Decision-Making under Subjective Risk: Toward a General Theory of Pessimism∗

The primary objective of this paper is to develop a framework in which a decisionmaker may have subjective beliefs about the “riskiness” of prospects, even though the risk structure of these prospects is objectively specified. Put differently, we investigate preferences over risky alternatives by postulating that such preferences arise from more basic preferences that act on the subjective transformations of these prospects. This allows deriving a theory of preferences over lotteries with distorted probabilities and provides information about the structure of such distortions. In particular, we are able to formulate a behavioral trait such as “pessimism” in the context of risk (independently of any sort of utility representation) as a particular manifestation of the uncertainty aversion phenomenon. Our framework also provides a strong connection between the notions of aversion to ambiguity and risk which are regarded as distinct traits in decision theory. JEL Classification: D11, D81.