Econ 351 Chapter 7 Key Terms
Selena has the following utility from income: u(I)=√𝐼. She bought a new Ferrari for $280,900. With probability 25%, a paparazzi will cause $78,400 in damages to the car (in this case, the car value becomes $202,500). With probability 75% nothing happens, and the car keeps its original value. AAA offers to fully insure the car for a price P. What is the maximum insurance premium P that Selena is willing to pay? A) 20,800 B) 20,900 C) 20,700 D) 20,600 E) 20,500
A) 20,800
Smith just bought a house for $250,000. Earthquake insurance, which would pay $250,000 in the event of a major earthquake, is available for $25,000. Smith estimates that the probability of a major earthquake in the coming year is 10 percent, and that in the event of such a quake, the property would be worth nothing. The utility (U) that Smith gets from income (I) is given as follows: U(I) = I^0.5. Should Smith buy the insurance? A) Yes. B) No. C) Smith is indifferent. D) We need more information on Smith's attitude toward risk.
A) Yes.
The concept of paying a risk premium applies to a person that is A) risk averse. B) risk neutral. C) risk loving. D) all of the above.
A) risk averse.
A person with a diminishing marginal utility of income A) will be risk averse. B) will be risk neutral. C) will be risk loving. D) cannot decide without more information.
A) will be risk averse.
Suppose your utility function for income that takes the form U(I) = , and you are considering a self-employment opportunity that may pay $10,000 per year or $40,000 per year with equal probabilities. What certain income would provide the same satisfaction as the expected utility from the self-employed position? A) $15,000 B) $22,500 C) $25,000 D) $27,500
B) $22,500
Amos Long's marginal utility of income function is given as: MU(I) = I^1.5, where I represents income. From this you would say that he is A) risk averse. B) risk loving. C) risk neutral. D) none of the above.
B) risk loving.
An individual with a constant marginal utility of income will be A) risk averse. B) risk neutral. C) risk loving. D) insufficient information for a decision.
B) risk neutral.
Blanca would prefer a certain income of $20,000 to a gamble with a 0.5 probability of $10,000 and a 0.5 probability of $30,000. Based on this information: A) we can infer that Blanca neutral. B) we can infer that Blanca is risk averse. C) we can infer that Blanca is risk loving. D) we cannot infer Blanca's risk preferences.
B) we can infer that Blanca is risk averse.
A consumer with a increasing marginal utility of income will be A) risk averse. B) risk neutral. C) risk loving. D) insufficient information for a decision.
C) risk loving.
Risk Averse
Condition of preferring a certain income to a risky income with the same expected value - has diminishing marginal utility of income - convex graph
An investment opportunity has two possible outcomes. The expected value of the investment opportunity is $250. One outcome yields a $100 payoff and has a probability of 0.25. What is the payoff of the other outcome? A) -$400 B) $0 C) $150 D) $300 E) none of the above
D) $300
Sofia owns some shares of Activision. The company is about to release a new video game. With probability 75% the new game will be a success, in which case the value of her investment will go up to $529. With probability 25% the game will fail in the market, in which case the value of her investment will go down to $225. Her utility from income is given by u(I)= √𝐼. Compute Sofia's expected utility. A) E(u)=25 B) E(u)=23 C) E(u)=20 D) E(u)=21 E) E(u)=22
D) E(u)=21
The difference between the utility of expected income and expected utility from income is A) zero because income generates utility. B) positive because if utility from income is uncertain, it is worth less. C) negative because if income is uncertain, it is worth less. D) that expected utility from income is calculated by summing the utilities of possible incomes, weighted by their probability of occurring, and the utility of expected income is calculated by summing the possible incomes, weighted by their probability of occurring, and finding the utility of that figure. E) that the utility of expected income is calculated by summing the utilities of possible incomes, weighted by their probability of occurring, and the expected utility of income is calculated by summing the possible incomes, weighted by their probability of occurring, and finding the utility of that figure.
D) that expected utility from income is calculated by summing the utilities of possible incomes, weighted by their probability of occurring, and the utility of expected income is calculated by summing the possible incomes, weighted by their probability of occurring, and finding the utility of that figure.
Riskless (or risk-free) Asset
asset that provides a flow of money or services that is known with certainty
Risky Asset
asset that provides an uncertain flow of money or services to its owner
actuarially fair
characterizing a situation in which an insurance premium is equal to the expected payout
Risk Neutral
condition of being indifferent between a certain income and an uncertain income with the same expected value - linear graph
Risk Loving
condition of preferring risky income to a certain income with the same expected value -concave graph
Deviation
difference between expected payoff and actual payoff
Value of Complete Information
difference between the expected value of a choice when there is complete information and the expected value when information is incomplete
Variability
extent to which possible outcomes of an uncertain event differ
Price of Risk
extra risk that an investor must incur to enjoy a higher expected return
Risk Premium
maximum amount of money that a risk-averse person will pay to avoid taking a risk
Mutual Fund
organization that pools funds of individual investors to buy a large number of different stocks of other financial assets
Diversification
practice of reducing risk by allocating resources to a variety of activities whose outcomes are not closely related
Expected Value
probability-weighted average of the payoffs associated with all the possible outcomes
Actual Return
return that an asset earns
Expected Return
return that an asset should earn on average
Real Return
simple (or nominal) return on an asset, less the rate of inflation
Assets
something that provides a flow of money or services to its owner
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
Expected Utility
sum of the utilities associated with all possible outcomes, weighted by the probability that each outcome will occur
Probability
the likelihood that a given outcome will occur
Return
total monetary flow of an asset as a fraction of its price
Payoff
value associated with a possible outcome
Negatively Correlated Variables
variables having a tendency to move in opposite directions
Positively Correlated Variables
variables having a tendency to move in the same direction