Decision Making Under Risk Flashcards
Why is Info Incomplete
Uncertainty and risk
Uncertainty: the future is unknown and probabilities cannot be given for outcomes
Risk: present when managers know the possible outcomes of a particular course of action and can assign probabilities to them
Ambiguous information
Time constraints and information costs
Measuring Uncertainty
Expected value = mean * probability
Examine the statistical characteristics of the distribution of outcomes for the decisions
Mean or expected value
Variance or spread
Decision Making with Additional Info
P(A∣B)= P(B∣A)×P(A)/P(B)
Often, additional information is either readily available or can be obtained to revise the preliminary estimates
Posterior probability
How to revise your estimates?
How to decide whether or not to procure the additional information?
Expected Value of Perfect Information
= expected with perfect - expected without
The maximum value of perfect information to the decision-maker – how much would the decision-maker be willing to spend to obtain that perfect information?
Decision Trees
Graphical representation of decisions and outcomes
Square: where the decision is made
Circle: the point where different outcomes could occur
Triangle: outcomes
Expected Utility Theory
individuals make decisions based on the expected utility value of various available actions and their potential outcomes
The expected utility value refers to the anticipated satisfaction or benefit that an individual expects to derive from a particular decision or action. It combines the utility, or value, that the individual assigns to each possible outcome with the probability of each outcome occurring. By calculating the expected utility for each available option, individuals can make rational decisions by selecting the option with the highest expected utility. This concept helps individuals weigh the potential benefits against the risks or costs associated with different choices, enabling them to make informed decisions that maximize their overall well-being or utility.
Actual decisions made depend on the willingness to accept risk
Expected utility theory allows for different attitudes toward risk-taking in decision-making
Managers are assumed to derive utility from earning profits
Utility function measures utility associated with a particular level of profit
Certainty Equivalent
The equivalent of a gamble is the sum of money which you would accept in place of a gamble
= expected payoff/ (1 + risk premium)
You are risk averse with respect to a gamble if you prefer the expected value of the gamble with certainty to the gamble itself.
You are risk-averse if the expected value is greater than the certainty equivalent.
