E251.F11.W05.2.Ch5

# E251.F11.W05.2.Ch5 - ECON 251x Week 05.2 Uncertainty...

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ECON 251x Week 05.2 Chapter 5

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CHAPTER 5 OUTLINE 5.1 Describing Risk 5.2 Preferences Toward Risk 5.3 Reducing Risk 5.4 The Demand for Risky Assets 5.5 Behavioral Economics
Uncertainty and Consumer Behavior 1. In order to compare the riskiness of alternative choices, we need to quantify risk. 2. We will examine people’s preferences toward risk. 3. We will see how people can sometimes reduce or eliminate risk. 4. In some situations, people must choose the amount of risk they wish to bear. In the final section of this chapter, we offer an overview of the flourishing field of behavioral economics. To examine the ways that people can compare and choose among risky alternatives, we will take the following steps:

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DESCRIBING RISK 5.1 Probability probability Likelihood that a given outcome will occur. Subjective probability is the perception that an outcome will occur. expected value Probability-weighted average of the payoffs associated with all possible outcomes. Expected Value payoff Value associated with a possible outcome. The expected value measures the central tendency— the payoff or value that we would expect on average. Expected value = Pr(success)(\$40/share) + Pr(failure)(\$20/share) = (1/4)(\$40/share) + (3/4)(\$20/share) = \$25/share E ( X ) = Pr 1 X 1 + Pr 2 X 2 E ( X ) = Pr 1 X 1 + Pr 2 X 2 + . . . + Pr n X n More generally:
DESCRIBING RISK 5.1 Variability variability Extent to which possible outcomes of an uncertain event differ. deviation Difference between expected payoff and actual payoff. OUTCOME 1 OUTCOME 2 Probability Income (\$) Probability Income (\$) Expected Income (\$) Job 1: Commission Job 2: Fixed Salary .5 .99 2000 1510 1000 510 .5 .01 1500 1500 TABLE 5.1 Income from Sales Jobs TABLE 5.2 Deviations from Expected Income (\$) Outcome 1 Deviation Outcome 2 Deviation Job 1 Job 2 2000 1510 500 10 1000 510 - 500 - 990 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.

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DESCRIBING RISK 5.1 Variability Outcome 1 Deviation Squared Deviation Squared Outcome 2 Deviation Squared Weighted Average Standard Deviation Job 1 Job 2 2000 1510 250,000 100 1000 510 250,000 980,100 250,000 9900 500 99.50 Table 5.3 Calculating Variance (\$) Outcome Probabilities for Two Jobs The distribution of payoffs associated with Job 1 has a greater spread and a greater standard deviation than the distribution of payoffs associated with Job 2. Both distributions are flat because all outcomes are equally likely. Figure 5.1
DESCRIBING RISK 5.1 Variability Unequal Probability Outcomes The distribution of payoffs associated with Job 1 has a greater spread and a greater standard deviation than the distribution of payoffs associated with Job 2. Both distributions are peaked because the

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E251.F11.W05.2.Ch5 - ECON 251x Week 05.2 Uncertainty...

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