# Chap011 - Chapter 11 - Choices Involving Risk Chapter 11:...

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Chapter 11 - Choices Involving Risk Chapter 11: Choices Involving Risk Main Concepts and Learning Objectives This chapter focuses on risk. Two fundamental concepts, expected value and standard deviation, are explained in-detail. The chapter uses the Guaranteed Consumption line diagram to explain the impact of risk attitudes on individual decisions, and to explain the concepts of a risk premium and a certainty equivalent. These two concepts are then used to explain fundamental insurance concepts. Students who master the material presented in this chapter will be able to: Compute expected value and standard deviation Analyze risk using the Guaranteed Consumption line diagram. Analyze the implications of subjective probabilities and risk attitudes for individual decision-making Compute the risk premium, expected utility and the certainty equivalent Compute the value of full and partial insurance Describe strategies for risk management 11-1

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Chapter 11 - Choices Involving Risk Multiple Choice Quiz (10 questions) covering main points: 1. The expected value of a risky investment is a. the more likely payoff – that is most expected. b. the weighted average of all possible payoffs, where the weights are the probabilities of the payoffs. c. the payoff that actually occurs. d. none of the above 2. DiMasi, Hansen and Grabowski estimate that the average successful prescription drug must generate \$802 million in profits to cover development costs. They argue that the number is so high because a. \$802 million is spent on research for each drug. b. for every new drug that obtains FDA approval, many others do not. If each successful drug earns \$802 million, (while the unsuccessful drugs lose hundreds of millions), then the expected value of new drug research is high enough to continue to attract investors. 3. The guaranteed consumption bundle a. is guaranteed by the insurance company. b. is guaranteed by the government. c. can be guaranteed by a non-profit coop. d. none of the above 4. The slope of the constant expected consumption line is a function of: a. the probabilities of the two states of nature. b. the prices of the two goods. c. the individual’s preferences. d. all of the above 5. The certainty equivalent to a risky bundle is a. the price the individual would have to pay to pay an insurance company to provide compensation if the less-preferred outcome occurs. b. the guaranteed bundle that lies on the same indifference curve as the risky bundle. c. the price the consumer would be willing to pay to eliminate risk d. none of the above 6. True or False? The size of the risk premium reflects the psychological cost of risk. a. True b. False 11-2
Chapter 11 - Choices Involving Risk 7. If people are typically risk averse, why is sports betting such a big business? Application 11.2 argues that risk averse people may bet on sports if

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## This note was uploaded on 04/06/2011 for the course ECON 3332 taught by Professor Craig during the Spring '11 term at Rensselaer Polytechnic Institute.

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Chap011 - Chapter 11 - Choices Involving Risk Chapter 11:...

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