RMI 2302 Exam 1 Nyce

Static Risk

"is the risk changing through time?" These risks do not change through time.

Normative Questions

"what should be". These questions are subjective. A question about what policies or institutional arrangements lead to the best outcomes. It involves our values about what ought to be or should be.

Positive Questions

"what the consequences will be". These questions are objective. A question about the consequences of specific policies or institutional arrangements. It involved what will be. These questions align with economic analysis.

Pure Risk

"will there be a loss or no loss?" There are clear expectations. These risks only involve two possible outcomes.

Speculative Risk

"will there be a loss, no loss, or a gain?"

Advantages of Corporations

-Most effective for raising money. For example - stocks (equity financing) and bonds (debt financing) -Limited liability - Owners/stockholders risk only what they paid for the stock. Personal assets are not at stake. -Expand easily due to attracting capital. -Life independent of owners and officers. -Long range planning and growth

Households dispose of their income in the following ways:

1. Personal Taxes 2. Personal Saving 3. Personal Consumption Expenditures

Business Population

Businesses constitute the second major part of the private sector.

Risk Financing

Either you pay for the adverse outcomes that may occur (risk retention) or you get someone else to pay for it (risk transfer).

Laplace Principle

Find the Average, Pick the Highest

Maximax or Minimin Principle

Find the Maximum, Pick the Highest - we do not know the probabilities in these decision criteria.

Maximin

Find the Minimum, Pick the Highest- deals with profit. Consider the minimum payoffs resulting from the adoption of various strategies. Choose the one with the maximum profit. This maximizes the minimum profit. (Find the minimum profit from each column and choose the highest of those minimums).

Maximum Likelihood Principle

Find the Most Likely Event, Pick the Highest Payoff Within that Event

Risk Likelihood

Frequency - the probability that a loss can occur. This can be described as high, medium, or low.

Functional Distribution of Income

Indicates how the nation's earned income is apportioned among wages, rents, interests, and profits according to the function performed by the income receiver.

Expected Utility

Individuals use this. Using utility functions reflect if someone is risk averse and enables us to understand behavior and make decisions. This explains the benefit and the reservation price. Utility takes into account time and joy, which wealth does not.

Nondurable Goods

Life expectancy less than 3 years. (29% of spending)

Durable Goods

Life expectancy of 3 years or more. (12% of spending)

Personal Consumption Expenditures

More than 85% of total household income flows back into the business sector as money spent on consumer goods.

Expected Value

Organizations use this Outcome x Probability

Risk Impact

Severity - the potential effect that a loss could have if it arises. The magnitude can also be described as high, medium, or low.

Risk Control

The first risk management technique that involves avoiding losses. Aimed at reducing the number of risks facing the organization or the amount of loss that can arise from these exposures. It includes risk prevention (frequency) and risk reduction (severity). Consider cost benefit analysis. This refers to the group of risk management techniques that are designed to reduce either the frequency of potential losses or the severity of potential losses or a combination of the two.

Personal Saving

The portion of income that is not paid in taxes or used to purchase consumer goods but instead flows to bank accounts, insurance policies, bonds and stocks, mutual funds, and other financial assets. U.S. households typically save about 3% of income.

Utility Function

The utility function is usually a function of wealth. Each individual looks at the utility of their wealth in each potential outcome and chooses their action based on expected utility. It should possess the property of completeness. It is complete if it measures the utility for all of the possible alternatives that are available. If complete, it allows for a comparison of different outcomes.

Utility Index

The utility index is used for predictive purposes. It allows us to predict which choice a person prefers and enables them to make a decision. It takes into account how a person values a dollar.

Risk

Uncertainty regarding loss. There are different magnitudes of risk based on the decision maker: individual, organization, and society. Danger does not equal risk. Information does not alter risk.

Certain Equivalent

When you are willing to pay a little bit more to avoid risk. This only occurs in risk aversion.

Uncertainty

When you do not know the outcome, there is uncertainty. Multiple outcomes can also lead to uncertainty. Uncertainty is doubt about our ability to predict future outcomes. Because uncertainty is subjective, it can differ across individuals even when the risk is the same. Information can alter uncertainty. Reduction in uncertainty can be a good thing.

Decision Theory

aka Decision Analysis- this is used to determine optimal strategies where a decision maker is faced with several different alternatives and an uncertain or risky, pattern if future events. "How do you make decisions when faced with risk?"

Expectation Principle

aka Expected Value Principle - multiply the probability by the outcome, sum them to find the expected payoff, then choose the highest

Intangible Hazards

attitudes or culture

Moral Hazard

behavioral changes - effects the frequency / severity of loss

Firm

business organization that owns and operates plants. (May be one plant or many).

Sunk Costs

costs that are beyond recovery at the moment the decision is made. These costs should be ignored.

Minimax

deals with costs. Consider the maximum cost associated with each alternative. Choose the one with the least cost. This minimizes the maximum cost. (find the highest costs from each column and choose the lowest from those maximums) This is choosing the best / minimum cost from the set of worst / maximum costs.

Principle Agent Problem

downside to corporations - Exists when interests of principals and agents are not aligned. Owners want maximum company profit and stock price, but agents want power, high pay, etc. regardless of company performance.

Vertically integrated

firms own plants that performs different functions in the various stages of the production process

Conglomerates

firms that have plants, which produce products in several industries.

Industry

groups of firms that produce the same, or similar, products.

Liability Risks

having to take responsibility for your actions / inactions

Personal distribution of income

indicates how the nation's money income is divided among individual households. There is income inequality / income disparity and it keeps getting bigger (growing gap between wealthy and poor). The middle-income class hasn't gotten a real raise in 15 years. The rich are getting richer and the poor are getting poorer.

Morale Hazard

indifference - effects the frequency / severity of loss

Societal Hazard

legal or cultural attitude - effects the frequency / severity of loss

Multi-plant firms

may be organized horizontally, with several plants performing much the same function.

Public Goods and Services

opposite characteristics as private goods. They are non-rivalry and non-excludability and create the free rider problem. These goods are financed in the form of taxes.

Core Risk

organizational level risk - these are directly associated with what an organization or business does.

Secondary Risk

organizational level risk - these have nothing to do with what an organization or business does.

Risk Neutral

people who are indifferent towards risks. The value of risky situations is the expected loss or expected outcome.

Risk Seeker

people who prefer risk. Willing to pay more than expected return/gain to engage in risky situations. Willing to gamble or take on risk at values below the expected value.

Maximin or Minimax Principle

pessimistic decision makers who are conservative tend to use this decision criteria because it minimizes the worst-case scenario. Associated with risk averse. We don't know the probabilities in these decision criteria.

Plant

physical establishment that performs one or more functions in fabricating and distributing goods and services.

Private Goods and Services

produced through competitive market system. Private goods have the characteristics of rivalry and excludability.

Physical Hazards

property / tangible conditions (aka tangible hazards)

Von Neumann and Morgenstern

proposed an index for measuring utility in situations involving risk for the decision maker. They developed the expected utility principle.

Personal Risks

related to life, health, and safety on the individual level

Property Risks

related to the potential damage to physical property / material things / stuff

Fundamental Risk

risks that effect everyone / a large portion of the population at the same time.

Particular Risk

risks that effect individuals / a small group of people at a given time.

Financial Risks

savings and investments

People save for two reasons

security and speculation.

Average Benefits

the average benefit of undertaking 'n' units of n activity is the total benefit of the activity divided by 'n'. These should be ignored.

Average Costs

the average cost of undertaking 'n' units of an activity is the total cost of the activity divided by 'n'. These should be ignored.

Dynamic Risk

the chances of something happening now and happening later are different. They change through time.

Risk Averse

the general population is this - people who prefer to avoid risk. Willing to pay more than the expected loss to avoid the risk.

Marginal Benefits

the increase in total benefit that results from carrying out one additional unit of an activity. Marginal benefit is downward sloping because the value of an additional unit declines with the total amount that has occurred thus far.

Marginal Costs

the increase in total cost that results from carrying out one additional unit of an activity. These are constant as the cost per unit is the same.

Reservation Price

the minimum amount to get you to undertake an activity. Aka the price at which a person would be indifferent between doing activity X and activity Y

Minimin

the minimum cost for each alternative is considered and then the alternative that minimizes the minimum cost is chosen. This is choosing the lowest cost

Law of Large Numbers

these work well for independent losses that have no correlation to others. Insurance companies have thousands of independent losses. As policies increase, total standard deviation increases. This enables insurance companies to substitute certainty for uncertainty and to be in the skinny tall curve. This law narrows the range of outcomes.

Maximax

this is the optimist's principle of choice. It suggests that for each strategy, the maximum profit should be considered and the strategy with which the highest of those values is associated should be chosen. This is choosing the highest profit

Expectation Principle

this principle does not always provide an adequate and satisfactory basis for decision making because it does not take into account that people do not always take decisions that will maximize their expected monetary value.

Payoff Table

this represents the matrix of the conditional values associated with all of the possible combinations of the acts and the events. In other words, it depicts the economics of a given problem.

Government's Role in Society

to understand how/why/what type of decisions government entities make, you need to understand the government's role in society. It is important to remember that the roles played by governments in other countries may be vastly different.

Black Scholes Formula

valuing stock options. This attempts to establish the extent to which measurable or observable external factors might relate to the price of an option to buy that particular asset.

Loss

what you could have had, but don't, can be considered a loss.

Free Rider Problem

when people can receive benefits from a public good without contributing to its cost.

Services

work done for consumers by lawyers, barbers, doctors, etc. (59% of spending)