Decisions Involving Uncertainty

Flashcards covering essential concepts from Chapter 20 on Decisions Involving Uncertainty, including risk aversion, strategies for reducing risk, and insights from behavioral economics.

Risk Aversion

The tendency to reject uncertain outcomes in favor of outcomes with known results, often due to fear of losses.

Diminishing Marginal Utility

The principle that each additional unit of wealth (or utility) provides a smaller increase in satisfaction than the previous unit.

Expected Utility

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

Cost-Benefit Analysis

A process of comparing the costs and benefits of different options to determine the best choice.

Fair Bet

A gamble where the expected gains and losses cancel each other out on average.

Utility Function

A mathematical representation that assigns a utility value to different levels of wealth or outcomes.

Risk-Reward Trade-off

The balance between the potential rewards of a risky option and the potential losses.

Insurance

A policy that provides compensation in the event of a specified loss or adverse outcome.

Hedging

A strategy to offset potential losses in one asset by investing in another asset that is expected to perform well.

Behavioral Economics

The study of how psychological factors influence economic decision-making.

Availability Bias

The tendency to overestimate the likelihood of events based on how easily examples come to mind.

Anchoring Bias

The tendency to rely too heavily on an initial piece of information when making decisions.

Loss Aversion

The principle that losses have a greater emotional impact on individuals than an equivalent amount of gains.

Diversification

A risk management strategy that mixes a wide variety of investments within a portfolio.

Risk Spreading

A strategy to distribute risk over a large number of smaller risks.

Focusing Illusion

The cognitive bias that leads people to focus on certain factors while ignoring other relevant factors.