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Risk, Ambiguity and Uncertainty

So let’s consider this distinction between risk and ambiguity. When Frank Knight advanced idea there were two distinct forms of uncertainty he did so based not on data but on his own intuitions.

The Ellsberg paradox

The idea of unmeasurable uncertainty makes sense to Knight and it helped his arguments, but he didn’t have any evidence that it actually existed. That evidence didn’t come until 1961 through the efforts of a doctoral student in economics named Daniel Ellsberg.

The name Daniel Ellsberg, may sound familiar to some of you, particularly those who have interests in war politics and American history. Ellsberg wasn’t exactly the typical academic economist. In the work that led to his PhD dissertation Ellsberg sought to identify the circumstances under which people might behave as if influenced by ambiguity instead of just risk.

He developed a thought problem that since become known as the Ellsberg paradox. No matter what though you shouldn’t switch your choices, but almost everyone does and that’s the Ellsberg paradox. The reason why people switch their choices in these two decisions going from red to black is because of ambiguity aversion. People don’t want to battle situations in which the probabilities are unknown.

The ambiguity aversion

There’s a debate within economics as to whether people really are averse to ambiguity per se or instead are using simple heuristics to hedge against uncertainty. For example, one might expect the carnival barker has more information than you and then when he offers you a bet with unknown odds those odds aren’t likely to be in your favor.

Resolving that debate is far beyond the scope of this discussion. We’ll stick with the ambiguity aversion as a term that describes people’s behavior but as you’ll see people show the same behavior in several different situations, some of which are consistent with a simple heuristic and some of which are not.

So who was Daniel Ellsberg? Following his academic work on certainty which explored examples of hidden information like this one. During the 1960s he moved to the Pentagon eventually to the State Department where he applied his research to problems in military decision-making, things like the potential decision to start a nuclear war.

In 1968 Ellsberg help prepare a 7000 page document that summarized US decision-making Vietnam, including the many lessons that were being learned as the war went worse and worse for US troops. In 1969 Ellsberg learned that those lessons were being ignored by the current administration and he began covertly photocopying and distributing that enormous history of Vietnam era decision-making.

First distributing it to members of Congress and then to the major newspapers of the day. Those leaked documents became known as the Pentagon Papers. So Daniel Ellsberg the academic researcher who set the stage for how we think about decision-making under ambiguity is now chiefly famous for his role in shaping the public narrative about the Vietnam War, perhaps a single conflict with the most unknown unknowns in US history.