Uncertainty, Risk and Expected Utility: every key term you need (+ practice quiz)
25 flashcard terms for Intermediate Microeconomics Topic 4, written to match the course framework. Study them here, then drill them as interactive flashcards, or test yourself with the 15-question quiz — free, no account needed.
A mutually exclusive description of how uncertainty resolves, such as accident or no accident. Consumption is indexed by state, which lets choice under risk reuse the ordinary consumer machinery.
Contingent consumption plan
A specification of how much the decision maker consumes in each state. Insurance and gambling are simply trades that move consumption from one state to another at a market rate.
Lottery
A list of outcomes paired with the probabilities of each. Choice under uncertainty is modelled as a preference ranking over lotteries rather than over sure bundles.
Expected value of a gamble
The probability-weighted average of monetary outcomes. It measures the average payoff but says nothing about how the risk itself is valued, which is why it rarely ranks gambles correctly.
Expected utility
The probability-weighted average of the utility of each outcome. Preferences with this form are additively separable across states, which is what makes the analysis of risk tractable.
Independence axiom
Mixing two lotteries with a common third lottery leaves their ranking unchanged. It is the assumption that delivers the linear-in-probabilities expected utility representation.
Bernoulli utility function
The utility index applied to outcomes inside the expectation. Its curvature encodes attitudes to risk, unlike the outer expectation which is linear in probabilities by construction.
Risk aversion
Preferring the sure expected value of a gamble to the gamble itself, which corresponds to a concave utility of wealth. Concavity means each extra dollar matters less, so losses hurt more than gains help.
Risk neutrality
Indifference between a gamble and its expected value, corresponding to linear utility of wealth. A risk-neutral agent ranks prospects purely by expected monetary payoff.
Risk loving behaviour
Preferring a gamble to its sure expected value, matching a convex utility of wealth. It generates the appetite for long-shot bets even at actuarially unfavourable odds.
Certainty equivalent
The sure amount of money that leaves the agent exactly as well off as facing a gamble. For a risk averse agent it lies strictly below the expected value of that gamble.
Risk premium
The gap between the expected value of a gamble and its certainty equivalent, that is the amount an agent will pay to shed the risk. It rises with both curvature of utility and the size of the risk.
Jensen inequality intuition
For a concave utility the utility of the average exceeds the average of the utilities, which is precisely the statement that a risk averse agent prefers the sure thing.
Absolute risk aversion
A local measure of curvature given by minus the second derivative of utility divided by the first. It predicts how the dollar amount put at risk changes as wealth changes.
Decreasing absolute risk aversion
The plausible property that richer agents place larger absolute sums at risk. It is why wealthier investors hold more of a risky asset in dollar terms than poorer ones.
Relative risk aversion
Absolute risk aversion scaled by wealth, describing attitudes to gambles proportional to wealth. Constant relative risk aversion implies the share of wealth in risky assets is independent of wealth.
Actuarially fair insurance
A policy whose premium equals the expected payout, so the insurer breaks even on average. Facing fair odds, a risk averse agent chooses full insurance and equalises consumption across states.
Full insurance result
With fair premiums the optimum sets consumption equal in every state, because the budget line through the endowment has the same slope as the certainty line tangency requires.
Loading factor on a premium
The markup above the actuarially fair price covering administration and profit. Positive loading makes full insurance too expensive, so the agent optimally retains some risk through a deductible.
Diversification
Spreading wealth across imperfectly correlated risks so that independent shocks partly cancel. It reduces variance without reducing expected return, which is why it is called the only free lunch.
Risk pooling versus risk spreading
Pooling combines many independent risks so the average becomes predictable, while spreading divides one large risk among many bearers so each faces a small stake.
Moral hazard
The change in behaviour once insured, since the insured party no longer bears the full cost of carelessness. It explains deductibles and co-payments as devices to restore some incentive.
Adverse selection
The tendency for the worst risks to buy insurance when the insurer cannot observe type. Pricing at the average drives out good risks, which raises the average again and can unravel the market.
Mean-variance preferences
Ranking prospects by expected return and variance alone. It coincides with expected utility only under quadratic utility or normally distributed returns, but it underpins standard portfolio analysis.
State-contingent budget line
The constraint linking consumption across states, whose slope is set by the price of moving a dollar from the good state to the bad state. Insurance markets make that price explicit.