Capacity Aversion

This paper examines an agent’s asymmetric attitudes toward non-probabilistic subjective uncertainty. Our main theorems are generalizations of Arrow-Pratt approximation and the Jensen inequality under model uncertainty as described by the Choquet expected utility model of Schmeidler (1982,1989), Gilboa (1987) and Sarin and Wakker (1992). We show that the order of Arrow-Pratt approximation differs between gains and losses, which is not the case in the the smooth ambiguity model of Klibanoff, Marinacci, and Mukerji (2005). We propose the Jensen inequality for all concave functions and provide a new economic meaning to Schmeidler’s uncertainty aversion by disentangling risk aversion from uncertainty aversion. These results are then applied to analyze the demand for insurance and public investment decisions.