chapter 7 book: Uncertainty and Consumer Behavior Flashcards
Probability
likelihood that a given outcome will occur
probabilities for all possible events must add up to what?
probabilities for all possible events must add up to 1
Subjective probability
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
objective interpretation of probability relies on?
relies on the frequency with which certain events tend to occur
what can cause subjective probabilities to vary among individuals?
Either different information or different abilities to process the same information
two important measures that help us describe and compare risky choices
expected value (mean)
variability of the possible outcomes
expected value (mean) associated with an uncertain situation
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
central tendency
the payoff or value that we would expect on average
payoff
Value associated with a possible outcome
variability of the possible outcomes
extent to which the possible outcomes of an uncertain situation differ
the thing with standard deviation and everything of the sort
how do we measure variability?
by recognizing that large differences between actual and expected payoffs (whether positive or negative) imply greater risk
these differences are called deviations
deviation
difference between expected payoff and actual payoff
why do deviation by themselves not provide a measure of variability?
Because they are sometimes positive and sometimes negative
average of the probability-weighted deviations is always 0
how do we solve the problem that deviations can be negative as well?
we square each deviation, yielding numbers that are always positive
We then measure variability by calculating the standard deviation
standard deviation
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
what does a high standard deviation indicate?
a high standard deviation indicates that the values are spread out over a wider range
it means there is more risk
what does a low standard deviation indicate?
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
expected utility E(u)
Sum of the utilities associated with all possible outcomes, weighted by the probability that each outcome will occur
An individual who is risk averse
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
A person who is risk neutral
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
an individual who is risk loving
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
the most common attitude toward risk
risk averse
the risk premium
the maximum amount of money that a risk-averse person will pay to avoid taking a risk
what does the magnitude of the risk premium depend on?
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)
The extent of an individual’s risk aversion depends on what?
depends on the nature of the risk and on the person’s income
why are indifference curve in this chapter upward sloping?
because risk is undesirable
the greater the amount of risk, the greater the expected income needed to make the individual equally well off
for an individual who is highly risk averse, an increase in the standard deviation of income requires what?
a large increase in expected income
for an individual who is slightly risk averse, a large increase in the standard deviation of income requires what?
only a small increase in expected income
three ways by which both consumers and businesses commonly reduce risks
diversification
insurance
obtaining more information about choices and payoffs
diversification
allocating your resources to a variety of activities whose outcomes are not closely related
Risk can be minimized by diversification
negatively correlated variables
tend to move in opposite directions
ex: whenever sales of one are strong, sales of the other are weak
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
true
is diversification important for people who invest in the stock market?
ye bruv, very important
mutual funds
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
stock prices are mostly positively or negatively correlated variables? why?
stock prices are to some extent positively correlated variables
They tend to move in the same direction in response to changes in economic conditions
why would risk averse individuals enjoy insurance?
because it guarantees them the same utility (or income) no matter what happens
law of large numbers
tells us that although single events may be random and largely unpredictable, the average outcome of many similar events can be predicted
why does the law of large numbers apply to insurance companies?
because they know that when they sell a large number of poli- cies, they face relatively little risk
actuarially fair insurance
When the insurance premium is equal to the expected payout
why do insurance companies typi- cally charge premiums above expected losses?
because they must cover administrative costs and make some profit
The value of complete information
the difference between the expected value of a choice when there is complete information and the expected value when information is incomplete
asset
something that provides a flow of money or services to its owner
capital gain
An increase in the value of an asset
capital loss
A decrease in the value of an asset
realized capital gain or loss
whenever you sell the asset and incurred gain or loss
risky asset
provides a monetary flow that is at least in part random
the monetary flow is not known with certainty in advance
riskless (or risk-free) asset
pays a monetary flow that is known with certainty
ex: Short-term U.S. government bonds—called Treasury bills
The return on an asset
the total monetary flow it yields (including capital gains or losses) as a fraction of its price
The real return on an asset
its simple (or nominal) return less the rate of inflation
The expected return on an asset
the expected value of its return
the return that it should earn on average
an asset’s actual return
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
true or false
usually, the higher the expected return on an investment, the greater the risk involved
true bruv
the budget line of an investor
equation and meaning?
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
the price of risk
Extra risk that an investor must incur to enjoy a higher expected return
the slope of the budget line
buying stocks on a margin
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
the Internet bubble
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
informational cascade
actions based on actions based on actions … , etc., driven by very limited fundamental information
the basic theory of consumer demand is based on which three assumptions
(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)
objective of behavioral economics
incorporating more realistic and detailed assumptions regarding human behavior to better understand consumer demand and firm decisions
Adjustments to the standard model of consumer preferences and demand can be grouped into which three categories?
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
reference point
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
endowment effect
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
loss aversion
the tendency of individuals to prefer avoiding losses over acquiring gains
with experience (such as stock brokers) this disappears
framing
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
all manifestation of reference points
endowment effect
loss aversion
framing
what does the ultimatum game show?
shows how fairness can affect economic decisions
anchoring
refers to the impact that a suggested (perhaps unrelated) piece of information may have on your final decision
effects of rules of thumb
can introduce biases in decision making
help to save time and effort and result in only small biases
the law of small numbers
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
