Chapter 15 & chapter 16

risk loving

A characteristic of a decision maker who prefers a lottery to a sure thing that is equal to the expected value of the lottery.

probability distribution

A depiction of all possible payoffs in a lottery and their associated probabilities.

expected value

A measure of the average payoff that a lottery will generate.

What is a risk premium? What determines the magnitude of the risk premium?

A risk premium is the difference between the expected value of a lottery and the payoff from a sure thing so that the decision maker is indifferent between the lottery and the sure thing. A key determinant of the risk premium is the variance associated with the lottery. If two lotteries have the same expected value but one has a higher variance, the risk premium associated with the lottery that has a higher variance will be larger. The decision maker is requiring a greater premium to take on greater risk.

Explain why diminishing marginal utility implies that a decision maker will be risk averse.

A utility function that exhibits diminishing marginal utility will imply the decision maker is risk averse. This is because with a utility function with diminishing marginal utility a decision maker will prefer a sure thing to a lottery with the same expected value. By preferring the sure thing, the decision maker prefers less risk, implying the decision maker is risk averse.

lottery

Any event for which the outcome is uncertain.

absolute advantage

One country has an absolute advantage over another country in the production of a good x if production of one unit of x in the first country requires fewer units of a scarce input (e.g., labor) than it does in the second country.

subjective probabilities

Probabilities that reflect subjective beliefs about risky events.

Production under free trade

Switzerland: heavily dependent

What is the difference between the expected value of a lottery and the expected utility of a lottery?

The expected value of a lottery measures the average payoff of the lottery in monetary terms. The expected utility of a lottery takes into account how much the decision maker values the expected payoff, particularly in terms of the risk associated with the expected payoff. For example, while the expected payoff from one lottery may exceed the expected payoff from a second lottery, if the second lottery has less risk associated with it, a decision maker might prefer the second lottery to the first.

expected utility

The expected value of the utility levels that the decision maker receives from the payoffs in a lottery.

risk premium - Important we can model risk

The necessary difference between the expected value of a lottery and the payoff of a sure thing to make the decision maker indifferent between the lottery and the sure thing.

Consumption under free trade

Trade producers loses but both countries are better off

Autarchy:

in isolation or self sufficient - Countries that live in autarchy don't do trading

probability

is the likelihood that this outcome will occur.

comparative advantage

one country has a comparative advantage over another country in the production of good x if the opportunity cost of producing an additional unit of good x—expressed in terms of forgone units of some other good y—is lower in the first country than in the second country.

risk averse

one who prefers a sure thing to a lottery of equal expected value