Perloff_397614_IM_Ch16 - Chapter 16 Uncertainty Chapter...

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Chapter 16 Uncertainty ± Chapter Outline 16.1 Degree of Risk Probability Expected Value Variance and Standard Deviation 16.2 Decision Making Under Uncertainty Expected Utility Attitudes Toward Risk Degree of Risk Aversion 16.3 Avoiding Risk Just Say No Obtain Information Diversify Insure 16.4 Investing Under Uncertainty How Investing Depends on Attitudes Toward Risk Investing with Uncertainty and Discounting Investing with Altered Probabilities ± Teaching Tips Chapter 16 begins with a review of some basic statistics. If the class you are teaching has a statistics prerequisite, you may be able to either skip this review all together, or give it a brief treatment to refresh the students’ memories. The von Nuemann–Morgenstern utility material can be included as part of utility analysis (Chapter 4) if you will not have time to cover this chapter separately. When describing attitudes toward risk, beware of the classroom demonstration. I once watched a professor come pretty close to losing $10 on a coin flip bet in an effort to demonstrate risk neutrality. When circumstances are artificial, such as classroom experiments, or there is value to posturing by participants, risk-preferring behavior is much more likely than in a true empirical test. (However, I also know two professors who were able to “win” a lot of hours of community service from students in a demonstration that showed quite clearly that the students were overconfident in their betting, and did not fully understand the odds of winning casino-style games.)
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218 Perloff • Microeconomics: Theory and Applications with Calculus One interesting application of this material is the complication caused by scope economies in regulated industries. In regulated industries, one way to determine a fair rate of return is to compare the rates of return to nonregulated industries in a similar risk class. Under such a system, a regulated telecommunications provider’s allowable earnings would end up being determined in part by the level of risk that regulators believe they are exposed to. Although the portfolio effect of multiple output production can be used to create a reduction in risk by evening out revenue flows, there is also a risk concentrating effect of using the same capital to produce multiple outputs. For example, in 1988, in Hinsdale, Illinois, a fire at a telecommunications switch caused the complete loss of service to all outputs provided by that switch. WATS lines, 800 service, residential and business calling were all interrupted. While the switch is in operation, the telephone company receives the benefits of reduced production cost (scope economies), as well as a reduction in revenue fluctuations through diversification. However, producing all of these outputs using the same switch concentrates risk. If one type of risk is accounted for, but the other is not, the firm may be misclassified.
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Perloff_397614_IM_Ch16 - Chapter 16 Uncertainty Chapter...

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