Econ corner: A rational reason (beyond the usual “risk aversion” or concave utility function) for wanting to minimize future uncertainty in a decision-making setting

Eric Rasmusen sends along a paper, Option Learning as a Reason for Firms to Be Averse to Idiosyncratic Risk, and writes:

It tries to distinguish between two kinds of risk. The distinction is between uncertainty that the firm will learn about, and uncertainty that will be bumping the profit process around forever. It’s not the Knightian risk or ambiguity idea, though.

I took a look at the article and didn’t have any deep responses. If I’m understanding right, Rasmusen’s point is that adding uncertainty adds a chance that someone will make a bad decision; it adds a component of uncertainty with a potential downside but no upside. The only think I wonder is whether this result would hold a setting where there are multple firms, all of which can have uncertainty. If you move to a setting with more uncertainty, then this might be a setting where your competitors have more uncertainty. In which case, the question is not whether you might make a bad decision under uncertainty, but whether you’ll do worse in this aspect than your competitors.

More generally, I am uncomfortable with the way that “risk aversion” is commonly discussed in economics. I’ve written about this many times on the blog but maybe not for a few years.

I sent Rasmusen the above brief comments and he replied:

You do have it right. I haven’t thought much about it with several competitors, but it would work much the same way. It might be, however, that for each firm some of the value risk is over what his competitors are like and will do. In fact, I think it’s realistic to have a number of firms entering a new industry, with each of them having a rational belief that it might be good at this new product, but knowing that in fact only one of them will survive, and that firm surviving because ex post it turns out to have the lowest costs.

You are quite right to be uncomfortable with how economists handle risk aversion, as every good economist ought to be. It’s definitely appropriate sometimes, and definitely inappropriate other times, and where it’s inappropriate we just don’t have a good convention to model it, and maybe there isn’t a single one. There isn’t a unique reason people dislike uncertainty. In my paper, the reason is that they find it makes decisionmaking harder. For individuals and firms, it often is that it means you have to do contingency planning, or incur the thinking cost of changing what you do later when the unexpected happens. Both of those rational reasons can lead to Gigerenzer rules of thumb, a general dislike of uncertainty. In the Ellsberg Paradox, I think its that people know that when a decision is more complicated, they are (a) more likely to make calculation mistkaes, and (b) more likely to get cheated.