Question

1What do we mean by Knightian Uncertainty? Illustrate the effect of uncertainty using the Ellsberg Paradox. DON'T submit picture, keyboard input please

Answer 1

The Knightian uncertainty is a term in economics which seeks to differentiate risks from uncertainty. It states that risk can be estimated basis the odds of an outcome and in those situations wherein the odds are measurable. On the other hand uncertainty remains in those situations wherein estimating odds is itself not possible.

The Ellsberg paradox is a thought experiement, wherein people are given a chance to select a urn and pick a marble and told that if the marble is black then they stand to win $100. The two urns are such that one urn – Urn A contain 50 black marbles and 50 white marbles. While Urn B contains unknown number of marbles of each kind with total number of marbles being 100.

While mathematically it can be proven that irrespective of the Urn that a person chooses, the probability of drawing a black marble is 50%. However when people were surveyed, it was found that an overwhelming number chose Urn A. Thus people tend to display an aversion of ambiguity and preference for the Urn wherein odds could be estimated.