Risk Flashcards
Risk
know the probability of each outcome
uncertainity
do not know the probability of each outcome
probabilities
the likelihood of each outcome occurring
pay offs
economic consequences for each outcome
expected value formula
(Prob. of X) (Payoff of X) + (Prob. of Y) (Payoff of Y)
What are risk preferences?
risk averse (don’t like risk), risk loving (like risk), risk neutral (doesn’t effect decision)
risk averse
when you do not like risk so you try to reduce risk
How to reduce risk?
Insurance, information, diversification, factionalism, and flexibility
How does insurance reduce risk?
avoids extreme uncertainty. Ex: your house is worth 300,000 the probability of it being destroyed is low however if destroyed will cost you 300,000 but if you have insurance and pay 1000 per year if your house is destroyed insurance will pay for it
How does information reduce risk?
Information can change your decision. however there is the issue of misinformation and you may have to pay for this information
Diversification
businesses spread their investments across different things ex: may sell sunglasses and umbrellas so changes in weather will benefit you either way
fractionalization
split risk into smaller parts
Ex: property costs $100,000 but you only pay in $10,000 intervals
flexibility
learning about something before fully committing to it. Be prepare for both situations and accept either.
asymmetric information
one side knows more than the other
unobserved quality
buyers dont know the quality of the product