity, SecondStage Independence, First-Stage Independence, Reversal of Order and AA-Dominance if and only if it has an SEU representation.

An SEU representation cannot accommodate Ellsberg-type behavior. Therefore, I proceed to develop a generalization of this model. 5

Under Reversal of Order, one of the two Independence axioms is redundant. I leave both of them to compare with the next section.

8

f R + B = 200 R=? B=?

prob. 1

R

prob. 1

?

prob. 1

B g

prob. 1

R

prob. 1

prob. 1

B R

1 1 prob. 1 f ⊕ g 2 2

B

R 1/ 2

B

1 1 f + g 2 2

R

1/ 2

B

1/ 2

$ 100

1/ 2

1/ 2

$0 $ 100

1/ 2

$0

prob. 1 prob. 1

$ 100 $0 $0 $ 100

$ 100

$0

prob. 1 $ 0 prob. 1

$ 100

Figure 3: One ball is randomly drawn from the Ellsberg urn which contains 200 balls that are either red or blue. The exact number of red (or blue) balls is unknown. An act f is a bet on red and g is a bet on blue. The second-stage mixture 21 f 12 g is unambiguous but the …rst-stage mixture is not.

4

Main Representation Theorem

Here I show that by dropping Reversal of Order and modifying AA-Dominance, one obtains a model of preference that can accommodate nonindi¤erence to ambiguity. Consider the following example that illustrates that Reversal of Order is problematic given ambiguity. In the Ellsberg example described in the Introduction, let f be the act that gives $100 if the chosen ball is red (RI or RII ), and nothing otherwise; g gives $100 if the ball drawn is blue (BI or BII ), and nothing otherwise. Let p be ($100; 1=2; $0; 1=2). As Ellsberg predicted and later experiments con…rmed, many people feel indi¤erent between f and g, but strictly prefer p to f and p to g. 9

1 Compare 12 f + 21 g and 12 f g (see Figure 3). The …rst-stage mixture 21 f + 12 g gives 2 ambiguous acts f or g. If the agent strictly prefers p to f and p to g, it is reasonable to assume that he strictly prefers p to 21 f + 12 g by the intuition of First-Stage Independence. On the other hand, the second-stage mixture 12 f 21 g has no ambiguity and can be identi…ed with p because it yields the lottery p whichever state is realized. Therefore the agent will strictly prefer 12 f 12 g to 12 f + 12 g. Under Reversal of Order, 21 f 12 g and 12 f + 12 g must be indi¤erent. This illustrates the intuition against adopting Reversal of Order.6 However one may think in a di¤erent way. For any number of blue balls in the urn, the …nal probability of getting $100 is 1/2 not only for 21 f 12 g but also for 12 f + 12 g. Hence the agent may be indi¤erent between 12 f 21 g and 12 f + 12 g; while preferring 12 f 12 g to f and g. Implicit in this argument is that 12 f + 21 g becomes a two-stage lottery when the number of blue balls is given and that the agent reduces the two-stage lottery to a one-stage lottery.7 The preceding argument supporting Reversal of Order is normatively appealing. But Halevy (2007) reports that most people who reduce compound lotteries are ambiguity neutral (see the next section). Since the argument to maintain Reversal of Order requires reduction, it may not be acceptable at a descriptive level. In this paper, I drop Reversal of Order and suggest a descriptive model to explain Ellsberg-type behavior.

Recall that AA-Dominance deals only with H, not with (H). Under Reversal of Order, stating properties on H is enough to describe properties on (H). Since I drop Reversal of Order, AA-Dominance must be modi…ed. Each f 2 H and 2 (S) induce a one-stage lottery, namely (f; ) (s1 )f (s1 ) (s2 )f (s2 ) ::: (sjSj )f (sjSj ) 2 (Z); that is, (f; ) is the one-stage lottery, or constant act, obtained by ‘reducing’ the act f using the probability law . For P 2 (H), de…ne the two-stage lottery (P; ) 2 ( (Z)) by (P; )(B) = P (ff 2 H : (f; ) 2 Bg) for each B 2 BH . See Figure 4 for an example of (P; ), and recall that the preference on (H) directly induces preferences over two-stage lotteries (including the object (P; )) by its restriction to lotteries over constant acts.

Axiom 7 (Dominance) For any P; Q 2 then P Q.

(H) ; if

6

(P; )

(Q; ) for all

2

(S),

The preceding intuition translates to the present setting Gilboa and Schmeidler(1989)’s rationale for their axiom “Uncertainty Aversion”, namely, that “hedging” across ambiguous states can increase utility. 7 See Ellsberg (2001, p.230) for a similar argument by Pratt and Rai¤a.

10

P( f )

s1

f (s1 )

s2

f (s2 )

s1

g (s1 )

s2

g (s2 )

f

P P(g )

Ψ(f , µ )

s1

Ψ ( f , µ ) ≡ µ (s1 )f (s1 )⊕ µ (s2 ) f (s2 )

s2

Ψ(f , µ )

s1

Ψ (g , µ )

s2

Ψ (g , µ )

=

P( f )

g

Ψ (P, µ )

Figure 4: If (P; ).

Ψ (g , µ )

=

P (g )

is assumed to be the true probability law, the decision maker translates P to

To interpret Dominance, consider an agent who is not certain of the true probability law over states, but who believes that there is a true law. Now suppose that (P; ) (Q; ) for every 2 (S), that is, for every probability law, he prefers the two-stage lottery induced by P to the one induced by Q. Then he must prefer P to Q. There is an implicit assumption behind this interpretation. When the probability law is given, one may interpret the choice object P 2 (H) as a three-stage lottery which is out of the domain. Dominance implicitly assumes that the agent reduces stages two and three of the three-stage lottery –the two-stage lottery (P; ) is formed by reducing the acts in the support of P to constant acts using the probability law . See the end of this section for more discussion of Dominance and for an example illustrating that Dominance excludes some interesting preferences. It is instructive to compare Dominance with AA-Dominance. Since the latter deals only with acts in H, extend AA-Dominance to lotteries over acts. Then, the extended AADominance states that P Q if (P; ) (Q; ) for all Dirac measures = s , s 2 S. Dominance posits the stronger hypothesis that (P; ) (Q; ) for all measures in (S). Thus Dominance is weaker than the extended AA-Dominance.

11

It is also instructive to observe that the extended AA-Dominance implies Kreps’Reversalof-Order-style axiom (Kreps, 1988, p.107). It states that all lotteries over Savage acts (prizes of the acts are elements in Z) that, for each state s, map naturally to the same lottery over outcomes, must be indi¤erent.8 The Kreps’axiom is essential to SEU. As aforementioned, Dominance is a weaker axiom than the extended AA-Dominance, thereby allowing for more general representation than SEU. A more complete and formal comparison of Dominance and AA-Dominance is provided in the next lemma.

Lemma 4.1 (i) Order, Continuity, Reversal of Order and AA-Dominance imply Dominance. (ii) Dominance and Second-Stage Independence imply AA-Dominance.

The main utility representation is de…ned.

De…nition 4 A Second Order Subjective Expected Utility (SOSEU) representation is a probability measure m 2 ( (S)), a bounded continuous mixture linear function u : (Z) ! R, and a bounded continuous and strictly increasing function v : u ( (Z)) ! R, such that V represents on (H), where Z U (f ) dP (f ) , and (4.1) V (P ) = H Z Z u (f ) d dm ( ) : U (f ) = v S

(S)

The probability measure m is called a second-order belief.

SOSEU can accommodate nonindi¤erence to ambiguity. When the second-order belief m is nondegenerate and v is nonlinear, the implied behavior cannot be explained by a unique 8

To see the extended AA-Dominance implies the Kreps’axiom, consider two lotteries P and Q over Savage acts. Assume that, for each s, the two lotteries induce the same lottery over Z. Then, (P; s ) = (Q; s ) for every s 2 S and the extended AA-Dominance implies that P is indi¤erent to Q.

12

(subjective) probability on S. Instead the agent behaves as though he has multiple priors on S and assigns a probability to each prior on S. SEU is the special case when v is linear.9 The new representation theorem follows. Theorem 4.2 Preference on (H) satis…es Order, Continuity, Second-Stage Independence, First-Stage Independence and Dominance if and only if it has an SOSEU representation. Appendix A provides a sketch of the proof and also some examples to demonstrate the tightness of the theorem. The complete proof is in Appendix B. Lemma 4.1 suggests that Reversal of Order is the crucial di¤erence between an SEU representation and an SOSEU representation. This is summarized in the next corollary. Corollary 4.3 Preference on (H) has an SEU representation if and only if it has an SOSEU representation and satis…es Reversal of Order. AA assume Reversal of Order. Under Reversal of Order, the agent does not care when the objective uncertainty is resolved and he collapses the two objective uncertainties into one objective uncertainty. Thus the above corollary says that if the agent collapses the two objective probabilities into one, he also collapses the second-order belief (on (S)) into the belief (on S). Consider brie‡y uniqueness of the representation in Theorem 4.2. It is easy to show that u and v u are unique up to a positive a¢ ne transformation (see Appendix C). The second-order belief m is unique in some special cases – for example, if v (z) = exp (z), the representation has a similar form to a moment generating function and m is unique. However, m is not unique in general. For example, suppose that v is linear. Then, any second-order belief that has the same …rst moment will show the same behavior. Similarly, a polynomial v of degree n implies that if two second-order beliefs, m and m0 , represent the same preference, they have the same moments up to n-th order. See Appendix C for a characterization of the uniqueness class of measures for any given u and v. 9

The functional form of an SOSEU representation is similar to that of KMM(2005). Many properties of the functional form are investigated in their paper.

13

I conclude this section with an interesting example of preference violating Dominance. Gilboa and Schmeidler (1989) axiomatize the multiple-priors model on H. Consider two alternative extensions to (H) : Z Z MP 1 u (f ) d dP (f ), and V (P ) = min 2C H S Z Z MP 2 min u (f ) d dP (f ) V (P ) = H

2C

S

for a closed set C (S). Both representations induce the same preference on H, but only V M P 1 satis…es Dominance (see examples in Appendix A). The reason can be understood as follows : agents having either representation might behave as if they were playing a game with a malevolent nature. They suspect that nature will choose a probability law that is most unfavorable to them. The di¤erence between V M P 1 and V M P 2 lies in the agent’s view of timing of nature’s move –it is before the …rst randomization (corresponding to P ) in V M P 1 and afterwards in V M P 2 . But when evaluating P 2 (H), an agent satisfying Dominance uses two-stage lotteries (P; ) as if , though still unknown, has already been chosen by nature. Therefore, V M P 1 satis…es Dominance and V M P 2 does not.

5

Ambiguity and Compound Lotteries

Here I discuss the relations between ambiguity attitude and a two-stage lottery. A two-stage lottery deals only with objective probabilities and ambiguity attitude deals with the situation where objective probabilities are unknown. The two may seem conceptually distinct, but in an SOSEU representation, they are closely related. An axiom on compound lotteries is introduced.10 Axiom 8 (Reduction of Compound Lotteries or ROCL) For any p; q 2 p (1 )q p + (1 )q.

(Z) and

2 [0; 1],

Since p and q are one-stage lotteries, p+(1 )q constitutes a two-stage lottery. Observe that p (1 )q and p + (1 )q have the same …nal outcome distribution. Thus, under 10

Segal (1990) has a slightly di¤erent form of ROCL. But it is not di¢ cult to see that the two axioms are equivalent.

14

ROCL, the agent considers only the …nal distribution and he does not care about the timing of risk resolution. An SOSEU representation does not satisfy ROCL unless v is linear. When v is nonlinear, V ( p + (1

) q) =

v (u (p)) + (1

6= v ( u (p) + (1 = V( p

(1

) v (u (q)) ) u (q)) ) q) .

R R Under SOSEU, the utility of any act f is given by U (f ) = (S) v S u(f )d dm( ); which suggests the interpretation that the agent processes an act in a two-stage fashion. This suggests further a connection between the evaluations of acts and two-stage lotteries. In the following, I will show that, given other axioms, ROCL is equivalent to Reversal of Order and that ROCL implies neutrality to ambiguity. Lemma 5.1 ROCL and Reversal of Order are equivalent under Dominance. Proof. Since (Z) H, it is straightforward that Reversal of Order implies ROCL. Conversely, assume ROCL. Then, for any 2 (S), ( f + (1

) g; ) = =

Applying Dominance leads to f + (1

)g

(f; ) + (1

)

(g; )

(f; )

)

(g; )

(1

( f

(1

) g; ) :

f

(1

) g.

Corollary 5.2 Preference has an SEU representation if and only if it has an SOSEU representation and satis…es ROCL. Proof. By Lemma 5.1 and Corollary 4.3, this is straightforward. An SOSEU representation reduces to SEU if and only if ROCL is satis…ed. In particular, ROCL implies neutrality to ambiguity. This is consistent with Halevy’s (2007) experimental …ndings. Halevy designs the following experiment. There are 3 urns, each containing 10 balls which can be red or black11 . One ball is to be drawn. Urn 1 contains 5 red balls and 5 black balls. 11

In his experiment, there were 4 urns. The fourth urn is omitted here because it is not relevant to my point.

15

In Urn 2, the proportion is unknown. For Urn 3, a ticket is drawn from a bag containing 11 tickets with numbers 0 to 10 written on them. The number on the drawn ticket determines the number of red balls in Urn 3. Each participant is asked to place a bet on the color of the drawn ball from each urn. Before any ball is drawn, the participant is given the option to sell each bet. The subject is asked the minimal price at which he/she is willing to sell the bet. Let Vi be the reservation price for urn i, i = 1; 2; 3. Ambiguity neutrality implies V1 = V2 and ROCL implies V1 = V3 . In Halevy’s experiment, 18 subjects set V1 = V3 and 17 out of them set V1 = V2 . Moreover, out of 86 subjects who show V1 6= V3 , 80 show V1 6= V2 . He concludes that “there is a very tight association between ambiguity neutrality and reduction of compound lotteries”and that “a descriptive theory that accounts for ambiguity aversion should account - at the same time - for violation of reduction of compound objective lotteries.” The domain in this paper includes both acts and two-stage lotteries, and an SOSEU representation relates ambiguity attitude to ROCL.12

6

Related Literature

The idea of second-order probabilities appears in Savage (1972, p.58). But he implicitly assumes reduction and argues that second-order probabilities accomplish nothing more than …rst-order probabilities do. Segal (1987, 1990) allows nonreduction of two-stage lotteries. In the former paper, he shows that a model of preferences allowing nonreduction of two-stage lotteries can accommodate the Ellsberg paradox. He uses anticipated utility theory and thus his model can accommodate also the Allais paradox. Gärdenfors and Sahlin (1982, 1983) also suggest a second-order probability measure. They use it to determine the set of all ‘satisfactorily reliable’ …rst-order beliefs and apply the maximin criterion for expected utilities (MMEU) rule. The violation of ROCL and the recursive structure of utility in the present model bring to mind the closely related model of Kreps and Porteus (1978). They provide axiomatic foundations for recursive expected utility with objective temporal lotteries. Their model not only has a similar functional form to SOSEU, but also takes a similar approach – Kreps and Porteus assume Independence at each stage and relax reduction. However, precise 12

Klibano¤, Marinacci and Mukerji(2005) deal with acts but not with compound lotteries. Segal’s (1990) model has two-stage lotteries but no acts.

16

probabilities are not given in most real world problems. Klibano¤ and Ozdenoren (2007) incorporate subjective uncertainty to characterize subjective recursive expected utility, which does not deal with ambiguity. SOSEU is also de…ned on a domain involving subjective uncertainty but features second-order beliefs that can accommodate Ellsbergian behavior. Violations of ROCL have been documented in some experimental literature. See, for example, Ronen (1971), Snowball and Brown (1979), Schoemaker (1987), Beranosconi and Loomes (1992), Bernasconi (1994) and Busescu and Fischer (2001). However, Cubitt, Starmer and Sugden (1998) do not …nd signi…cant violation of ROCL in an experiment testing several well-known accounts of the common ratio e¤ect. Keller (1985) reports that framing of the problems may a¤ect the degree of the violations, and Güth, van Damme and Weber (2005) …nd that the level of econometrics education may also have similar e¤ects. Some experiments deal with ambiguous urns and two-stage risky urns at the same time. Yates and Zukowski (1976), Chow and Sarin (2002) and Halevy (2007) design experiments involving one-stage risky urns, ambiguous urns and two-stage risky urns. Those urns are similar to urns 1, 2 and 3 mentioned in the previous section, respectively. All three papers report that one-stage risky urns are most preferred, ambiguous urns are least preferred and two-stage risky urns are intermediate to the others. Halevy …nds a tight association between ambiguity neutrality and ROCL, while this connection is not addressed in the other papers. Kreps (1988, pp. 105-110) notes that Order, Continuity and First-Stage Independence deliver the representation (4.1) with no further structure on the function U . He also notes that adding a Reversal-of-Order-style axiom and a monotonicity assumption (p.109, Axiom 7.16) guarantees AA’s subjective expected utility model. Theorem 4.2 (suitably modi…ed) provides a similar result : Order, Continuity, First-Stage Independence and Dominance (instead of the Reversal-of-Order-style and monotonicity axioms) are equivalent to the utility R b b is the restriction of U to representation (4.1) with U (f ) = (S) U (f; ) dm ( ) where U the constant acts (Z).13 Finally, consider (further to the discussion in the introduction) the relation to KMM. They additionally assume preference 2 over the set of all (second-order) acts on (S), and impose 3 axioms. The natural question is how their axioms are related to the ones in this paper. 13

See Lemma B.8 where Second-Stage Independence does not play a role in constructing m.

17

One needs to de…ne 2 to discuss the connection to KMM. For f 2 H, let f 2 : (Z) be the act on (S) satisfying f 2 ( ) = (f; ), and de…ne14 f2

2

g 2 if and only if f

(S) ! (6.1)

g:

Then, preference over H induces 2 over the subset ff 2 : f 2 Hg of all second-order acts. Similarly, preference over (H) induces 2 over (ff 2 : f 2 Hg), the set of lotteries over the second-order acts f 2 , having the form f 2 ( ) = (f; ). Now their axioms can be considered. First, (6.1) is KMM’s Consistency axiom. Second, their axiom, Expected Utility on Lotteries, is equivalent to Second-Stage Independence under Order and Continuity. Finally, their axiom, Subjective Expected Utility on Second Order Acts, is the counterpart of First-Stage Independence and Dominance again given Order and Continuity. One can see the last connection by observing that Theorem 4.2 may be viewed as proving that 2 has the representation Z Z 2 b f 2 ( ) dm ( ) dP 2 f 2 , for P 2 2 U P 7 ! f2 : f 2 H ; b on (Z) and measure m 2 ( (S)). Thus the for some bounded continuous function U restriction of 2 to ff 2 : f 2 Hg is a subjective expected utility preference.

A

Appendix : Proof Sketch and Examples

This section sketches the su¢ ciency proof of Theorem 4.2 and provides examples to demonstrate the tightness of the theorem. Proof sketch : First-Stage Independence implies that preference can be represented by R V (P ) = H U (f ) dP (f ). The key part of the proof is to construct the second-order belief m 2 ( (S)) satisfying Z b U (f; ) dm ( ) = U (f ) for all f 2 H, (S)

b is the restriction of U to the constant acts (Z). For intuition about existence of where U such a measure m, consider the discretized version where there are n available acts and k 14

If f and f 0 induce the same second-order act, the two acts must be the same, because for all implies f = f 0 . Thus, 2 is well-de…ned.

18

(f; ) =

(f 0 ; )

possible priors: Am = b where 0

b U

(f1 ; .. .

b U

1)

(f1 ; .. .

B .. A = @ . b b U (fn ; 1 ) U 0 1 0 1 m1 U (f1 ) B .. C B .. C m = @ . A, b = @ . A. mk

k)

1

C A (fn ; k )

U (fn )

By Farkas’Lemma, Am = b has a nonnegative solution m if and only if, for all y 2 Rn , AT y

0 =) bT y

0:

By the in…nite dimensional version of Farkas’Lemma (see Theorem B.1), it su¢ ces to show that, for all signed measures t0 on H, Z b U (f; ) dt0 (f ) 0 for all 2 (S) (A.1) H Z =) U (f ) dt0 0 . (A.2) H

To show that, under Dominance, (A.1) implies (A.2). First notice that t0 can be decomposed into P Q where P; Q 2 (H) are in the domain of objects of choice and ; 0. 15 Then, rearranging (A.1) gives Z Z b d (Q; ) for all 2 (S): b U (A.3) U d (P; ) (Z)

(Z)

R

Normalize U such that H U dR = 0 for some R 2 ( (Z)): Consider the case > 0. R b Other cases can be proved similarly. Recall that P 7 ! (Z) U dP represents preference on ( (Z)). Then, (A.3) implies (P; )

(Q; ) + 1 =

15

Recall that Theorem,

R;

Q+ 1

R;

for all

2

(S).

(P; )(B) = P (ff 2 H : (f; ) 2 Bg) for B 2 BH . Thus, by the Change of Variables Z Z b (p) d (P; ) (p) = b U U (f; )dP (f ): H

(Z)

The same is true for Q.

19

Now apply Dominance to get P

Q+ 1

R.

R Since V (P ) = H U (f ) dP (f ) represents preference, (A.2) follows and thus a second-order belief m exists. b = v u; where u is a mixture linear Second-Stage Independence is used only to derive U function on (Z) and v is a strictly increasing function on u ( (Z)). Since u is mixture R R R linear, U (f ) = (S) v u (f; ) dm ( ) = (S) v S u (f ) d dm ( ) follows. Examples for the tightness of Theorem 4.2 : Each example satis…es all but one of the axioms characterizing an SOSEU representation.

Example 1 All but Second-Stage Independence : let Z Z V (P ) = u(f )d for some …xed

2

dP (f )

S

H

(S) and a bounded continuous but non-mixture-linear u :

Example 2 All but First-Stage Independence : let Z Z V (P ) = min u (f ) d 2C

H

dP (f )

S

where u is bounded, continuous, mixture-linear and C Dominance, note that

=) =)

(S) is a closed subset. To show

(P; ) (Q; ) for all 2 (S) Z Z Z u (f ) d dP (f ) u (f ) d dQ(f ) for all 2 H S H S Z Z Z Z min u (f ) d dP (f ) min u (f ) d dQ(f ) :

Z

2C

H

(Z) ! R.

2C

S

20

H

S

(S)

Example 3 All but Dominance : modify Example 2 by taking Z Z V (P ) = min u (f ) d dP (f ): H

2C

S

This violates (only) Dominance. Let S = f1; 2g, P = 21 f + 21 g; Q = h , u (f (1)) = 1, u (f (2)) = 2, u (g (1)) = 1, u (g (2)) = 0, u (h (1)) = 1, u (h (2)) = 1 and C = ( (S)). Then, V ( (P; )) = 1 = V ( (Q; )) for all 2 (S) but V (P ) = 1=2 < 1 = V (Q).

B B.1

Appendix : Proofs Preliminaries

Notations and de…nitions follow AB (1999) and Craven and Koliha (1977). For any real vector space M, let M# be the algebraic dual of M, i.e., the set of all linear functionals on M. Denote by m; m# an evaluation of m# 2 M# at the point m 2 M. Suppose that A : M ! T is a linear map between two vector spaces M and T . The algebraic adjoint A# : T # ! M# of A is the linear map satisfying m; A# t# = Am; t#

for all m 2 M and t# 2 T # .

A dual pair is a pair hM; M0 i of two vector spaces together with a function (m; m0 ) 7 ! hm; m0 i, from M M0 into R, satisfying 1) m 7 ! hm; m0 i is linear, 2) m0 7 ! hm; m0 i is linear, 3) if hm; m0 i = 0 for each m0 2 M0 , then m = 0, and 4) if hm; m0 i = 0 for each m 2 M, then m0 = 0. I will refer to 3) and 4) as separation properties. Given a dual pair hM; M0 i, the weak topology on M is denoted by (M; M0 ). Under (M; M0 ); a sequence mn 2 M converges to m 2 M if and only if hmn ; m0 i ! hm; m0 i for all m0 2 M0 . It is well known that the topological dual of (M; (M; M0 )) may be identi…ed with M0 . In other words, for each (M; M0 )-continuous linear functional on M, there is a unique m0 2 M0 such that (m) = hm; m0 i for all m 2 M. The weak topology (M0 ; M) is de…ned symmetrically for M0 . From now on, for any dual pair hM; M0 i, M and M0 are topological vector spaces equipped with the weak topologies. Given dual pairs hM; M0 i and hT ; T 0 i, the continuity of a linear mapping A : M ! T can be checked by using A# ; A is continuous if and only if A# (T 0 ) M0 . The restriction 21

A0 of A# to T 0 is called the topological adjoint of A with respect to hM; M0 i and hT ; T 0 i, or simply the adjoint of A. A nonempty set K M is called a convex cone if K + K K and K K for every 0. The polar cone K 0 M0 of the convex cone K M is de…ned as K 0 = fm0 : hm; m0 i 0 for all m 2 Kg. The main tool used in the paper is the following result from Craven and Koliha (1977, Theorem 2): Theorem B.1 (Generalized Farkas Theorem) Let hM; M0 i and hT ; T 0 i be dual pairs, let K be a convex cone in M, and let A : M ! T be a continuous linear map. Let A(K) be closed and 2 T . Then the following conditions are equivalent.16 (a) The equation Am = has a solution m 2 K: (b) A0 t0 2 K 0 =) h ; t0 i 0:

B.2

Proof of Theorem 4.2

Lemma B.2 The map (f; ) 7 !

(f; ) from H

(S) into

(Z) is continuous.

Proof. Suppose that (fn ; n ) converges to (f; ) in the product space H (S). Note that S is …nite. Then, for any 2 Cb (Z); Z Z d (fn ; n ) = d n (s1 )fn (s1 ) ::: n (s2 )fn (s2 ) n (sjSj )fn (sjSj ) Z Z Z X = dfn (s) n (s) s2S

!

X s2S

(s)

Z

Z

df (s)

Z

=

Z

d (f; ):

Z

Proof. Necessity: Completeness, transitivity and continuity are clear. 16

It is easy to see (a))(b). Suppose that Am = ; m 2 K and A0 t0 2 K 0 . Then h ; t0 i = hAm; t0 i = hm; A0 t0 i 0, because A0 t0 2 K 0 .

22

Second-Stage Independence : For p 2 (Z), V (p) = v (u(p)) because p does not depend on the probability measure m 2 ( (S)). Since v is strictly increasing, preference on (Z) is represented by u. Thus Second-Stage Independence is satis…ed because u is mixture linear. First-Stage Independence : Let 2 (0; 1] and P; R 2 (H). Then, it is easy to see that V ( P + (1

)R) = V (P ) + (1

)V (R):

First-Stage Independence is clear. Dominance : Let P be any element in (H). By Lemma B.2 and continuity of v u, v [u( (f; ))] is jointly continuous on H (S) and hence P m-measurable. Since v u is bounded, v [u( (f; ))] is P m-integrable. Then, apply the Fubini Theorem (AB (1999, p.411)) to get Z Z Z u(f )d dm( )dP (f ) v V (P ) = S H (S) Z Z v [u( (f; ))] dm( )dP (f ) = H (S) Z Z v [u( (f; ))] dP (f )dm( ): = (S)

H

Note that by the Change of Variables Theorem (AB (1999, p.452)), Z Z v u (p) d (P; ) (p) = V ( (P; )) : v [u ( (f; ))] dP (f ) = (Z)

H

Thus, V (P ) =

Z

V ( (P; )) dm( ): (S)

Since m is a nonnegative measure, this completes the proof. Turn to su¢ ciency. When P assume that satis…es :

Q for all P; Q 2

Axiom 9 (Nondegeneracy) P

Q for some P; Q 2

Follow these Lemmas to prove su¢ ciency.

23

(H), the representation is trivial. Thus

(H).

Lemma B.3 (i) Preference restricted to (Z) is represented by a bounded continuous mixture linear function u : (Z) ! R. Moreover, u is unique up to positive a¢ ne transformation. (ii) Preference is represented on (H) by Z V (P ) = U (f )dP (f ) H

for P 2 (H), where U : H ! R is a bounded continuous function and unique up to positive a¢ ne transformation. Proof. (i) Since H is a metric space, the mapping f 7! f from H into (H) is an embedding (AB (1999, p.480)). Moreover, H is a product space of (Z)’s. Thus, the weak convergence topology on (Z) coincides with the relative topology on (Z) induced by (H). Hence, Continuity implies that the restriction of to (Z) is continuous under the weak convergence topology on (Z). Moreover, preference restricted to (Z) satis…es Order and (Second-Stage) Independence. Therefore (i) holds (see Grandmont (1972), for example). (ii) can be proved in a similar way. b be the restriction of U to Let U

Lemma B.4 There exist p; q 2 b (p) 6= 0. lottery p such that U

(Z).

(Z) such that p

q. Consequently, there is a one-stage

Proof. Suppose that p q for all p and q in (Z). This means that P Q for all P and Q in ( (Z)), by Lemma B.3(ii). Then, for any P; Q 2 (H) and 2 (S), (P; ) (Q; ) because (P; ); (Q; ) 2 ( (Z)). By Dominance axiom, P Q for all P; Q 2 (H), contradicting to Nondegeneracy. In order to apply the Generalized Farkas Theorem, let M = ca( (S)), M0 = Cb ( (S)) and T

= Cb (H), T 0 = ca(H)

where ca(X) denotes the set of all Borel signed measures on X having bounded variation. R Both of hM; M0 i and hT ; T 0 i are dual pairs with bilinear operations hm; m0 i = (S) m0 dm R and ht; t0 i = H tdt0 for m 2 M; m0 2 M0 , t 2 T and t0 2 T 0 (AB (1999, p.475)). Let K = ca+ ( (S)) 24

be the subset of M consisting of all nonnegative Borel measures on (S). K is clearly a b is the restriction of U to (Z) and de…ne a linear mapping A convex cone. Recall that U from M into the set of all functionals on H by Z b (Am)(f ) = U (f; )dm( ) for f 2 H: (B.1) (S)

The premises of the Generalized Farkas Theorem will be veri…ed.

Lemma B.5 The mapping A is a linear mapping from M into T . Proof. It su¢ ces to show that A(M) T = Cb (H). Let m 2 M and assume that b is bounded and U b b fn ! f for fn ; f 2 H. Note that U (fn ; ) ! U (f; ) by R b Lemma B.2. By the Lebesgue Dominated Convergence Theorem, (S) U (fn ; )dm( ) ! R b U (f; )dm( ). Hence f 7! (Am) (f ) is continuous. Boundedness of f 7! (Am) (f ) (S)

b. comes from boundedness of U

Lemma B.6 The mapping A is continuous. Proof. It su¢ ces to show that A# (T 0 ) A# t0 is a linear functional on M. Hence, # 0

m; A t

0

= hAm; t i = Z Z b = U (S)

H

M0 . Let t0 2 T 0 . Then A# t0 lies in M# , i.e., Z

(Am) (f )dt0 (f )

H

(f; )dt0 (f )dm( ) = hm; m0 i

R b where m0 2 M# is de…ned by m0 ( ) = H U (f; )dt0 (f ). The order of integration has b changed in the third equality by the Fubini Theorem. Since U is bounded continuous, 0 b U is t m-integrable and the Fubini Theorem can be applied. b Now, it su¢ ces to show that m0 2 M0 = Cb ( (S)). Since U is bounded, m0 is b bounded. To see continuity, let n ! for n ; 2 (S). Since 7! U (f; ) is b b b continuous for each f 2 H, it follows that U (f; n ) ! U (f; ). Observing that U is bounded, Z Z 0 0 b b m ( n) = U (f; n )dt (f ) ! U (f; )dt0 (f ) = m0 ( ) H

H

by the Lebesgue Dominated Convergence Theorem. Hence m0 2 M0 . 25

Lemma B.7 A(K) is closed. Proof. Suppose that n = A( n mn ) 2 A(K) converges to 2 T , where n 2 R+ and mn 2 ( (S)): Step 1. mn has a subsequence mk(n) that converges to some m 2 ( (S)) : Since S is …nite, (S) is a compact metric space and so is ( (S)) (AB (1999, p.482)). Hence, mn has a converging subsequence. Step 2. Amk(n) ; t0 ! hAm; t0 i for any t0 2 T 0 : By Step 1 and the continuity of A, Amk(n) ! Am. Thus this step is proved. Step 3. k(n) converges to some 0 : By Lemma B.4, take p 2 (Z) such that b b (p) 6= 0 for any 2 (S). Then, U (p; ) = U Z b b (p) 6= 0; U (p; )dm( ) = U (Am)(p) = (S)

which implies that Am 6= 0. Therefore, by the separation property of a dual pair, hAm; t0 i = 6 0 for some t0 2 T 0 . Note that k(n) Amk(n) ; t0 = k(n) ; t0 ! h ; t0 i. Then by Step 2, it follows that k(n) ! h ; t0 i = hAm; t0 i. Since n 0 for all n, 0. 0 0 0 Step 4. 2 A (K) : For all t 2 T , k(n) ; t = k(n) Amk(n) ; t0 ! hAm; t0 i = hA( m); t0 i. Moreover, by the hypothesis, k(n) ; t0 ! h ; t0 i for all t0 2 T 0 . Note that 0 is a sequence in R and converges to at most one point. Thus, hA( m); t0 i = h ; t0 i k(n) ; t for all t0 2 T 0 , and = A( m) 2 A(K) by the separation property of a dual pair. The following Lemma uses the Generalized Farkas Theorem to prove the existence of second-order belief. Lemma B.8 There exists m 2 f 2 H.

( (S)) such that

R

(S)

b U

(f; )dm( ) = U (f ) for all

Proof. It is enough to show that Am = U for some m 2 ( (S)), where A is de…ned in (B.1). First, I will prove that there exists m 2 K = ca+ ( (S)) solving Am = U . I have already shown in Lemmas B.5 - B.7, that the premises of the Generalized Farkas Theorem are satis…ed. Therefore, it su¢ ces to show that if hm; A0 t0 i 0 for all m 2 K, then hU; t0 i 0: Assume that hm; A0 t0 i 0 for all m 2 K and show that hU; t0 i 26

0:

(B.2)

R R R b By the hypothesis, hm; A0 t0 i = hAm; t0 i = H Amdt0 = H (S) U for all m 2 K. Since 2 K for each 2 (S), it follows that Z b U (f; )dt0 (f ) 0 for all 2 (S):

(f; )dm( )dt0 (f )

0

(B.3)

H

Let t0 = P Q by the Hahn Decomposition Theorem, where ; 0 and P; Q 2 (H). Let . The other case, < ; can be proved similarly. If = 0, the statement (B.2) is trivial because = = 0. Let > 0. Note that (B.3) implies Z Z b b U (f; )dP (f ) U (f; )dQ(f ) for all 2 (S); (B.4) H

H

where = = . Recall Lemma B.3(ii) that U is unique up to positive a¢ ne transformation. Normalize U R R b is the restriction of U , b dR = 0. such that H U dR = 0 for some R 2 ( (Z)): Since U U (Z) Observe that, for all B 2 BH and 2 (S), (R; )(B) = R (ff 2 H : = R (fp 2 = R (B \

(f; ) 2 Bg)

(Z) : p 2 Bg)

(Z)) = R(B).

The second equality comes from the fact that R assigns zero probability outside of (Z). R b d (R; ) = 0 for all 2 (S). Then, by the argument in Thus, R = (R; ) and (Z) U footnote 15, (B.4) implies Z Z Z b d (P; ) b d (Q; ) + (1 b d (R; ) for all 2 (S): U U ) U (Z)

(Z)

(Z)

Hence by Lemma B.3(ii), it follows that (P; )

) (R; ) for all

(Q; ) + (1

2

(S):

Moreover, for any B 2 BH , (Q; ) + (1 =

(Q; )(B) + (1

=

Q (ff 2 H :

= ( Q + (1 =

( Q + (1

) (R; ) (B) ) (R; )(B) (f; ) 2 Bg) + (1

)R) (ff 2 H : )R; )(B).

) R (ff 2 H :

(f; ) 2 Bg) 27

(f; ) 2 Bg)

(B.5)

Therefore, by (B.5), (P; )

)R; ) for all

( Q + (1

2

(S):

By Dominance, it follows, P Therefore, by Lemma B.3(ii), Z U dP H

Then, by (B.6), 0

hU; t i =

Z

Q + (1

Ud

Q + (1

)R:

)R =

H

Z

Z

U dQ:

(B.6)

H

0

U dt =

H

Z

U d [ (P

Q)]

0.

H

This completes the proof of (B.2). Now, apply the Generalized Farkas Theorem to obtain m 2 K = ca+ ( (S)) satisfying the equation Am = U , or equivalently Z b U (f; )dm( ) = U (f ) , for each f 2 H. (B.7) (S)

b (p) = To prove that m is a probability measure, let p 2 (Z) be such that U 6 0 as in b (p) 6= 0, Lemma B.4 and let f be the constant act giving p in every state. Since U (p) = U (B.7) becomes Z dm( ) = 1:

(S)

Now, I will show a general property about utility representation. Lemma B.9 Let X be a connected topological space. If two bounded continuous functions u : X ! R and w : X ! R represent the same preference on X, then there exists a continuous and strictly increasing function v : u(X) ! R such that w = v u. Proof. De…ne v on u (X) by v (y) = w (x) if u (x) = y: Then v is well-de…ned, strictly increasing and w = v u. In order to show the continuity of v, note that X is connected and w is continuous. Hence, v (u (X)) = w (X) is connected. Since v is (strictly) increasing, it must be continuous.

28

Lemma B.10 There exists a bounded continuous and strictly increasing function v : u ( (Z)) ! b = v u. R such that U b represents the same preference on (Z). By Lemma B.9, Proof. Observe that u and U b = v u. a continuous and strictly increasing function v : u ( (Z)) ! R exists such that U b is bounded. Boundedness comes from the fact that U R Finally, by Lemma B.3(ii), V (P ) = H U (f )dP (f ) represents on (H) and by Lemmas B.3(i), B.8 and B.10, it follows that Z Z b U (f; ) dm ( ) = v u (f; ) dm ( ) U (f ) = (S) (S) Z Z u (f ) d dm ( ) : v = (S)

B.3

S

Proof of Lemma 4.1

Proof. (i) Suppose that satis…es Order, Continuity, Reversal of Order and AADominance. For any P 2 (H), let (P ) be the act obtained by collapsing all the objective probabilities into (Z), i.e., is a function from (H) into H such that for every B 2 BZ and R s 2 S, (P ) (s) (B) = H f (s)(B)dP (f ). In order for to be well-de…ned, f (s)(B) must be P -integrable as a function of f . Step 1. is well-de…ned : Since Z is metrizable, the function p 7! p (B) from (Z) into R is measurable (AB (1999, p.485)). Moreover the function f 7! f (s) is measurable. Thus, f 7! f (s)(B) is measurable. Since f (s)(B) is bounded, f 7! f (s)(B) is P -integrable. R R R Step 2. Z (z) d (P ) (s) (z) = H Z (z) df (s) (z) dP (f ) for any s 2 S, 2 Cb (Z) and P 2 (H) : When is a measurable step function (i.e., (Z) is a …nite set), this is clear. For any 2 Cb (Z), take a sequence n of step functions such that n (z) converges to (z) for each z 2 Z. Then, by the Lebesgue Dominated Convergence Theorem, Z Z (z) d (P ) (s) (z) = lim n (z) d (P ) (s) (z) Z Z Z Z = lim n (z) df (s) (z) dP (f ) H Z Z Z = (z) df (s) (z) dP (f ) : H

29

Z

R

Z

Step 3. is continuous: Fix s 2 S. Suppose that Pn ! P . (z) df (s) (z) is continuous. Then, by Step 2, Z

(z) d (Pn ) (s) (z) =

Z

Z

H

!

Z

H

Z

(z) df (s) (z) dPn (f )

Z

Z

Note that f 7!

(z) df (s) (z) dP (f ) =

Z

Z

(z) d (P ) (s) (z) :

Z

Thus, P 7! (P ) (s) is continuous for every s 2 S. Therefore is continuous. Step 4. (P ) P for any P 2 (H): Reversal of Order implies that (P ) P when P has a …nite support. Since H is metrizable, the set of all probability measures on H with …nite support is dense in (H) (AB (1999, p.481)). For any P 2 (H), take Pn 2 (H) with …nite support such that Pn ! P . Then (Pn ) Pn for all n. By Continuity and Step 3, (P ) = lim (Pn ) lim Pn = P: Step 5.

( (P ); ) for any P 2 (H) and 2 (S) : For any B 2 BZ , Z Z ( (P; )) (s)(B) = f (s)(B)d (P; )(f ) = p (B) d (P; )(p) H (Z) Z = (f; )(B)dP (f ) H Z = (s1 )f (s1 ) ::: (sjSj )f (sjSj ) (B)dP (f ) H Z = (s1 ) [f (s1 )(B)] + ::: + (sjSj ) f (sjSj )(B) dP (f ) H Z Z f (sjSj )(B)dP (f ) f (s1 )(B)dP (f ) + ::: + (sjSj ) = (s1 ) ( (P; )) =

=

H

(s1 ) [ (P )(s1 )(B)] + ::: + (sjSj )

=

(s1 )

(P )(s1 )

=

( (P ); )(B).

:::

(sjSj )

H

(P )(sjSj )(B)

(P )(sjSj ) (B)

The third equality is obtained by the Change of Variables Theorem. Step 6. satis…es Dominance : Suppose that (P; ) (Q; ) for all Steps 4 and 5, (P; ) ( (P; )) = ( (P ); ):

30

2

(S). By

Therefore ( (P ); ) follows that (P )(s)

( (Q); ) for all 2 (S). Since ( (P ); s ) = (P ) (s), it (Q)(s) for all s 2 S. For k = 0; 1; :::; jSj ; de…ne hk 2 H by hk (s) =

(P )(s) if s > k : (Q)(s) if s k

Then, by AA-Dominance and Step 4, P

(P ) = h0

h1

:::

hjSj =

(Q)

Q;

which completes the proof of (i). (ii) Let f; g 2 H and suppose that f (s) = g(s) for all s 6= s0 and f (s0 ) g(s0 ) for some s0 2 S. By Second-Stage Independence, (f; ) (g; ) for any 2 (S). Dominance implies f g.

C

Appendix : Uniqueness of the SOSEU Representation

The following Lemma provides some uniqueness properties. Lemma C.1 Suppose that P Q for some P; Q 2 (H) and let the two triples (u; v; m) 0 0 0 and (u ; v ; m ) represent on (H). Then (i) u and u0 are the same up to positive a¢ ne transformation and so are v u and v 0 u0 R R (ii) (S) 'dm = (S) 'dm0 for all ' 2 D where Z D = ' 2 C ( (S)) : 9 2 ca (T ) such that ' ( ) = v ( t) d (t) for all T

jSj

and T = [u ( (Z))]

jSj

R :

Proof. (i) : Note that u and u0 represent the same preference on (Z), and so do R R P 7! (Z) v udP and P 7! (Z) v 0 u0 dP on ( (Z)). (ii) : Note that u0 = au + b for some a > 0 and b 2 R, and v 0 u0 = cv u + d for some c > 0 and d 2 R: Thus, v 0 (ax + b) = cv (x) + d for any x 2 u ( (Z)). Then, Z Z Z Z 0 0 0 0 v u (f )d dm ( ) = v a u(f )d + b dm0 ( ) (S) S (S) S Z Z = c v u(f )d dm0 ( ) + d: (S)

31

S

Since ence,

R

(S)

Z

v0

R

S

u0 (f )d Z

v

dm0 ( ) and

u(f )d

dm( ) =

S

(S)

Since S is …nite, it follows that Z Z v ( t) dm( ) = (S)

Integrating both sides gives Z Z v( u( (Z))

jSj

R

(S)

Z

R

v

S

Z

v

dm( ) represent the same prefer-

u(f )d u(f )d

S

(S)

dm0 ( ) for all f 2 H.

t) dm0 ( ) for all t 2 u ( (Z))jSj :

v( (S)

t) dm( )d (t) =

Z

u( (Z))

(S)

jSj

Z

v(

t) dm0 ( )d (t)

(S)

for any 2 ca u ( (Z))jSj . Observe that ( ; t) 7! v ( t) is jointly continuous and bounded and hence m -integrable. By the Fubini Theorem, Z Z Z Z v ( t) d (t) dm0 ( ) for all 2 ca (T ) ; v ( t) d (t) dm( ) = (S)

T

(S)

T

for T = [u ( (Z))]jSj , which completes the proof. By the above Lemma, characterizing D is crucial in determining the class of m that represents the same preference.

References [1] C. D. Aliprantis and K. C. Border, In…nite Dimensional Analysis, Springer, Berlin, 1999. [2] F. J. Anscombe, R. J. Aumann, A De…nition of Subjective Probability, Ann. Math. Statist. 34 (1963), 199-205. [3] M. Bernasconi, Nonlinear Preferences and Two-Stage Lotteries: Theories and Evidence, The Econ. J. 104 (1994), 54-70. [4] M. Beranosconi and G. Loomes, Failures of the Reduction Principle in an Ellsberg-Type Problem, Theory and Decision 32 (1992), 77-100. 32

[5] D. Busescu and I. Fischer, The Same but Di¤erent: An Empirical Investigation of the Reducibility Principle, J. of Behavioral Decision Making 14 (2001), 187-206. [6] C. C. Chow and R. Sarin, Known, Unknown and Unknowable Uncertainties, Theory and Decision 52 (2002), 127–138. [7] B. D. Craven and J. J. Koliha, Generalizations of Farkas’ Theorem, SIAM J. Math. Anal. 8 (1977), 983-997. [8] R. Cubitt, C. Starmer and R. Sugden, Dynamic Choice and the Common Ratio E¤ect: an Experimental Investigation, Econ J. 108 (1998), 1362-1380. [9] D. Ellsberg, Risk, Ambiguity and the Savage Axioms, Quarterly J. of Econ. 75 (1961), 643-669. [10] D. Ellsberg, Risk, Ambiguity and Decision, Gerland Publishing, New York, 2001. [11] H. Ergin and F. Gul, A Subjective Theory of Compound Lotteries, working paper 2004. [12] P. Gärdenfors and N. E. Sahlin, Unreliable Probabilities, Risk Taking, and Decision Making, Synthese 53 (1982), 361-386. [13] P. Gärdenfors and N. E. Sahlin, Decision Making with Unreliable Probabilities, British J. of Math. and Stat. Psychology 36 (1983), 240-251. [14] I. Gilboa and D. Schmeidler, Maxmin Expected Utility with Non-unique Prior, J. Math. Econ. 18 (1989), 141-153. [15] J. Grandmont, Continuity Properties of a von Neumann-Morgenstern Utility, J. Econ. Theory 4 (1972), 45-57. [16] W. Güth, E. van Damme, M. Weber, Risk Aversion on Probabilities: Experimental Evidence of Deciding Between Lotteries, Homo Oeconomicus 22 (2005), 191-209. [17] Y. Halevy, Ellsberg Revisited: an Experimental Study, Econometrica 75 (2007), 503536. [18] L. R. Keller, Testing of the ‘Reduction of Compound Alternatives’Principle, Omega 13 (1985), 349-358.

33

[19] P. Klibano¤, M. Marinacci, and S. Mukerji, A Smooth Model of Decision Making under Ambiguity, Econometrica 73 (2005), 1849-1892. [20] P. Klibano¤ and E. Ozdenoren, Subjective Recursive Expected Utility, Econ. Theory 30 (2007), 49-87. [21] D. M. Kreps, Notes on the Theory of Choice, Westview Press, 1988. [22] D. M. Kreps and E. L. Porteus, Temporal Resolution of Uncertainty and Dynamic Choice Theory, Econometrica 46 (1978), 185-200. [23] R. F. Nau, Uncertainty Aversion with Second-Order Utilities and Probabilities, Management Science 52 (2006), 136-145. [24] J. Quiggin, A Theory of Anticipated Utility, J. of Econ. Behavior and Organization 3 (1982), 323-343. [25] J. Ronen, Some E¤ects of Sequential Aggregation in Accounting on Decision-Making, J. of Accounting Research 9 (1971), 307-332. [26] L. J. Savage, The Foundations of Statistics, (original ed. Wiley, 1954) Dover, 1972. [27] P. Schoemaker, Preferences for Information on Probabilities versus Prizes- the Role of Risk-Taking Attitudes, J. of Risk and Uncertainty 2 (1989), 27-60. [28] U. Segal, The Ellsberg Paradox and Risk Aversion: an Anticipated Utility Approach, International Econ. Review 28 (1987), 175-202. [29] U. Segal, Two-Stage Lotteries without the Reduction Axiom, Econometrica 58 (1990), 349-377. [30] D. Snowball and C. Brown (1979), Decision Making Involving Sequential Events: Some E¤ects of Disaggregated Data and Dispositions Toward Risk, Decision Sciences 10 (1979), 527-546. [31] F. J. Yates and L. G. Zukowski, Characterization of Ambiguity in Decision Making, Behavioral Science 21 (1976), 19-25.

34