#774 The difference between risk and uncertainty

The experiment goes like this: imagine if I have an urn. In this urn, I’ve got 100 balls and 50 of the balls are colored red and 50 of them are colored black. And you and I are going to play a game where you pick a color, red or black. Don’t tell me what it is, but write it down on a piece of paper. Then I’m going to draw a ball out of this urn. If the color of the ball that I draw is the color you wrote down, I’m going to pay you $10,000.

And if it’s not, I’m going to pay you nothing. Now the question is: how much would you be willing to pay to play that game?

When most people think about the odds, they come up with an answer of about $5,000, because that’s the expected value. That’s the probability of getting the ball of your color multiplied by the odds of winning. That’s an example of risk. You know what the odds are.

But now, suppose I change the game slightly and I have another urn. In this urn I’ve got 100 balls, but I’m not going to tell you what the proportion of red or black is. It could be 100 percent black. It could be 100 percent red or 50-50, 75-25 and so on. Now the question is, “If we play the exact same game, where you write down the color of your choice, and I pick a ball from this second urn, what would you pay to play this game with me?”

In this case, most people would pay much, much less than $5,000. This is an example of uncertainty. You don’t know the odds, and so therefore you’re much less likely to want to play. And that, in a nutshell, is the difference between risk and uncertainty.

 

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