Professional Documents
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ninth edition
Thomas Maurice
Chapter 15
Decisions Under Risk and Uncertainty
McGraw-Hill/Irwin McGraw-Hill/Irwin Managerial Economics, 9e Managerial Economics, 9e
Copyright 2008 by the McGraw-Hill Companies, Inc. All rights reserved.
Managerial Economics
Uncertainty
Cannot list all possible outcomes Cannot assign probabilities to the outcomes
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Expected Value
Expected value (or mean) of a probability distribution is:
E( X ) Expected value of X pi X i
i 1 n
Where Xi is the ith outcome of a decision, pi is the probability of the ith outcome, and n is the total number of possible outcomes
15-5
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Expected Value
Does not give actual value of the random outcome
Indicates average value of the outcomes if the risky decision were to be repeated a large number of times
15-6
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Variance
Variance is a measure of absolute risk
Measures dispersion of the outcomes about the mean or expected outcome
Variance(X) pi ( X i E( X ))
2 x i 1
The higher the variance, the greater the risk associated with a probability distribution
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Standard Deviation
Standard deviation is the square root of the variance
x Variance(X)
The higher the standard deviation, the greater the risk
15-9
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Coefficient of Variation
When expected values of outcomes differ substantially, managers should measure riskiness of a decision relative to its expected value using the coefficient of variation
A measure of relative risk
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Meanvariance rules
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Rules should be used to help analyze & guide decision making process
As much art as science
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MU profit U ( )
Marginal utility (slope of utility curve) determines attitude toward risk
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Risk loving
Risk neutral
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Determine worst potential regret associated with each decision, where potential regret with any decision & state of nature is the improvement in payoff the manager could have received had the decision been the best one when the state of nature actually occurred. Manager chooses decision with minimum worst potential regret. Assume each state of nature is equally likely to occur & compute average payoff for each. Choose decision with highest average payoff.