Comm220 Ch 5 - CHAPTER 5 UNCERTAINTY AND CONSUMER BEHAVIOR...

Info icon This preview shows pages 1–4. Sign up to view the full content.

Source: Pindyck and Rubinfeld (2009), Microeconomics , 7 th Ed., Pearson Prentice Hall, Chapter 5. 1 CHAPTER 5 - UNCERTAINTY AND CONSUMER BEHAVIOR Key Concepts and Topics Describing Risk Preferences Toward Risk Reducing Risk The Demand for Risky Assets Behavioral Economics Describing Risk To measure risk we must know: 1. All of the possible outcomes 2. The probability or likelihood that a given outcome will occur Interpreting Probability Objective probability Observed frequency of past events Subjective probability Perception that an outcome will occur Influenced by different information or different abilities to process the same information – based on judgment or experience 2 measures to help describe and compare risky choices 1. Expected value 2. Variability Expected Value Probability - weighted average of the payoffs or values associated with all possible outcomes measures the central tendency ; the payoff or value expected on average Example: Investment in offshore drilling exploration: 2 possible outcomes Success – the stock price increases from $30 to $40/share Failure – the stock price falls from $30 to $20/share Objective Probability 100 explorations: 25 successes and 75 failures Probability of success = 0.25 and probability of failure = 0.75 EV = Pr(success)(value of success) + Pr(failure)(value of failure) = 0.25($40/share) + 0.75($20/share) = $25/share
Image of page 1

Info icon This preview has intentionally blurred sections. Sign up to view the full version.

Source: Pindyck and Rubinfeld (2009), Microeconomics , 7 th Ed., Pearson Prentice Hall, Chapter 5. 2 In general, for n possible outcomes: E(X) = Pr 1 X 1 + Pr 2 X 2 + … + Pr n X n where X 1 , X 2 , … X n = payoffs of possible outcomes Pr 1 , Pr 2 , … Pr n = probabilities of each outcome Variability Extent to which possible outcomes of an uncertain event differ How much variation exists in the possible choices Example: Suppose you are choosing between two part-time sales jobs that have the same expected income ($1,500) Outcome 1 Outcome 2 Pr Income Pr Income Job 1: Commission 0.5 $2,000 0.5 $1,000 Job 2: Fixed salary 0.99 $1,510 0.01 $510 E(X 1 ) = 0.5($2,000) + 0.5($1,000) = $1,500 E(X 2 ) = 0.99($1,510) + 0.01($510) = $1,500 Same expected values, but different variability Greater variability from expected values signals greater risk Variability comes from deviations in payoffs Difference between expected payoff and actual payoff Deviations from Expected Income ($) Outcome 1 Deviation Outcome 2 Deviation Job 1 $2,000 $500 $1,000 –$500 Job 2 $1,510 $10 $510 –$990 Average deviations are always zero so we must adjust for negative numbers by taking the squares of the deviations Measure variability with standard deviation , σ Square root of the weighted average of the squares of the deviations (variance, σ 2 ) Measures how variable your payoff will be More variability means more risk Individuals generally prefer less variability – less risk
Image of page 2
Source: Pindyck and Rubinfeld (2009), Microeconomics , 7 th Ed., Pearson Prentice Hall, Chapter 5. 3 The standard deviation is written: 2 2 2 2 1 1 )) ( ( Pr )) ( ( Pr X E X X E X + = σ Standard deviations of the two jobs are: 50 . 99 900 , 9 ) 100 , 980 ( 01 . ) 100 ( 99 .
Image of page 3

Info icon This preview has intentionally blurred sections. Sign up to view the full version.

Image of page 4
This is the end of the preview. Sign up to access the rest of the document.

{[ snackBarMessage ]}

What students are saying

  • Left Quote Icon

    As a current student on this bumpy collegiate pathway, I stumbled upon Course Hero, where I can find study resources for nearly all my courses, get online help from tutors 24/7, and even share my old projects, papers, and lecture notes with other students.

    Student Picture

    Kiran Temple University Fox School of Business ‘17, Course Hero Intern

  • Left Quote Icon

    I cannot even describe how much Course Hero helped me this summer. It’s truly become something I can always rely on and help me. In the end, I was not only able to survive summer classes, but I was able to thrive thanks to Course Hero.

    Student Picture

    Dana University of Pennsylvania ‘17, Course Hero Intern

  • Left Quote Icon

    The ability to access any university’s resources through Course Hero proved invaluable in my case. I was behind on Tulane coursework and actually used UCLA’s materials to help me move forward and get everything together on time.

    Student Picture

    Jill Tulane University ‘16, Course Hero Intern