Lecture 12 notes - UNCERTAINTY: Chapter Review QUESTIONS...

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BE530 Page 1 of 6 Lecture 12 UNCERTAINTY: Chapter Review QUESTIONS FOR REVIEW 1. What does it mean to say that a person is risk averse ? Why are some people likely to be risk averse while others are risk lovers? A risk averse person has a diminishing marginal utility of income and prefers a certain income to a gamble with the same expected income. A risk lover has an increasing marginal utility of income and prefers an uncertain income to a certain income when the expected value of the uncertain income equals the certain income. To some extent, a person’s risk preferences are like preferences for different vegetables. They may be inborn or learned from parents or others, and we cannot easily say why some people are risk averse while others like taking risks. But there are some economic factors that can affect risk preferences. For example, a wealthy person is more likely to take risks than a moderately well off person, because the wealthy person can better handle losses. Also, people are more likely to take risks when the stakes are low (like office pools around NCAA basketball time) than when stakes are high (like losing a house to fire). 3. George has $5000 to invest in a mutual fund. The expected return on mutual fund A is 15 percent and the expected return on mutual fund B is 10 percent. Should George pick mutual fund A or fund B? George’s decision will depend not only on the expected return for each fund, but also on the variability of each fund’s returns and on George’s risk preferences. For example, if fund A has a higher standard deviation than fund B, and George is risk averse, then he may prefer fund B even though it has a lower expected return. If George is not particularly risk averse he may choose fund A even if its return is more variable. 4. What does it mean for consumers to maximize expected utility? Can you think of a case in which a person might not maximize expected utility? To maximize expected utility means that the individual chooses the option that yields the highest average utility, where average utility is the probability-weighted sum of all utilities. This theory requires that the consumer knows each possible outcome that may occur and the probability of each outcome. Sometimes consumers either do not know all possible outcomes and the relevant probabilities, or they have difficulty evaluating low-probability, extreme-payoff events. In some cases, consumers cannot assign a utility level to these extreme-payoff events, such as when the payoff is the loss of the consumer’s life. In cases like this, consumers may make choices based on other criteria such as risk avoidance. 5. Why do people often want to insure fully against uncertain situations even when the premium paid exceeds the expected value of the loss being insured against? Risk averse people have declining marginal utility, and this means that the pain of a loss increases
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Lecture 12 notes - UNCERTAINTY: Chapter Review QUESTIONS...

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