Uncertainty, Risk and Private Information

Question 1

Define random variable

Answer 1

A variable with an uncertain future value

Question 2

How is the expected value calculated?

Answer 2

(P1 x S1) + (P2 X S2)

Question 3

Define expected utility

Answer 3

The expected value of an individual’s total utility, given uncertainty about future outcomes

Question 4

What 2 principles does the insurance industry rest on?

Answer 4

• Trading risk can produce mutual gains (people who want less risk transfer it to people who are more willing to bare it)
• Some risk can be made to disappear through diversification

Question 5

Define diversification

Answer 5

Investing in several things so that the possible losses are independent events

Question 6

Define pooling

Answer 6

A strong form of diversification; an individual takes a small share in each of many independent events