Another example of how ambiguity influences decisions will consider decision-making in unfamiliar contexts.

Suppose that offer you $1000 for predicting the weather on July 4 of next year and I’ll even give you your choice of two questions. Question A) will the high temperature in New York City on July 4 be more or less than 85°F. Question B) with a high temperature in Baku Azerbaijan the more less than 85°F. Which question would you choose to answer? A or B?

When faced with questions like this one people show a strong tendency to make predictions about something familiar which for majority of US residents at least would be New York City. So they’d rather guess about New York’s temperature even if the aren’t about which way to guess. I want to emphasize our bias toward the familiar doesn’t depend on actually knowing the answer to the question.

85° is approximately the median high temperature New York City on that date and none of us can predict whether next year’s temperature would be higher or lower than that average. So our guesses aren’t likely to be any better on a coin flip or any better on a complete gas in an unfamiliar context. Suppose that I then told you the 85° is also approximately the median high temperature in Baku Azerbaijan on the date.

You’ll probably still have a strong bias toward answering the question about New York City even though the questions are well matched in terms of both temperature and probability. But why? We prefer to make decisions by drawing conclusions from our own knowledge is imperfect and probabilistic as may be. Even if that knowledge isn’t sufficient to help us make a good decision as in the case the weather protection task.

I just described it still seems better than the ambiguity that’s associated with the unfamiliar context I just described three sorts of situations that lead to ambiguity aversion: hidden information, asymmetric knowledge and unfamiliar contexts. In all three situations we tend to avoid choice options were information is missing and where we feel less competent and in all three situations the presence of ambiguity means that we treat the decisions differently than that there was only risk.

So how can we minimize the effects of ambiguity on our decisions? There is no easy answer here. Our version ambiguity is often well justified, ambiguity arises in some of the most difficult decision problems that we face. I will suggest a two-step approach that can help us think about ambiguity if not always deal with. In a first step ask yourself what information is missing.

Is there something that I should know before I make this decision. If you cannot identify any missing information the situation may simply involve risk and you can make the decision using any of the tools discussed throughout this course, but if there is some missing information then the situation likely does involve ambiguity and you should proceed to the second question: how can I get the missing information?

Identify a path, if possible, for converting your decision from ambiguity to risk. Perhaps you are bidding on a new home and realtor the seller has information of the homes quality that you lack. Seek disclosure of that information minimize the asymmetry in knowledge between you and the seller, but sometimes despite your best efforts you still won’t get all the information you need.

Decisions when faced with missing information or ambiguity can be some of the most difficult to make, you know that a good decision can be made with the right information, but you just don’t have it. Donald Rumsfeld after making that distinction between known and unknowns and unknown unknowns continued by saying.

“And if one looks throughout the history of our country in other free countries it is the latter category, unknown unknowns, that tend to be the difficult ones”. Decisions often aren’t hard because what we know they are hard because what we don’t know. In the next lecture will move from decisions about probability risk and ambiguity to decisions about time.

Should we spend now or save for the future? Such decisions present a particularly challenging form of uncertainty one that we all face when dieting investing in our education or saving for retirement.

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