chapter 7: Uncertainty and Consumer Behavior Flashcards

1
Q

probability

A

the ikelihood that a given outcome will occur

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2
Q

what does an objective interpretation of probability rely on?

A

on the frequency with which certain events tend to occur

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3
Q

Subjective probability

A

the perception that an outcome will occur

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4
Q

Two important measures that help us describe and compare risky choices

A

expected value (mean)

variability

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5
Q

Expected Value (mean)

A

is a probability-weighted average of the payoffs associated with all possible outcomes

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6
Q

payoff

A

a value associated with a possible outcome

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7
Q

what does the expected value measure?

A

the mean

the central tendency

the payoff or value that we would expect on average

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8
Q

Variability

A

the extent to which possible outcomes of an uncertain event differ

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9
Q

Deviation

A

the extent to which possible actual payoffs of an uncertain event differ from expected payoffs

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10
Q

Standard deviation

A

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

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11
Q

Expected utility

A

sum of the utilities associated with all possible outcomes

weighted by the probability that each outcome will occur

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12
Q

Risk averse

A

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

a consumer’s marginal utility diminishes as income increases

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13
Q

Risk-loving

A

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

increasing marginal utility as income increases

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14
Q

risk neutral

A

indifferent between a risky income to a certain income with the same expected value.

indifferent between certain and uncertain events with the same expected income

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15
Q

RISK PREMIUM

A

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

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16
Q

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

A

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

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17
Q

An increase in a highly risk averse individual’s standard deviation of income requires what?

A

requires a large increase in expected income if he or she is to remain equally well of

18
Q

An increase in a slightly risk averse individual’s standard deviation of income requires what?

A

requires only a small increase in expected income if he or she is to remain equally well off

19
Q

Diversification

A

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

20
Q

Negatively correlated variables

A

variables having a tendency to move in opposite directions

21
Q

Mutual fund

A

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

22
Q

Positively correlated variables

A

variables having a tendency to move in the same direction (e.g. stock prices)

23
Q

who enjoys a higher utility by purchasing insurance? why?

A

risk averse individuals

because losses count more (in terms of changes in utility) than gains

24
Q

THE LAW OF LARGE NUMBERS

A

The ability to avoid risk by operating on a large scale is based on the 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

ex: insurance companies

25
actuarially fair
When the insurance premium is equal to the expected payout characterizing a situation in which an insurance premium is equal to the expected payout
26
The value of complete information
difference between the expected value of a choice when there is complete information and the expected value when information is incomplete
27
true or false Internet-based price comparison sites offer a valuable informational resource to consumers
true
28
Asset
omething that provides a flow of money or services to its owner
29
increase in the value of an asset
capital gain
30
decrease in the value of an asset
capital loss
31
Risky Asset
asset that provides an uncertain flow of money or services to its owner
32
Riskless (or risk-free) Asset
asset that provides a flow of money or services that is known with certainty
33
asset return
total monetary flow of an asset as a fraction of its price
34
real return
simple (or nominal) return on an asset, less the rate of inflation
35
Expected Return
return that an asset should earn on average
36
Actual Return
return that an asset actually earns
37
The budget line
describes the trade-off between risk and expected return the equation for a straight line The equation says that the expected return on the portfolio Rp increases as the standard deviation of that return σp increases
38
equation to determine how much to invest in the stock market this is the budget line
1: Rp = bRm + (1 - b) * Rf Rf: risk-free return on the Treasury bill Rm: the expected return from investing in the stock market 2: Rp = Rf + b(Rm - Rf) b = 𝜎𝑝/σ𝑚 3: Rp = Rf + ((Rm - Rf)/σ𝑚) * 𝜎𝑝 slope of the budget lien: (Rm - Rf)/σ𝑚)
39
the price of risk
(Rm − Rf)/σm = slope of budget line extra risk that an investor must incur to enjoy a higher expected return describes the trade-off between the expected return and its riskiness, as measured by the standard deviation of the return
40
the utility maximizing point
The utility-maximizing investment portfolio is at the point where indifference curve is tangent to the budget line
41
BUYING STOCKS ON MARGIN
she would like to invest more than 100 percent of her wealth in the stock market borrowing from a brokerage firm to help finance her investment