# Week 7 chapter notes

Chapter 5 Uncertainty and Consumer Behaviour Notes

5.1 Describing Risk

Probability

x probability Æ likelihood that a given outcome will occur

x one interpretation of probability can depend on the nature of the uncertain event, on the beliefs of the people involved, or both

x one objective interpretation of probability relies on the frequency with which certain events tend to occur

x subjective probability is the perception that an outcome will occur, which may be based on a person’s judgment or experience,

but not necessarily on the frequency with which a particular outcome has actually occurred in the past

Expected Value

x expected value Æ probability-weighted average of the payoffs associated with all possible outcomes

x payoff Æ value associated with a possible outcome; probabilities of each outcome are used as weights

x the expected value measures the central tendency—the payoff or value that is expected on average

Variability

x variability Æ extent to which possible outcomes of an uncertain event differ

x deviation Æ difference between expected payoff and actual payoff

x standard deviation Æ square root of weighted average of squares of deviations of payoffs from their expected values

5.2 Preferences Toward Risk

x expected utility Æ sum of utilities associated with all possible outcomes, weighted by probability that each outcome will occur

Different Preferences Toward Risk

x risk averse Æ condition of preferring a certain income to a risky income with the same expected value

x risk neutral Æ condition of being indifferent between a certain outcome and an uncertain outcome with the same expected value

x risk loving Æ condition of preferring a risky outcome to a certain outcome with the same expected value

x risk premium Æ maximum amount of money that a risk-averse person will pay to avoid taking a risk

5.3 Reducing Risk

Diversification

x diversification Æ practice of reducing risk by allocating resources to variety of activities whose outcomes are not closely related

x negatively correlated variables Æ variables having a tendency to move in opposite directions

x mutual fund Æ firm that pools funds of individual investors to buy large number of diverse stocks or other financial assets

x positively correlated variables Æ variables having a tendency to move in the same direction

Insurance

x actuarially fair Æ characterizing a situation in which an insurance premium is equal to the expected payout

The Value of Information

x value of complete information Æ difference between the expected value of a choice when there is complete information and the

expected value when information is incomplete

Summary

1. Consumers and managers frequently make decisions in which there is uncertainty about the future. This uncertainty is

characterized by the term risk, which applies when each of the possible outcomes and its probability of occurrence is known.

2. Consumers and investors are concerned about the expected value and the variability of uncertain outcomes. The expected value

is a measure of the central tendency of the values of risky outcomes. Variability is frequently measured by the standard deviation

of outcomes, which is the square root of the probability-weighted average of the squares of the deviation from the expected value

of each possible outcome.

3. Facing uncertain choices, consumers maximize their expected value—an average of the utility associated with each outcome—

with the associated probabilities serving as weights.

4. A person who would prefer a certain return of a given amount to a risky investment with the same expected return is risk averse.

The maximum amount of money that a risk-averse person would pay to avoid taking a risk is called the risk premium. A person

who is indifferent between a risky investment and the certain receipt of the expected return on that return is risk neutral. A risk-

loving consumer would prefer a risky investment with a given expected return to the certain receipt of that expected return.

5. Risk can be reduced by (a) diversification, (b) insurance, and (c) additional information.

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## Document Summary

N mutual fund firm that pools funds of individual investors to buy large number of diverse stocks or other financial assets. Summary: consumers and managers frequently make decisions in which there is uncertainty about the future. This uncertainty is characterized by the term risk, which applies when each of the possible outcomes and its probability of occurrence is known: consumers and investors are concerned about the expected value and the variability of uncertain outcomes. The expected value is a measure of the central tendency of the values of risky outcomes. The maximum amount of money that a risk-averse person would pay to avoid taking a risk is called the risk premium. A person who is indifferent between a risky investment and the certain receipt of the expected return on that return is risk neutral.