The order of knowledge and robust action. How to deal with economic uncertainty?

Abstract

Uncertainty in economics is generated by “nature” but also by the model we use to “produce the future”. The production of the future comprises besides the allocation of resources on different instruments (technologies, financial products) also the design of the instruments. Specialization and diversification considerations point to the advantages of targeting instruments to a rich set of possible future states. But, if a rich state space comes with unreliable probability measures, the actions based on such a set will be unreliable, too. The proliferation of financial products is a salient example. This paper argues that an appropriate model for dealing with uncertainty keeps the knowledge required by the model from its user in line with the available knowledge. In particular, it proposes to order state spaces by their “granularity” and “coverage”. Appropriate upper bounds are derived for these characteristics. A practical implication of the presented approach would be to limit financial product innovation.