3. Decision Making Under Uncertainty

Question 1

Risk

Answer 1

Unknown events with objective probabilities

Question 2

Uncertainty

Answer 2

Events for which such probabilities can’t be assigned

Question 3

Common knowledge

Answer 3

Knowledge which everyone knows

Question 4

What is the state preference model?

Answer 4

The most general model that describes preferences over future possibilities. Useful for studying incomplete markets and pricing assets with uncertain payoffs through arbitrage

Question 5

What is the Expected utility hypothesis

Answer 5

Most commonly used model. It introduces probabilities and allows derivation of expectations

Question 6

What is the mean variance model?

Answer 6

The specific functional form for utility function. Simplicity allows for the consideration of uncertainty within traditional general equilibirum models

Question 7

What is true of states?

Answer 7

• each state is a description of a possible event
• only one state will occur (mutually exclusive)
• the description is complete (all relevant info has been included)

Question 8

Arrow Debreu security

Answer 8

A security that has a payoff of one unit in a particular state and zero in every other state

Question 9

What are Complete markets

Answer 9

Where there is an Arro Debreu security for each state, this means there is complete insurance against risk

Question 10

Definition of a risk averse person

Answer 10

They will always decline a gamble with a zero expected payoff

Question 11

What does the mean variance model say that expected utility depends on?

Answer 11

The expected value and variance of terminal wealth