The foundations of probability with black swans (Q609724): Difference between revisions

Summary: We extend the foundation of probability in samples with rare events that are potentially catastrophic, called black swans, such as natural hazards, market crashes, catastrophic climate change, and species extinction. Such events are generally treated as ``outliers'' and disregarded. We propose a new axiomatization of probability requiring equal treatment in the measurement of rare and frequent events-the swan axiom-and characterize the subjective probabilities that the axioms imply: these are neither finitely additive nor countably additive but a combination of both. They exclude countably additive probabilities as in [\textit{M. H. De Groot}, Optimal statistical decisions. McGraw-Hill Series in Probability and Statistics. New York etc.: McGraw-Hill (1970; Zbl 0225.62006); and \textit{K. J. Arrow}, Essays in the theory of risk-bearing. Amsterdam-London: North-Holland Publishing (1970; Zbl 0215.58602)] and are a strict subset of Savage [\textit{L. J. Savage}, The foundations of statistics. Wiley Publications in Statistics. New York: John Wiley \& Sons (1954; Zbl 0055.12604)] probabilities that are finitely additive measures. Our subjective probabilities are standard distributions when the sample has no black swans. The finitely additive part assigns however more weight to rare events than standard distributions do and in that sense explains the persistent observation of ``power laws'' and ``heavy tails'' that eludes classic theory. The axioms extend earlier work by \textit{G. Chichilnisky} [Soc. Choice Welfare 13, No.~2, 231--257 (1996; Zbl 0846.90005); Resource and Energy Economics 22, No.~3, 221--231 (2000); Catastrophic risk, in: Encyclopedia of environmetrics, Chichester: Wiley, 274--279 (2001); J. Math. Econ. 45, No.~12, 807--816 (2009; Zbl 1180.91104)] to encompass the foundation of subjective probability and axiomatic treatments of subjective probability by \textit{C. Villegas} [Ann. Math. Stat. 35, 1787--1796 (1964; Zbl 0127.34807)], \textit{L. E. Dubins} and \textit{L. J. Savage} [How to gamble if you must. Inequalities for stochastic processes. McGraw-Hill Series in Probability and Statistics. New York-St. Louis-San Francisco-Toronto-London-Sydney: McGraw-Hill (1965; Zbl 0133.41402)], \textit{L. E. Dubins} [Ann. Probab. 3, 89--99 (1975; Zbl 0302.60002)], \textit{R. W. Purves} and \textit{W. D. Sudderth} [Ann. Probab. 4, 259--276 (1976; Zbl 0367.60034)] and of choice under uncertainty by Arrow [loc. cit.].