chapter 7 book: Uncertainty and Consumer Behavior

Question 1

Probability

Answer 1

likelihood that a given outcome will occur

Question 2

probabilities for all possible events must add up to what?

Answer 2

probabilities for all possible events must add up to 1

Question 3

Subjective probability

Answer 3

the perception that an outcome will occur

may be based on a person’s judgment or experience, but not necessarily on the frequency with which a particular outcome has actually occurred in the past

Question 4

objective interpretation of probability relies on?

Answer 4

relies on the frequency with which certain events tend to occur

Question 5

what can cause subjective probabilities to vary among individuals?

Answer 5

Either different information or different abilities to process the same information

Question 6

two important measures that help us describe and compare risky choices

Answer 6

expected value (mean)

variability of the possible outcomes

Question 7

expected value (mean) associated with an uncertain situation

Answer 7

a weighted average of the payoffs or values associated with all possible outcomes

The probabilities of each outcome are used as weights

measures the central tendency

basically, just the mean

Question 8

central tendency

Answer 8

the payoff or value that we would expect on average

Question 9

payoff

Answer 9

Value associated with a possible outcome

Question 10

variability of the possible outcomes

Answer 10

extent to which the possible outcomes of an uncertain situation differ

the thing with standard deviation and everything of the sort

Question 11

how do we measure variability?

Answer 11

by recognizing that large differences between actual and expected payoffs (whether positive or negative) imply greater risk

these differences are called deviations

Question 12

deviation

Answer 12

difference between expected payoff and actual payoff

Question 13

why do deviation by themselves not provide a measure of variability?

Answer 13

Because they are sometimes positive and sometimes negative

average of the probability-weighted deviations is always 0

Question 14

how do we solve the problem that deviations can be negative as well?

Answer 14

we square each deviation, yielding numbers that are always positive

We then measure variability by calculating the standard deviation

Question 15

standard deviation

Answer 15

square root of the weighted average of the squares of the deviations of the payoffs associated with each outcome from their expected values

a measure of the amount of variation or dispersion of a set of values

Question 16

what does a high standard deviation indicate?

Answer 16

a high standard deviation indicates that the values are spread out over a wider range

it means there is more risk

Question 17

what does a low standard deviation indicate?

Answer 17

A low standard deviation indicates that the values tend to be close to the mean (also called the expected value)

it means there is lower risk

Question 18

expected utility E(u)

Answer 18

Sum of the utilities associated with all possible outcomes, weighted by the probability that each outcome will occur

Question 19

An individual who is risk averse

Answer 19

prefers a certain given income to a risky income with the same expected value

Such a per- son has a diminishing marginal utility of income

the most common attitude toward risk

losses are more important (in terms of the change in utility) than gains

risk-averse people prefer a smaller variability of outcomes

Question 20

A person who is risk neutral

Answer 20

is indifferent between a certain income and an uncertain income with the same expected value

the marginal utility of income is constant for a risk-neutral person

Question 21

an individual who is risk loving

Answer 21

prefers an uncertain income to a certain one, even if the expected value of the uncertain income is less than that of the certain income

Question 22

the most common attitude toward risk

Answer 22

risk averse

Question 23

the risk premium

Answer 23

the maximum amount of money that a risk-averse person will pay to avoid taking a risk

Question 24

what does the magnitude of the risk premium depend on?

Answer 24

on the risky alternatives that the person faces

The greater the variability of income, the more the person would be willing to pay to avoid the risky situation (for risk averse individuals)

Question 25

The extent of an individual’s risk aversion depends on what?

Answer 25

depends on the nature of the risk and on the person’s income

Question 26

why are indifference curve in this chapter upward sloping?

Answer 26

because risk is undesirable the greater the amount of risk, the greater the expected income needed to make the individual equally well off

Question 27

for an individual who is highly risk averse, an increase in the standard deviation of income requires what?

Answer 27

a large increase in expected income

Question 28

for an individual who is slightly risk averse, a large increase in the standard deviation of income requires what?

Answer 28

only a small increase in expected income

Question 29

three ways by which both consumers and businesses commonly reduce risks

Answer 29

diversification insurance obtaining more information about choices and payoffs

Question 30

diversification

Answer 30

allocating your resources to a variety of activities whose outcomes are not closely related Risk can be minimized by diversification

Question 31

negatively correlated variables

Answer 31

tend to move in opposite directions ex: whenever sales of one are strong, sales of the other are weak

Question 32

true or false As long as you can allocate your resources toward a variety of activities whose outcomes are not closely related, you can eliminate some risk

Answer 32

true

Question 33

is diversification important for people who invest in the stock market?

Answer 33

ye bruv, very important

Question 34

mutual funds

Answer 34

organizations that pool funds of individual investors to buy a large num- ber of different stocks this if whack af only like 2% return each year

Question 35

stock prices are mostly positively or negatively correlated variables? why?

Answer 35

stock prices are to some extent positively correlated variables They tend to move in the same direction in response to changes in economic conditions

Question 36

why would risk averse individuals enjoy insurance?

Answer 36

because it guarantees them the same utility (or income) no matter what happens

Question 37

law of large numbers

Answer 37

tells us that although single events may be random and largely unpredictable, the average outcome of many similar events can be predicted

Question 38

why does the law of large numbers apply to insurance companies?

Answer 38

because they know that when they sell a large number of poli- cies, they face relatively little risk

Question 39

actuarially fair insurance

Answer 39

When the insurance premium is equal to the expected payout

Question 40

why do insurance companies typi- cally charge premiums above expected losses?

Answer 40

because they must cover administrative costs and make some profit

Question 41

The value of complete information

Answer 41

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

Question 42

asset

Answer 42

something that provides a flow of money or services to its owner

Question 43

capital gain

Answer 43

An increase in the value of an asset

Question 44

capital loss

Answer 44

A decrease in the value of an asset

Question 45

realized capital gain or loss

Answer 45

whenever you sell the asset and incurred gain or loss

Question 46

risky asset

Answer 46

provides a monetary flow that is at least in part random the monetary flow is not known with certainty in advance

Question 47

riskless (or risk-free) asset

Answer 47

pays a monetary flow that is known with certainty ex: Short-term U.S. government bonds—called Treasury bills

Question 48

The return on an asset

Answer 48

the total monetary flow it yields (including capital gains or losses) as a fraction of its price

Question 49

The real return on an asset

Answer 49

its simple (or nominal) return less the rate of inflation

Question 50

The expected return on an asset

Answer 50

the expected value of its return the return that it should earn on average

Question 51

an asset’s actual return

Answer 51

In some years, may be much higher than its expected return and in some years much lower Over a long period, however, the average return should be close to the expected return

Question 52

true or false usually, the higher the expected return on an investment, the greater the risk involved

Answer 52

true bruv

Question 53

the budget line of an investor equation and meaning?

Answer 53

Rp = Rf + ((Rm - Rf) / standard deviation m) * standard deviation p it describes the trade-off between risk (standard deviation p) and expected return (Rp) The equation says that the expected return on the portfolio Rp increases as the standard deviation of that return (tandard deviation p) increases (Rm - Rf) / standard deviation m = slope of budget line = the price of risk

Question 54

the price of risk

Answer 54

Extra risk that an investor must incur to enjoy a higher expected return the slope of the budget line

Question 55

buying stocks on a margin

Answer 55

a form of leverage the investor must borrow money because she wants to invest more than 100 percent of her wealth in the stock market the investor increases her expected return above that for the overall stock market, but at the cost of increased risk she would borrow money from a brokerage firm in order to invest more than she actually owns in the stock market

Question 56

the Internet bubble

Answer 56

an increase in the prices of Internet stocks based not on the fundamentals of business profitability, but instead on the belief that the prices of those stocks would keep going up applies for all bubbles Bubbles are often the result of irrational behavior

Question 57

informational cascade

Answer 57

actions based on actions based on actions ... , etc., driven by very limited fundamental information

Question 58

the basic theory of consumer demand is based on which three assumptions

Answer 58

(1) consumers have clear preferences for some goods over others (2) consumers face budget constraints (3) given their preferences, limited incomes, and the prices of different goods, consumers choose to buy combinations of goods that maximize their satisfaction (or utility)

Question 59

objective of behavioral economics

Answer 59

incorporating more realistic and detailed assumptions regarding human behavior to better understand consumer demand and firm decisions

Question 60

Adjustments to the standard model of consumer preferences and demand can be grouped into which three categories?

Answer 60

A tendency to value goods and services in part based on the setting one is in a concern about the fairness of an economic transaction the use of simple rules of thumb as a way to cut through complex economic decisions

Question 61

reference point

Answer 61

created by the setting the consumer is in at the moment references might be at least partly based on this setting or reference point the point from which the individual makes the consumption decision which can strongly affect the buying decision

Question 62

endowment effect

Answer 62

A well-known example of a reference point the fact that individuals tend to value an item more when they happen to own it than when they do not ex: the gap between the price that a person is willing to pay for a good and the price at which she is willing to sell the same good to someone else

Question 63

loss aversion

Answer 63

the tendency of individuals to prefer avoiding losses over acquiring gains with experience (such as stock brokers) this disappears

Question 64

framing

Answer 64

also influences preferences is another manifestation of reference points a tendency to rely on the con- text in which a choice is described when making a decision

Question 65

all manifestation of reference points

Answer 65

endowment effect loss aversion framing

Question 66

what does the ultimatum game show?

Answer 66

shows how fairness can affect economic decisions

Question 67

anchoring

Answer 67

refers to the impact that a suggested (perhaps unrelated) piece of information may have on your final decision

Question 68

effects of rules of thumb

Answer 68

can introduce biases in decision making help to save time and effort and result in only small biases

Question 69

the law of small numbers

Answer 69

tendency to overstate the probability that certain events will occur when faced with relatively little information from recent memory ex: roulette player who bets on black after seeing red come up three times in a row