Uncertainty and Risk Flashcards
What is a Lottery?
the list of different outcomes and their associated probability of occuring
What is Expected Utility?
The Expected Utility of an individual if they were to play the Lottery. Calculated by using the individuals utiltiy function x probability of outcome occuring.
Are Expected Utility results cardinal or ordinal?
They are cardinal because of the % associated with probability.
What is a state of nature?
A state of nature refers to a possible future condition or outcome that affects decisions under uncertainty, independent of the decision-maker’s actions.
What is expected Value?
The Expected value of for example a Lottery is the average outcome of the Lottery. EV is an objective fact and is not related to Expected Utility.
What does Risk averse mean?
An individual who would prefer to be paid the EV of the Lottery rather than playing it. Their simple utility function is concave.
What does Risk Loving mean?
An individual who would rather play the lottery than be paid the EV amount. Their utility functions are convex
What does risk neutral mean?
A risk neutral individual has a linear utility function and is indifferent to being paid the EV amount and playing the lottery.
What is the Certainty Equivalent?
The certaintity equivalent is the amount of sure cash that would be needed to be paid to the individual to make them indifferent to taking the CE amount or playing the Lottery. CE a point on the x-axis.
What is the Risk Premium?
The RP = EV -CE, and is the amount of money that an individual is willing to give up in order to avoid playing the lottery
