Risk Flashcards

1
Q

Risk

A

know the probability of each outcome

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2
Q

uncertainity

A

do not know the probability of each outcome

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3
Q

probabilities

A

the likelihood of each outcome occurring

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4
Q

pay offs

A

economic consequences for each outcome

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5
Q

expected value formula

A

(Prob. of X) (Payoff of X) + (Prob. of Y) (Payoff of Y)

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6
Q

What are risk preferences?

A

risk averse (don’t like risk), risk loving (like risk), risk neutral (doesn’t effect decision)

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7
Q

risk averse

A

when you do not like risk so you try to reduce risk

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8
Q

How to reduce risk?

A

Insurance, information, diversification, factionalism, and flexibility

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9
Q

How does insurance reduce risk?

A

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

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10
Q

How does information reduce risk?

A

Information can change your decision. however there is the issue of misinformation and you may have to pay for this information

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11
Q

Diversification

A

businesses spread their investments across different things ex: may sell sunglasses and umbrellas so changes in weather will benefit you either way

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12
Q

fractionalization

A

split risk into smaller parts
Ex: property costs $100,000 but you only pay in $10,000 intervals

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13
Q

flexibility

A

learning about something before fully committing to it. Be prepare for both situations and accept either.

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14
Q

asymmetric information

A

one side knows more than the other

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15
Q

unobserved quality

A

buyers dont know the quality of the product

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16
Q

adverse selection

A

one side hides information. ex: insurance companies

17
Q

moral hazard

A

people will take more risks when they do not face the full consequence. ex: may drive more reckless because you have car insurance

18
Q

how to combat moral hazard and increase effort?

A

provide incentives. Ex: people will work hard if there is a chance for a raise or people will drive safer if their insurance will increase for every accident.