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Economics for Management Studies

Chapter 5 Uncertainty and Consumer Behaviour Notes 5.1 Describing Risk Probability N probability likelihood that a given outcome will occur N one interpretation of probability can depend on the nature of the uncertain event, on the beliefs of the people involved, or both N one objective interpretation of probability relies on the frequency with which certain events tend to occur N subjective probability is the perception that an outcome will occur, which may be based on a persons judgment or experience, but not necessarily on the frequency with which a particular outcome has actually occurred in the past Expected Value N expected value probability-weighted average of the payoffs associated with all possible outcomes N payoff value associated with a possible outcome; probabilities of each outcome are used as weights N the expected value measures the central tendencythe payoff or value that is expected on average Variability N variability extent to which possible outcomes of an uncertain event differ N deviation difference between expected payoff and actual payoff N standard deviation square root of weighted average of squares of deviations of payoffs from their expected values 5.2 Preferences Toward Risk N expected utility sum of utilities associated with all possible outcomes, weighted by probability that each outcome will occur Different Preferences Toward Risk N risk averse condition of preferring a certain income to a risky income with the same expected value N risk neutral condition of being indifferent between a certain outcome and an uncertain outcome with the same expected value N risk loving condition of preferring a risky outcome to a certain outcome with the same expected value N risk premium maximum amount of money that a risk-averse person will pay to avoid taking a risk 5.3 Reducing Risk Diversification N diversification practice of reducing risk by allocating resources to variety of activities whose outcomes are not closely related N negatively correlated variables variables having a tendency to move in op
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