Ch8: Decision Making in a World of Risk Flashcards
(1) Risks and Uncertainty (2) Attitudes to Risk / Types of Decision Makers (3) Methods of Risk: Probabilities and Expected Values (EV) - (a) Payoff Matrix ; (b) Profit Tables ; (c) Perfect Information ; (d) Decision Trees (4) Decision Rules - (a) Maximin ; (b) Maximax ; (c) Minimax. (5) Methods of Dealing with Uncertainty - (a) Sensitivity Analysis ; (b) Simulation (6) Allowing for Uncertainty - (a) Focus Groups (b) Market Research (7) Standard Deviation (21 cards)
What is Risk?
- Risk involves the possibility of several outcomes which are known in advance along with their related probabilities.
- It is quantifiable.
- Example: Car insurance for young drivers.
What is Uncertainty?
- Uncertainty refers to potential outcomes of a decision that are not known in advance and are unquantifiable.
- Example: Insurance companies not insuring new medical procedures due to lack of statistical data.
What are the types of decision makers based on their attitude to risk?
- Risk Seekers: Interested in the best outcome, no matter how small the chance.
- Risk Neutral: Concerned with the most likely outcome, using Expected Value (EV).
- Risk Averse: Assume the worst possible outcome and aim to minimize potential loss.
What is Expected Value (EV) in risk analysis?
- EV represents the average outcome if a decision is repeated many times.
- FORMULA: EV = ∑px where: p = Probability x = Value of Outcome
- HIGHEST EV = BEST OPTION
What are the advantages and disadvantages of using Expected Value (EV)?
Advantages:
- Reduces information to one number, easily understood.
Disadvantages:
- Difficult to estimate probabilities.
- Average may not correspond to any possible outcome.
- Unsuitable for one-off decisions.
- Ignores risk spread.
What is Perfect Information?
- Information that predicts with 100% accuracy what the outcome of the situation will be.
- VALUE OF PERFECT INFORMATION (VOPI) = EV WITH PERFECT INFORMATION - EV WITHOUT PERFECT INFORMATION (given)
What are Decision Trees? A: Visual tools that help evaluate outcomes in the decision-making process.
SQUARES= represent decision forks,.
CIRCLES = represent probability forks.
What is the Maximin Decision Rule?
- Least unattractive worst outcome.
- Offering the highest return under the worst-case scenario.
- Suitable for risk-averse individuals.
What is the Maximax Decision Rule?
- Selects the alternative with the maximum possible payoff.
- Offering the highest return under the best-case scenario.
- Suitable for risk seekers.
What is the Minimax Regret Decision Rule?
- Aims to minimize the regret from making the wrong decision by choosing the option with the lowest maximum regret.
- Suitable for risk-averse individuals.
What is Sensitivity Analysis?
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- Measures the effect of changes in key factors on the future outcome, assessing the sensitivity of the expected outcome to variations in these factors.
Formula to calculate Sensitivity Analysis
SENSITIVITY % = PROFIT / VARIABLES
where: VARIABLES = Aggregated figures (e.g. REVENUE as a product of selling prices and sales quantity).
- The SMALLER THE PERCENTAGE, the MORE SENSITIVE the decision is to that variable.
What are the advantages of Sensitivity Analysis?
Advantages:
- Easy to understand.
- Highlights key variables.
- Adaptable for spreadsheets.
- Directs management’s attention to important factors.
What are the disadvantages of Sensitivity Analysis?
Disadvantages:
- Assumes changes are independent.
- Does not assess probability of changes.
- Time-consuming without software.
- No clear decision rule.
Purpose of Simulation.
- SENSITIVITY ANALYSIS = can ONLY be used to assess changes in ONE VARIABLE at a time due to uncertainty with some variables.
- Therefore, SIMULATION = is a technique that allows MORE THAN ONE VARIABLE to change at the same time.
What are the advantages of Simulation?
Advantages:
- Overcomes limitations of sensitivity analysis.
- Provides more information about possible outcomes.
- Useful for complex problems.
What are the disadvantages of Simulation?
Disadvantages:
- Not a decision-making technique.
- Time-consuming.
- Expensive.
- Relies on reliable estimates of probability distributions
What are Focus Groups?
Used before the launch of a product to obtain qualitative data about customer attitudes, reducing uncertainty and influencing product design and marketing decisions.
What is Market Research?
Systematic gathering of information about customers, competitors, and the market to reduce uncertainty and improve decision-making.
What is Standard Deviation in risk analysis?
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- Measures the variability of return or the range of possible outcomes by comparing each actual outcome with the mean outcome.
- Formula: STANDARD DEVIATION (σ)= √ [ (〖∑( x − ¯x )〗^2 ] / n
- LARGER STANDARD DEVIATION VALUE IN RELATION TO MEAN = MORE DISPERSED DATA
What is the Coefficient of Variation?
.
- Measures the standard deviation as a percentage of the mean.
- Useful for comparing the dispersion of two distributions.
- FORMULA: COEFFICIENT OF VARIATION= σ / MEAN .
- HIGHGER % = HIGHER DISPERSED
