chapter 7: Uncertainty and Consumer Behavior Flashcards
probability
the ikelihood that a given outcome will occur
what does an objective interpretation of probability rely on?
on the frequency with which certain events tend to occur
Subjective probability
the perception that an outcome will occur
Two important measures that help us describe and compare risky choices
expected value (mean)
variability
Expected Value (mean)
is a probability-weighted average of the payoffs associated with all possible outcomes
payoff
a value associated with a possible outcome
what does the expected value measure?
the mean
the central tendency
the payoff or value that we would expect on average
Variability
the extent to which possible outcomes of an uncertain event differ
Deviation
the extent to which possible actual payoffs of an uncertain event differ from expected payoffs
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
Expected utility
sum of the utilities associated with all possible outcomes
weighted by the probability that each outcome will occur
Risk averse
preferring a certain income to a risky income with the same expected value
a consumer’s marginal utility diminishes as income increases
Risk-loving
preferring a risky income to a certain income with the same expected value
increasing marginal utility as income increases
risk neutral
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
RISK PREMIUM
is maximum amount of money that a risk-averse person will pay to avoid taking a risk
The extent of an individual’s risk aversion depends on what
depends on the nature of the risk and on the person’s income
An increase in a highly risk averse individual’s standard deviation of income requires what?
requires a large increase in expected income if he or she is to remain equally well of
An increase in a slightly risk averse individual’s standard deviation of income requires what?
requires only a small increase in expected income if he or she is to remain equally well off
Diversification
is a practice of reducing risk by allocating resources to a variety of activities whose outcomes are not closely related
Negatively correlated variables
variables having a tendency to move in opposite directions
Mutual fund
organization that pools funds of individual investors to buy a large number of different stocks or other financial assets
Positively correlated variables
variables having a tendency to move in the same direction (e.g. stock prices)
who enjoys a higher utility by purchasing insurance? why?
risk averse individuals
because losses count more (in terms of changes in utility) than gains
THE LAW OF LARGE NUMBERS
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
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
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
true or false
Internet-based price comparison sites offer a valuable informational resource to consumers
true
Asset
omething that provides a flow of money or services to its owner
increase in the value of an asset
capital gain
decrease in the value of an asset
capital loss
Risky Asset
asset that provides an uncertain flow of money or services to its owner
Riskless (or risk-free) Asset
asset that provides a flow of money or services that is known with certainty
asset return
total monetary flow of an asset as a fraction of its price
real return
simple (or nominal) return on an asset, less the rate of inflation
Expected Return
return that an asset should earn on average
Actual Return
return that an asset actually earns
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
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)
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
the utility maximizing point
The utility-maximizing investment portfolio is at the point where indifference curve is tangent to the budget line
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
