final - Chapter 5 Describing Risk o Probability-the...

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C hapter 5 Describing Risk o Probability- the likelihood that a given outcome will occur; can depend on the nature of the uncertain event, on the beliefs of the people involved, or both; measures expected value and variability Objective- relies on the frequency with which certain events tend to occur Subjective- the perception that an outcome will occur; 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 o Expected Value- probability weighted average of the payoffs (value associated with a possible outcome) associated with all possible outcomes E(X)=Pr1X1+Pr2X2 o Variability- the extent to which possible outcomes of an uncertain event differ Deviation-difference between expected payoff and actual payoff Measure variability by calculating standard deviation-square root of the weighted average of the squares of the deviations of the payoffs associated with each outcome from their expected values Preferences Towards Risk E(u)=.5u(x)+.5u(x2) o Utility that consumers obtain from choosing among risky alternatives o Expected utility- sum of the utilities associated with all possible outcomes, weighted by the probability that each outcome will occur o Risk averse- condition of preferring a certain income to a risky income with the same expected value o Risk neutral- condition of being indifferent between a certain income and an uncertain income with the same expected value; marginal utility of income is constant for a risk neutral person o Risk loving- prefers a risky income to a certain income with the same expected value o Risk premium- maximum amount of money that a risk averse person will pay to avoid taking a risk Reducing Risk o Diversification, insurance, and obtaining more information about choices and payoffs o Diversification Allocating your resources to a variety of activities whose outcomes are not closely related Minimizes risk by allocating your time so that you can sell two or more products rather than a single product
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Negatively correlated variables- variables having a tendency to move in opposite directions; whenever sales of one are strong, sales of the other are weak The stock market-If a person invests all their money in a single stock, they are taking much more risk than necessary. They can diversify by buying shares in mutual funds, an organization that pools funds of individual investors to buy a large number of different stocks or other financial assets. Stock prices are sometimes positively correlated variables because they tend to move in the same direction in response to changes in economic conditions. Insurance-buying insurance assures a person of having the same income whether or not there is a loss. For a risk-averse individual, losses count more than gains.
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