RISK MANAGEMENT TEST 2 1 Individual Decision Making decision making a Utility theory Von Neumann and Morgenstern provide an alternate criterion that can be used for Decisions are made so as to maximize expected utility rather than expected monetary value Utility index is designed for predictive purposes i ii i Allows to predict which of several choices a person would prefer and thus enables him to take decisions b Expected utility EUA U x 1 1 U x 2 i ii Decisions are made so as to maximize expected utility rather than expected monetary value Allows predicting which of several choices a person would prefer and thus enables him to take decisions c Utility Function i d Decision Maker Classifications i Risk averse person who is always willing to accept a small cash certain amount than the expected values of a bet Most people are risk averse ii Risk seeker person who demands an amount of cash certain in excess of the expected monetary pay off utility function would be rising at increasing rate iii Risk neutral one who is neutral between a cash certain amount and a bet whose expected value is equal to that linear utility function e Deriving the Utility function i Utility functions are usually a function of wealth ii Each individual looks at the utility of their wealth in each potential outcome and chooses their action based on expected utility iii Utility is increasing in wealth more is always better than less iv Utility is increasing at a decreasing rate 100 to a student is different than 100 to a millionaire v Assume that people are generally risk averse f Cost Benefit Approach i When benefit is greater than cost do they activity g Common Pitfalls in Decision Making i Ignoring Implicit Costs If doing one activity means not being able to do a different activity the value of doing opportunity the second activity is an opportunity cost of doing the first activity ii Failing to Ignore Sunk Costs Sunk costs may seem relevant but in reality they re not and should be ignored interest and insurance 1 iii Measuring Costs and Benefits as Proportions Rather Than Absolute Dollar Amounts Would you drive an extra 15 minutes to Wal Mart if you could save 10 on a 20 clock Would you drive an extra 15 minutes to Wal Mart if you could save 10 on a tv for 1 010 2 1 1 3 4 1 2 3 You should answer the same way for both cases Even though you save 50 on the clock and less than 1 on the tv it s still 10 either way iv Failure to Understand the Average Marginal Distinction Ask Should I increase the level by which I am currently engaging in activity x Must compare the benefit and cost of an additional unit of activity marginal cost and marginal benefit Cost benefit rule tells us to keep increasing the level of an activity as long as its marginal benefit exceeds marginal cost 1 Measure risk and reward using expected utility 1 Use expected value 2 Efficient frontier optimal combination of risk and return 1 The only entity able to make risk regardless of the reward v 2 Results of decision making a Risk and Reward i Individuals ii Organizations iii Government b Bias i Age bias ii Cultural bias iii Experience bias iv Gender bias v Media bias c Incentives i Financial ii Moral iii Natural iv Coercive if you don t do it I will v Personal vs social vi Political 3 Government Decision Making a 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 b Personal distribution of income Indicates how the nation s money income is divided among individual households c Household spending household dispose of there incomes through i Personal Taxes ii Personal Saving average save about 3 of income 1 People save for security and speculation 1 Durable life expectancy of 3 years or more 2 Nondurable less than 3 years 3 Services work done for consumers by lawyers d Governments role i Providing legal structure iii Personal Consumption Expenditures 85 of income which is divided between 1 2 3 4 1 Sets legal statuses of business enterprises Ensures rights of private ownership Allows making and enforcement of contracts Establish rules of the game controlling relationships between businesses suppliers and consumers ii Maintaining competition In nearly all markets efficient production is best attained with a high degree of competition iii Redistributing income iv Reallocating resources 1 2 3 1 2 3 Transfer payments Provide relief to the destitute the dependent disabled and older citizens Welfare checks food stamps etc Market intervention Government modifies prices that are would be established by the market Paying above market prices to farmers requiring minimum wage etc Taxation Government uses personal income tax to take larger portions from the rich than from the poor to narrow after tax income differences Externality occurs when some of the cost or the benefits of a good are passed on to someone other than the immediate buyer or seller Negative externality Production or consumption costs inflicted on a third party without compensation Correcting negative externalities a Legislation b Specific taxes tax confined to a particular product v Public goods and services 1 Private goods produced through competitive market system a Private goods have characteristics of rivalry and excludability 2 Public goods opposite characteristics as private goods a Nonrivalry and nonexcludability creates free rider i Problem b c Free rider problem people can receive benefits from a public good without contributing to its costs Public goods are financed in the form of taxes 3 Quasi Public Goods Goods provided by government that fit the definition of a public good but can be delivered in such a way that exclusion is possible 4 Reallocation Process Government levies taxes on households to decrease the private demand This frees resources from production of private goods and makes them available for production of public and quasi public goods Taxes remove resources from private use vi Promoting Stability 1 When total spending matches economy s production capacity Prices are stable Stability is achieved by addressing two problems a b Unemployment occurs when private sector spending is too low common actions taken are an increase in government spending or lowering taxes Inflation occurs when spenders try to buy more then the economy s capacity to produce common actions taken are raising taxes or government reducing their total spending
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