RMI2302 02 15 2016 Risk probability of a person suffering an adverse effect from some activity or exposure over a given pd of time involvement Risk reduction has costs monetary and non requires putting a value on human life 5 Rules that Minimize Risk 1 Recognize that you need a model o Decision about risk and return when you adopt a new product technology is informed by a mental model may be an oversimplification models applied to real life situations exist semiconsciously Addt l variables and their relationships between one another make the model more complicated and more accurate o Mathematical Modeling allows more precision than human cognition humans can set guidelines to execute on their behalf more factors better risk assessment 2 Acknowledge your models limitations Incorrect vs Incomplete o Incorrect a model whose internal logic or underlying assumptions are manifestly wrong stop using it o Incomplete characteristic shared by all models basic model doesn t need to be unlearned but added to refine rather than reject 3 Expect the unexpected Some factors will be overlooked o True when an innovation interacts with other changes in the environment that are unrelated and not recognized as risk factors Recent financial crisis was caused when these three factors occurred simultaneously efficient mortgage refinancing market low interest rate rising house prices 4 Understand use and user o Models utility depends on who is using it and what for meaningfully evaluated only as a triplet model application and user Model characteristics workings of model are transparent consistently applied results can be reproduced and verified by others 5 Check infrastructure Consequences of innovation o Benefits risks in large are determined by infrastructure into which the innovation is introduced Pace of innovations in some industries is very high so changing infrastructure to accommodate is infeasible changes in infrastructure lag changes in products services that imbalance risk Attitude towards risk Risk neutral indifferent toward risk Risk adverse prefer to avoid risk willing to pay then loss to remove risk Risk seeker prefer risk would pay more then return to engage in risk Common Pitfalls in Decision Making Ignoring implicit costs if doing ativity x means not being able to do activity y the value of doing opportunity y is an opp cost of doing x o Ex should you go skiing or scrape plates Pay for scraping plates is 45 You are unwilling to do this for less than 30 Skiing is worth 60 to you and costs 40 for ski package Benefit B skiing 30 60 90 Cost C skiing 40 45 85 SHOULD YOU SKI OR SCRAPE PLATES Failing to Ignore Sunk Costs sunk costs may seem relevant but in reality they are NOT and should be ignored o Ex should I drive to Boston or take the bus 250 mile trip Bus fare is 100 Hertz says the cost of driving 10 000 a year 5 000 includes insurance interest fuel oil and maintenance Interest and insurance are sunk costs remaining costs oil fuel only 2 000 per 10 000 miles Cost of driving less then bus fare so DRIVE Measuring costs and benefits as proportions rather than absolute dollar amounts o Would you rather drive an extra 15 minutes to Wal Mar if you could save 10 on a o Would you drive an extra 15 minutes to Wal Mart if you could save 10 on a tv for Your answer should be the same for both cases even though you save 50 on the clock and less than 1 on the tv its still either 10 either way Failure to understand the average marginal distinction o Ask should I increase the level by which I am currently engaging in activity x Must compare the benefit and cost of an addt l unit of activity marginal cost marginal benefit Cost benefit rule tells us to keep increasing level of activity as long as its marginal benefit exceeds marginal cost o Ex How many boats should Tom launch Marginal cost is constant at 100 per launch so Tom should keep launching as long as marginal benefit is at least 100 Tom should launch at least 3 boats 20 clock 1 010 Marginal costs and benefits are relevant for choosing the level at which to pursue the activity this is NOT the same as avg costs and benefits Conglomerates firms that have plants which produce products in several industries Costs associated with risk Need for larger emergency funds loss of needed goods and services fear and worry Exposure person organization property facing risk loss Hazard condition affecting severity or frequency of loss Physical tangible conditions wet floor Intangible o Moral behavior changes o Morale indifference drive recklessly bc car has airbag o Societal hazard legal or cultural smoking Households as Income Receivers U S economy has about 113 million households o Households consist of one or more persons occupying a housing unit and both are the ultimate suppliers of all economic resources and the major spenders of economy o Income categorized by how it was earned and divided amount households The functional distribution of income indicates how nations income is earned among wages rents interests and profits according to the function performed by the income receiver Personal distribution of income indicates how the nations money income is divided among individual households o Households as Spenders they dispose of income in the following ways 1 Personal Taxes US households paid 12 of their income taxes in 2005 only 3 in 1941 2 Personal Saving Portion of income that is not paid in taxes or used to purchase consumer goods but instead flows to bank accounts insurance policies bonds and stocks mutual funds other financial assets US households save about 3 of income ppl save for 1 security and 2 speculation 3 Personal Consumption Expenditures more than 85 of total household income flows back into the business sector as money spent on consumer goods Divided between durable goods 12 life expectancy of 3 yrs or more nondurable goods 29 life expect less than 3 years and services 59 work done for consumers by lawyers barbers doctors etc Legal forms of businesses Sole proprietorship 72 of US firms business is owned and operated by one person Partnership 8 of US firms business in which two or more partners agree to own and operate a business together pooling financial resources and sharing risks of profits losses Corporation 20 of US firms Can acquire resources own assets produce sell products incur debts extend credit sue be sued o Advantages most effective for raising money ie stock and bonds limited liability owners stockholders risk only what they
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