RMI2302 Exam 2 RMI2302 Exam 2 Study Guide 1 Topic 3 Decision Making Under Risk and Uncertainty a Utility Theory Utility as a Basis for Decision Making i People do not always make decisions based on monetary value ii Von Neumann and Morgenstern decision are made so as to maximize utility rather than expected monetary value iii Utility Index is designed for predictive purposes 1 EUA aU x1 1 a U x2 b The Utility Functions i Decision Maker Classifications 1 Risk Averse a person who is willing to accept small cash certain amount than the expected value of the bet 2 Risk Seeker a person who demands an amount of cash certain in excess of expected payoff 3 Risk Neutral neutral between cash certain and a bet whose expected value is equal to that ii Deriving the Utility Function 1 Utility functions are usually a function of wealth 2 Each individual looks at the utility of their wealth in each potential outcome and chooses their action based on expected utility 3 Utility is increasing in wealth 4 Utility is increasing at a decreasing rate 100 is different to differing people 5 Assumption that individuals are generally risk averse c The Cost Benefit Approach to Decisions i Should I do an activity 1 If benefits are greater than cost Yes 2 If costs are greater than benefits No d The Role of Economic Theory i Economists don t assume people make calculations explicitly ii Behavior often differs from models iii Common Pitfalls in Decision Making 1 Ignoring Implicit Costs 2 Failing to Ignore Sunk Costs 3 Measuring Costs and Benefits as proportions rather than absolute dollar amounts iv Failure to understand the average marginal distinction 1 Cost Benefit Approach tells us to keep increasing the level of activity as long as its marginal benefit exceeds marginal cost v The Invisible Hand economic growth 1 the tendency of individuals while pursuing self interest to promote 2 Invisible Hand mechanism breaks down when important costs and benefits accumulate to others rather than the decision maker Page 1 of 10 RMI2302 Exam 2 vi Positive vs Normative 1 Positive what the consequences will be objective 2 Normative what should be subjective e Government Decisions i Households as Income Receivers 1 113 million households in the U S 2 Household consists of one or more persons occupying a housing unit and are both the ultimate suppliers of all economic resources and the major spenders ii The Fundamental Distribution of Income 1 U S Income 71 to wages and salaries 14 to corporate profit 9 to proprietors income 5 to interest 1 to rent iii Where Households Spend 1 Personal Taxes 2 Personal Savings a Flows to bank accounts insurance bonds stocks and other assets b About 3 of income c Reasons to save security and speculation 3 Personal Consumption Expenditures a More than 85 of income b Divided among types of goods i Durable life expectancy 3 years 12 ii Nondurable life expectancy less than 3 years 29 iii Service work done for consumers 59 iv The Business Population 1 Plant physical establishment that performs one or more functions in fabricating and distributing goods and services 2 Firm business organization that owns and operates plants 3 Industry groups of firms that produce the same or similar products v Organizational Structures of Firms 1 Multiplant may be organized horizontally with several plants performing much the same function 2 Vertically Integrated firms own plants that performs different functions in the various stages of the production process 3 Conglomerates firms that have plants which produce products in several industries vi Legal Forms of Business 1 Sole Proprietorship 72 Partnerships 8 and Corporations 20 2 Advantages of Corporations a Most effective for raising money limited liability expand easily life independent of owners vii Principle Agent Problem Page 2 of 10 RMI2302 Exam 2 1 Exists when the interests of the principles and agents are not aligned a Principles stockholders b Agents hired by stock holders to run business viii Government s Role in the Public Sector 1 Provide Legal Structure a Set legal statuses of business enterprises b Ensures rights of private ownership c Allows making and enforcement of contracts d Intervention of government is presumed to improve allocation of resources too much or too little a Preventing monopolies controls supply charges higher 2 Maintaining competition than competitive prices 3 Redistribute Income a Transfer Payments provide relief to destitute dependents and disabled welfare food stamps etc b Market Intervention modification of prices that otherwise would be maintained by the market farmers and price mandates c Taxation 4 Reallocation of Income 5 Public Goods and Services a Externalities occur when some of the costs or benefits are passed on to someone other than the immediate buyer or seller i Positive benefits others 1 To correct subsidize consumers subsidize suppliers provide goods via the government ii Negative costs inflicted upon a 3rd party without compensation 1 To correct taxes legislation a Private Goods produced through the competitive market system competitive and excludable b Public Goods available to everybody non rival in consumption and non excludable i Free Rider Problem individuals receive benefits of a public good without contributing to the costs ii Public Goods are financed through taxation iii Quasi Public Goods goods provided though the government that can be defined as public but also are exclusionary Ex libraries iv Reallocation Process 6 Promotion of Stability Page 3 of 10 RMI2302 Exam 2 a Total spending in a government matches the production capacity achieved by addressing unemployment and inflation ix The Circular Flow x Government Finance output 3 Taxes 1 Government Purchases exhaustive products purchased directly to absorb resources and are part of domestic output 2 Transfer Payments non exhaustive don t directly absorb or create a Personal Income Tax progressive tax levied on income b Payroll Taxes taxes based on wages and salaries c Corporate Income Tax levied on a corporation s profit d Excise Taxes levied individually on a small select list of f Government Decision Making Balancing Liberty i Balancing Liberty and the Pursuit of Well Being commodities 1 The free market fails to protect consumer interests requiring government to find appropriate ways to protect us from ourselves ii Maximization Begins with Measurement 1 Jeremy Bentham 19th Century urged politicians to design policies that maximized individual
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