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date: 12 July 2020

Abstract and Keywords

This article deals with the question of how a public decision maker should think about issues of known and unknown risks. The optimal investment levels are then derived and compared for a number of different decision rules. It discusses three decision rules: the best guess, the maximin, and the expected value decision rules. It presents the St Petersburg paradox, which clearly shows that the expected value decision rule cannot be universally applied and introduces a non-linear utility function to the model. It discusses the optimal investment rules for a special case of a state-dependent expected utility model. This article then presents another paradox, the Ellsberg paradox. It deals with the problem of unknown probabilities by adding probability distributions of the probabilities. Decision rules for three different models that allow for ambiguity aversion are then derived and discussed. The article returns to the more fundamental question regarding whether models of ambiguity aversion can be justified for normative analysis.

Keywords: risks, decision rules, St Petersburg paradox, Ellsberg paradox, ambiguity

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