Uncertainty and Consumer Behavior

These flashcards cover key concepts related to uncertainty and consumer behavior, focusing on risk, preferences toward risk, and related definitions.

Probability

Likelihood that a given outcome will occur.

Subjective Probability

The perception that an outcome will occur.

Expected Value

Probability-weighted average of the payoffs associated with all possible outcomes.

E(x)= Probability1(Outcome1) + Probability2(Outcome2) + … + ProbabilityN(OutcomeN)

Payoff

Value associated with a possible outcome.

Variability

Extent to which possible outcomes of an uncertain event differ.

Deviation

Difference between expected payoff and actual payoff.

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.

different risky alternatives by considering utility that is obtained by allowing risk in the utility function

A consumer gets utility from income

– Payoff measured in terms of utility

To compare risk vs certainty, we imagine a guaranteed amount equal to that expected value:

Risk Averse

Condition of preferring a certain income to a risky income with the same expected value.

E(U(I)) < (U(E(I))

expected utility of the risky <utility of the expected income

they prefer a guaranteed amount, even if it’s less than the expected monetary value of the gamble.They have a lower risk tolerance and prioritize stability over higher potential returns.

Risk Neutral

Condition of being indifferent between a certain income and an uncertain income with the same expected value.

E(U(I)) = (U(E(I))

expected utility of the risky =utility of the expected income

Risk Loving

Condition of preferring a risky income to a certain income with the same expected value.

E(U(I)) > (U(E(I))

expected utility of the risky >utility of the expected income

Risk Premium

Maximum amount of money that a risk-averse person will pay to avoid taking a risk.

Expected income – Certainty Equivalent

 E(I) – CE

Certainty Equivalent

Amount of 'certain' wealth that yields utility equal to the expected utility. taking the expected utility and solving backwards

Expected utility

Sum of the utilities associated with all possible outcomes, weighted by the probability that each outcome will occur

Preferences Towards Risk

• The extent of an individual’s risk aversion depends on the nature of the risk and on the person’s income.

• Other things being equal, risk-averse people prefer a smaller variability of outcomes.

• The greater the variability of income, the more the person would be willing to pay to avoid the risky situation