chapter 7: Uncertainty and Consumer Behavior

Question 1

probability

Answer 1

the ikelihood that a given outcome will occur

Question 2

what does an objective interpretation of probability rely on?

Answer 2

on the frequency with which certain events tend to occur

Question 3

Subjective probability

Answer 3

the perception that an outcome will occur

Question 4

Two important measures that help us describe and compare risky choices

Answer 4

expected value (mean)

variability

Question 5

Expected Value (mean)

Answer 5

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

Question 6

payoff

Answer 6

a value associated with a possible outcome

Question 7

what does the expected value measure?

Answer 7

the mean

the central tendency

the payoff or value that we would expect on average

Question 8

Variability

Answer 8

the extent to which possible outcomes of an uncertain event differ

Question 9

Deviation

Answer 9

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

Question 10

Standard deviation

Answer 10

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

Question 11

Expected utility

Answer 11

sum of the utilities associated with all possible outcomes

weighted by the probability that each outcome will occur

Question 12

Risk averse

Answer 12

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

a consumer’s marginal utility diminishes as income increases

Question 13

Risk-loving

Answer 13

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

increasing marginal utility as income increases

Question 14

risk neutral

Answer 14

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

Question 15

RISK PREMIUM

Answer 15

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

Question 16

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

Answer 16

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

Question 17

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

Answer 17

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

Question 18

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

Answer 18

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

Question 19

Diversification

Answer 19

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

Question 20

Negatively correlated variables

Answer 20

variables having a tendency to move in opposite directions

Question 21

Mutual fund

Answer 21

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

Question 22

Positively correlated variables

Answer 22

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

Question 23

who enjoys a higher utility by purchasing insurance? why?

Answer 23

risk averse individuals

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

Question 24

THE LAW OF LARGE NUMBERS

Answer 24

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

Question 25

actuarially fair

Answer 25

When the insurance premium is equal to the expected payout

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

Question 26

The value of complete information

Answer 26

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

Question 27

true or false

Internet-based price comparison sites offer a valuable informational resource to consumers

Answer 27

true

Question 28

Asset

Answer 28

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

Question 29

increase in the value of an asset

Answer 29

capital gain

Question 30

decrease in the value of an asset

Answer 30

capital loss

Question 31

Risky Asset

Answer 31

asset that provides an uncertain flow of money or services to its owner

Question 32

Riskless (or risk-free) Asset

Answer 32

asset that provides a flow of money or services that is known with certainty

Question 33

asset return

Answer 33

total monetary flow of an asset as a fraction of its price

Question 34

real return

Answer 34

simple (or nominal) return on an asset, less the rate of inflation

Question 35

Expected Return

Answer 35

return that an asset should earn on average

Question 36

Actual Return

Answer 36

return that an asset actually earns

Question 37

The budget line

Answer 37

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

Question 38

equation to determine how much to invest in the stock market

this is the budget line

Answer 38

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)

Question 39

the price of risk

Answer 39

(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

Question 40

the utility maximizing point

Answer 40

The utility-maximizing investment portfolio is at the point where indifference curve is tangent to the budget line

Question 41

BUYING STOCKS ON MARGIN

Answer 41

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