Chapter 15: A Keynesian Critique of Recent Applications of Risk-Sensitive Control Theory in Macroeconomics
James Juniper* INTRODUCTION Recent decades of research in decision theory have witnessed a variety of departures from the constraints of expected utility theory. In part, these have been motivated by the desire to explain the ﬁnding that decision-makers routinely violate the independence axiom (Allais, 1953).1 Typically, the abandonment of this axiom entails replacing the linear system of weighting expected utilities of each outcome in a lottery by their respective probabilities with a non-linear weighting system derived from a cumulative distribution deﬁned over a partitioning of the state space (Chew, 1989; Dekel, 1986; Tversky and Wakker, 1995).2 Research on ambiguity or uncertainty aversion is also motivated by the Ellsberg paradoxes (Ellsberg, 1961), which are associated with lotteries over unknown probabilities. Consider bets over draws from an urn containing 30 red balls and 60 others that are black and yellow. Fishburn (1987, p. 782), in his summary of Ellsberg’s ﬁndings, indicates that most people are observed to ‘prefer to bet on red rather than black, and to bet on black or yellow rather than red or yellow’. In Savage’s model, the ﬁrst preference suggests that the probability measure over red is preferred to the probability measure over black, whereas the second preference suggests the opposite. Under suitable conditions some of the generalizations of expected utility theory can accommodate uncertainty or ambiguity aversion. In Savage’s (1954) subjective decision-making framework, the ‘sure-thing’ principle plays the same role as the independence axiom in the expected utility approach. Uncertainty aversion can be introduced...
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