RMI Exam 1 Study guide Module 1 Risk is uncertainty regarding loss Expected value frequency X severity Uncertainty is doubt about our ability to predict future outcomes Sources of risks o Personal risks o Property risks o Liability risks o Financial risks Terminology o Exposure person or property facing risk of loss o Peril the immediate cause of loss o Hazard condition affecting the frequency or severity of loss Hazards o Physical hazards property conditions o Intangible hazards attitudes or culture Moral hazard behavioral changes Morale hazard indifference Societal hazards legal or cultural Attitude toward risk o Risk neutral indifferent toward risk o Risk averse prefer to avoid risk Companies Individuals o Risk seeker prefer risk Burden of risk on society o Need for larger emergency funds o Loss of needed goods and services o Fear and worry Module 2 Five rules to minimize risk o Recognize that you need a model Decision about risk and return is informed by a mental model Mental models may be an oversimplification Mathematical modeling allows for more precision than human cognition o Acknowledge your models limitations Incorrect model a model whose internal logic or underlying assumptions are themselves wrong Stop using this model Incomplete model characteristic shared by all models basic model doesn t need to be unlearned o Expect the unexpected Financial crisis causes Efficient mortgage refinancing market Low interest rates Rising house prices o Understand use and user Models utility depends not just on the model itself but on who is using it and what they are using it for Important characteristics of a model Workings of model are transparent Consistently applied Results can be reproduced and verified by others Changing infrastructure to accommodate every innovation that comes along is infeasible Changes in infrastructure usually lag changes in products and services and that imbalance can be a major source of risk o Check the infrastructure There is a time period in measuring risk o Number of days lost Risk reduction requires putting a value on human life Module 3 Decision theory is used to determine optimal strategies where a decision maker is faced with several alternatives Steps of the decision making process o Identification of various possible outcomes o Identification of all the courses of action o Determination of the pay off function o Choosing from among various alternatives on the basis of some criterion One stage decision making problems o Pay off tables represents the matrix of the conditional values associated with all the possible combinations o Laplace principle expected mean value of pay off for each strategy with the highest mean value is adopted Assumes all possible outcomes are equally as likely o Maximin principle find the minimum and pick the highest value o Maximax principle find the maximum and pick the highest value Pessimistic decision makers Optimistic decision makers o Maximum likelihood principle find the outcome that is most likely to occur then profit maximize Ignores information therefore it is not optimal o Expectation principle expected value multiply the probability by the outcome Uses the most information Multi stage decision making problems o Evaluate the decision proceeding in a backward manner by evaluating the best course of action at the later stages to decide o Decision tree o Rollback technique the solution to the problem is obtained by working backwards through the tree Module 4 Von Neumann and Morgenstern believed that decisions are made so as to maximize expected utility rather than expected monetary value o Utility index is designed for predicative purposes The utility function o Risk averse Most people o Risk seeker o Risk neutral o Utility functions are a function of wealth o Always increasing at a decreasing rate o Risk averse uses the square root utility function Reservation price the minimum amount it takes for you to get out of your chair Common pitfalls in decision making o Ignoring implicit costs If doing activity x means not being able to do activity y the value of doing opportunity y is an opportunity cost of doing x Skiing example o Failing to ignore sunk costs Insurance and interest are suck costs because you pay them no matter if you drive or don t drive o Measuring costs and benefits as proportions rather than absolute dollar amounts o Failure to understand the average marginal distinction Cost benefit rule tells us to keep increasing the level of an activity as long as its marginal benefit exceeds marginal costs o The individual pursuit of self interest is often not only consistent with broader social objectives but actually even required by them o The invisible hand mechanism breaks down when important costs of benefits accrue to people other than the decision makers themselves The invisible hand Questions o Normative question what should be o Positive question what the consequences will be Module 5 US economy has about 113 million households Households are both the ultimate suppliers of all economic resources and the major spenders of the economy The functional distribution of income indicates how the nations earned The personal distribution of income indicates how the nations money income is divided among individual households Household as spenders o Personal taxes o Personal saving o Persona expenditures Households typically save only 3 of their income Businesses constitute the second major part of the private sector Structures of firms o Mulitplant firms a firm that may be organized horizontally with several plants performing much of the same functions o Vertically integrated firms owning plants that perform different functions in the various states of the production process Forms of business o Sole proprietorship Most common o Partnership o Corporation Advantages of corporations o Most effective for raising money o Limited liability Personal assets are not at stake o Expand easily due to attracting capital o Life independent of owners and officers Can acquire resources own assets produce sell products o Exists when interest of principals and agents are not aligned Principal agent problem Roles of the government o Provide legal structure Sets legal statues of business enterprises Ensures the rights of private ownership Allows making and enforcement of contracts Establish rules of the game controlling relationships between businesses suppliers and consumers Intervention of gov is presumed to improve allocation
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