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