Chapter 20 – Decisions Involving Uncertainty (Vocabulary Flashcards)

These vocabulary flashcards cover the key definitions, concepts, and behavioral biases presented in Chapter 20, helping you master decisions involving uncertainty.

Risk

A situation involving uncertain outcomes, each with its own probability and payoff.

Risk Aversion

A dislike of uncertainty that leads people to reject fair bets and prefer certain outcomes.

Fair Bet

A gamble that, on average, leaves wealth unchanged because expected gains equal expected losses.

Utility

A measure of well-being or satisfaction derived from wealth or consumption.

Marginal Utility

The additional utility gained from one more dollar of wealth.

Diminishing Marginal Utility

The principle that each extra dollar adds less utility than the previous one, causing risk aversion.

Cost-Benefit Analysis (under Uncertainty)

Comparing expected utility gains and losses rather than just money amounts when making risky choices.

Risk-Reward Trade-off

The idea that people may accept risk if the potential reward is sufficiently large relative to potential loss.

Expected Utility

The probability-weighted average of the utilities from all possible outcomes of a decision.

Risk Neutral

Indifference to uncertainty; decisions are based solely on expected monetary value, not utility.

Risk Spreading

Breaking a large risk into many small independent risks and sharing them among many people.

Diversification

Reducing risk by combining many unrelated smaller risks in a portfolio so that negative outcomes offset positives.

Systematic Risk

Economy-wide risks (e.g., recessions, wars) that cannot be removed through diversification.

Insurance

A contract that compensates for specified losses in exchange for a premium, shifting risk to the insurer.

Premium

The price paid for an insurance policy.

Actuarially Fair Insurance

A policy whose expected payouts equal the premiums collected, reducing risk without changing average wealth.

Hedging

Acquiring an offsetting risk to counterbalance an existing risk (e.g., buying oil stock to offset higher fuel costs).

Gathering Information

Reducing uncertainty by obtaining more data before making a decision (e.g., checking weather, market research).

Behavioral Economics

Economic analysis that incorporates psychological factors to understand real-world decision making errors.

System 1 Thinking

Fast, automatic, intuitive mental processing that relies on heuristics.

System 2 Thinking

Slow, deliberate, logical reasoning that requires cognitive effort.

Overconfidence

The tendency to overrate the accuracy of one’s forecasts, leading to underestimated risks.

Availability Bias

Overestimating the likelihood of events that are easily recalled and underestimating less memorable ones.

Anchoring Bias

Relying too heavily on an initial value (anchor) and failing to adjust sufficiently from it.

Representativeness Bias

Judging probability by similarity to a stereotype while ignoring actual base rates.

Focusing Illusion

Predicting utility inaccurately by concentrating on a few salient factors and neglecting others.

Loss Aversion

Being more sensitive to losses than to equivalent gains.