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Ambiguity, Decision-Making and Hidden Information

There are three circumstances that induce ambiguity: hidden information, asymmetric knowledge and unfamiliar contexts. This article is about hidden information and how this influences a decision-making process.

Hidden information and risk aversion

Let’s consider a simple economic decision: suppose you could pay money to play a simple coin flip game, heads $100 tales you and nothing. How much would you pay to play the game? By now you recognize this decision involves just risk, not ambiguity. You know the outcomes and the probabilities so your willingness to pay depends just on your risk aversion.

If you are risk neutral you pay the expected value of the game which is $50, but if you are slightly risk-averse like most people you might pay a bit less, say $45. But we can introduce ambiguity under this decision. We can replace the flip of a coin with a draw from Ellsberg Hearn with 100 balls, some of which they win $100 and some of which say win nothing, but you don’t know the probabilities.

Let’s assume for the moment that the urn, like the coin is fair, there could be anywhere from 0 to 100 winning balls and that are with equal probabilities of any number. This is what statisticians call a uniform probability distribution, you just don’t know what that number is. How much would you pay to play the second game?

When people play with games like this in the laboratory aren’t willing to pay $50, even though that’s the expected value of the second game too. They are even willing to pay as much as they would for the similar coin flip, instead the average willingness to pay is much lower, perhaps $25 or even less.

Ambiguous decisions with hidden unknown probabilities

People don’t treat the second situation, where the probabilities are unknown, as just another risky decision. Something’s different about the decision when ambiguity is involved. A few years ago my colleagues I explored decisions of this sort using an approach that combines behavioral economics with neuroscience.

We examined the participants’ brains will be made either risky decisions with known probabilities or ambiguous decisions with hidden unknown probabilities. We found systematic brain differences between risk an ambiguity. In particular, decisions involving ambiguity evokes more activation in the brain’s prefrontal cortex, which has been frequently associated with setting up rules for behavior and that activation predicted how much ambiguity would affect people’s decisions.

Subsequent research has shown that this brain response is specific to situations where some true probability was known to be headed, like in the Ellsberg paradox, and is not there in situations of complete ignorance. In essence our brains recognize when we don’t have all the available information about probability, the unknown unknowns, enter brands construct rules that help us work around that missing information.

This constructive process isn’t necessary for risky decisions things that involve known unknowns.