Chapter 5: Uncertainty and Consumer Behaviour

Question 1

Define probability

Answer 1

Likelihood that a given outcome will occur. Probability can either be objective or subjective

Question 2

Differentiate between objective probability and subjective probability

Answer 2

Objective probability is the interpretation of probability that relies on the frequency with which certain events tend to occur (based on outcomes of previous experiences)

Subjective probability is the perception that an outcome will occur

Question 3

Explain variability

Answer 3

It is the extent to which possible outcomes of an uncertain event differ

Question 4

Expected values are ___, but however the variability ___

Answer 4

Expected values are exactly the same but however the variability does differ

Question 5

Explain deviation

Answer 5

The difference between outcomes of uncertain events.

Question 6

Explain standard deviation

Answer 6

Square root of the weighted average of the squares of the deviations of the payoff associated with each outcome from the expected values

Question 7

Define expected utility

Answer 7

Value of the probability weighted average of the utilities associated with all possible outcomes of an event

Question 8

Explain risk averse

Answer 8

Condition of preferring a certain income to a risky income with the same expected value

Question 9

Explain risk loving

Answer 9

Individual that prefers an uncertain income to a certain one with the same expected value

Question 10

Explain risk neutral

Answer 10

An individual that is indifferent between a certain and uncertain income with the same expected value. Their marginal utility for income is constant throughout

Question 11

Explain risk premium

Answer 11

Maximum amount of money that a risk averse person will pay to avoid taking a risk

Question 12

What strategies do risk averse individuals apply to reduce risk

Answer 12

• diversification
• insurance
• obtaining additional information

Question 13

Explain diversification

Answer 13

Practice of reducing risk by allocating resources to a variety of activities whose outcomes are not closely related

Question 14

Explain mutual funds

Answer 14

Organisation that pulls funds of individual investors to buy a large number of different stocks or other financial assets

Question 15

Explain actuarial fairness

Answer 15

Characterising a situation in which an insurance premium is equal to the expected payout

Question 16

Explain value of information

Answer 16

Difference between the expected value of a choice when there is complete information and the expected value and information is incomplete