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| Likelihood that a given outcome will occur. |
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| is the perception that an outcome will occur. |
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| Probability-weighted average of the payoffs associated with all possible outcomes. |
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| The expected value measures the central tendency, which is... |
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the payoff or value that we would expect on average.
E(X)=Pr1X1 +Pr2X2 +...+PrnXn |
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| value associated with a possible outcome. |
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| extent to which possible outcomes of an uncertain event differ. |
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| Difference between expected payoff and actual payoff. |
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- marginal utility diminishes as income increases
- curve is downward-sloping |
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- marginal utility increases as income increases
- curve is upward-sloping |
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- indifferent between certain and uncertain events with the same expected income
- curve is straight |
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| sum of the utilities associated with all possible outcomes, weighted by the probability that each outcome will occur. |
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| Condition of preferring a certain income to a risky income with the same expected value. |
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| Condition of being indifferent between a certain income and an uncertain income with the same expected value. |
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| Condition of preferring a risky income to a certain income with the same expected value. |
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| Maximum amount of money that a risk-averse person will pay to avoid taking a risk. |
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| The extent of an individual’s risk aversion depends on... |
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...the nature of the risk and on the person’s income.
Other things being equal, risk-averse people prefer a smaller variability of outcomes.
The greater the variability of income, the more the person would be willing to pay to avoid the risky situation. |
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| For highly risk-averse person to remain equally well off, an increase in this individual’s standard deviation of income requires... |
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| ...a large increase in expected income. |
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| diversification (similar to risk-spreading) |
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| Practice of reducing risk by allocating resources to a variety of activities whose outcomes are not closely related. |
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| The ability to avoid risk by operating on a large scale is based on the "law of large numbers," which... |
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| tells us that although single events may be random and largely unpredictable, the average outcome of many similar events can be predicted. |
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| Characterizing a situation in which an insurance premium is equal to the expected payout. |
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| value of complete information |
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| Difference between the expected value of a choice when there is complete information and the expected value when information is incomplete. |
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| point of behavioral economics |
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| to improve understanding of consumer demand (as well as the decisions of firms) by incorporating more realistic and detailed assumptions regarding human behavior. |
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| The point from which an individual makes a consumption decision. |
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| Tendency of individuals to value an item more when they own it than when they do not. |
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| Tendency for individuals to prefer avoiding losses over acquiring gains. |
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| Tendency to rely heavily on one or two pieces of information when making a decision. |
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| law of small numbers bias |
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| people tend to overstate the probability that certain events will occur when faced with relatively little information from recent memory. |
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| calculation of expected utility |
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| requires two pieces of information: a utility value for each outcome (from the utility function) and the probability of each outcome. |
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| most important assumption about consumer behavior |
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| assumes perfect information about risk |
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| steps for examining how people choose among risky alternatives |
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1. quantify risk in order to compare riskiness of alternate choices
2. examine peoples' preferences toward risk
3. see how people can reduce or eliminate risk
4. see how, in certain situations, people choose the amount of risk they wish to bear |
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