Decision Making Under Model Uncertainty: Fréchet–Wasserstein Mean Preferences

Electra V. Petracou (), Anastasios Xepapadeas and Athanasios N. Yannacopoulos ()
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Electra V. Petracou: Department of Geography, University of the Aegean, 811 00 Mytilene, Greece
Athanasios N. Yannacopoulos: Department of Statistics and Stochastic Modelling and Applications Laboratory, Athens University of Economics and Business, 104 34 Athens, Greece

Management Science, 2022, vol. 68, issue 2, 1195-1211

Abstract: This paper contributes to the literature on decision making under multiple probability models by studying a class of variational preferences. These preferences are defined in terms of Fréchet mean utility functionals, which are based on the Wasserstein metric in the space of probability models. In order to produce a measure that is the “closest” to all probability models in the given set, we find the barycenter of the set. We derive explicit expressions for the Fréchet–Wasserstein mean utility functionals and show that they can be expressed in terms of an expansion that provides a tractable link between risk aversion and ambiguity aversion. The proposed utility functionals are illustrated in terms of two applications. The first application allows us to define the social discount rate under model uncertainty. In the second application, the functionals are used in risk securitization. The barycenter in this case can be interpreted as the model that maximizes the probability that different decision makers will agree on, which could be useful for designing and pricing a catastrophe bond.

Keywords: ambiguity aversion; Fréchet mean preferences; Wasserstein metric; social discount rate; model uncertainty (search for similar items in EconPapers)
Date: 2022
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Citations: View citations in EconPapers (5)

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Persistent link: https://EconPapers.repec.org/RePEc:inm:ormnsc:v:68:y:2022:i:2:p:1195-1211

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