Economics: Decision Making under Uncertainty

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Questions and Answers

What is expected value in the context of decision making, and how is it used?

The expected value is the average amount one would earn by playing a lottery many times, used as a benchmark to decide whether to play a lottery or choose a safe option. It is used by risk-neutral individuals to make decisions based solely on calculation.

What does it mean to be risk averse, risk neutral, or risk seeking in the context of decision making?

Risk averse individuals have a certainty equivalent (w) less than the expected value (EV), risk-neutral individuals have w = EV, and risk-seeking individuals have w > EV.

What is the risk premium, and what does it represent?

The risk premium is the difference between the expected value (EV) and the certainty equivalent (w), quantifying an individual's risk aversion.

How does buying insurance help reduce risk exposure?

Buying insurance transfers some risk to a third entity, so the individual no longer bears the full risk. Signup and view all the answers

What is diversification in the context of risk management, and how does it work?

Diversification involves 'splitting the risk' by engaging in multiple, independent activities or investments, reducing overall risk. Signup and view all the answers

What is the main difference between a risk-neutral and a risk-averse individual?

A risk-neutral individual makes decisions based solely on calculation, while a risk-averse individual has a certainty equivalent (w) less than the expected value (EV). Signup and view all the answers

In what way can the concept of risk and preferences be used to interpret reality?

The concept of risk and preferences can be used to understand choices, such as job selection, as influenced by individual attitudes towards risk. Signup and view all the answers

Under what conditions would an individual choose to take the risk themselves rather than buying insurance?

If an individual is risk neutral or slightly risk averse, they may choose to take the risk themselves, as insurance would be too expensive. Signup and view all the answers

What is the effect of diversification on the possible outcomes of an event?

Diversification moves the possible outcomes of the event from the extremes to the center. Signup and view all the answers

What is pooling, and how does it protect a community from risk?

Pooling is when two or more people put all their earnings in one single pool and equally divide it, and it protects the community from risk by acting as a sort of social insurance. Signup and view all the answers

What is an example of an aggregate risk, and why can't diversification and pooling protect against it?

An example of aggregate risk is unemployment, and diversification and pooling can't protect against it because it affects the whole market and cannot be diversified or pooled. Signup and view all the answers

What is the distinction between aggregate or undiversifiable risk and idiosyncratic or diversifiable risk?

Aggregate or undiversifiable risk includes changes in trade policy, interest rates, or economy-wide demand for goods and services, while idiosyncratic or diversifiable risk includes a successful drug trial, or lawsuit alleging safety problems for a vehicle. Signup and view all the answers

Why is diversifiable risk essentially irrelevant in the valuation of securities?

Diversifiable risk is essentially irrelevant in the valuation of securities because investors can almost eliminate it by constructing portfolios that contain a large number of assets, each of which has a very small weight. Signup and view all the answers

What is systemic risk, and how does it differ from aggregate risk?

Systemic risk threatens the financial system itself, and differs from aggregate risk in that it affects the entire financial system rather than just a specific market or sector. Signup and view all the answers

How can investors reduce idiosyncratic risk in their portfolios?

Investors can reduce idiosyncratic risk by constructing portfolios that contain a large number of assets, each of which has a very small weight. Signup and view all the answers

Why is it important to distinguish between aggregate risk and idiosyncratic risk in finance?

It is important to distinguish between aggregate risk and idiosyncratic risk because idiosyncratic risk can be eliminated through diversification, while aggregate risk cannot. Signup and view all the answers

Study Notes

Uncertainty and Decision Making

Expected value (EV) represents the average amount earned by playing a lottery many times, used as a benchmark for deciding between a lottery and a safe option.
EV has nothing to do with personal preferences, but rather the object itself.
People can be risk-neutral, risk-averse, or risk-seeking, with different preferences influencing their decision-making.

Risk and Preferences

Certainty equivalent (w) represents the maximum willingness to pay for a lottery.
If w < EV, the person is risk-averse.
If w = EV, the person is risk-neutral.
If w > EV, the person is risk-seeking.
Risk premium is the difference between EV and w, quantifying a person's risk aversion.

Managing Risk

Insurance: paying a third entity to take on some risk, usually expensive and only beneficial for highly risk-averse individuals.
Diversification: "splitting the risk" by investing in multiple independent and identically distributed events, reducing risk and variance.
Pooling: combining earnings with others to protect the community from risk, similar to social insurance.

Types of Risk

Aggregate risk: affects everyone at the same time, such as unemployment, and cannot be diversified or insured.
Idiosyncratic risk: specific to an individual or firm, such as a successful drug trial, and can be diversified.
Systemic risk: threatens the entire financial system, such as a global economic crisis.

Assessing Risk

Diversifiable risk is essentially irrelevant in valuing securities, as investors can eliminate it by constructing diverse portfolios.
Systematic risk, affecting large classes of securities, cannot be diversified and is a significant concern.

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Description

Learn about expected value and its role in decision making, especially for risk-neutral individuals. Understand how it's used to evaluate lottery options and make informed choices.