A Note on Consumption and Savings under Knightian Uncertainty

An agent’s choice between saving and immediate consumption depends crucially on the future uncertainty. In the standard model, it is generally assumed that uncertainty is identical to risk. That is, a single probability measure on the state of the world is available to guide choice. For example, according to the rational expectations hypothesis, agents know precisely the objective probability law and their beliefs are identical to this probability law. Alternatively, according to the Bayesian approach, an agent’s beliefs are represented by a subjective prior. By either approach, the situation of uncertainty, where information is too imprecise to be summarized adequately by probabilities, is ruled out. By contrast, Knight (1921) emphasizes the distinction between risk and uncertainty and argues that uncertainty is more common in decision-making. For experimental evidence, the Ellsberg Paradox suggests that people prefer to act on known