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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

Risk

Must make a decision for which the outcome is not known with certainty Can list all possible outcomes & assign probabilities to the outcomes

Uncertainty

Cannot list all possible outcomes Cannot assign probabilities to the outcomes

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Managerial Economics

Table or graph showing all possible outcomes/payoffs for a decision & the probability each outcome will occur To measure risk associated with a decision

Examine statistical characteristics of the probability distribution of outcomes for the decision

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Managerial Economics

(Figure 15.1)

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Managerial Economics

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

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Managerial Economics

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

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Managerial Economics

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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Managerial Economics

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Managerial Economics

Standard Deviation

Standard deviation is the square root of the variance

x Variance(X)

The higher the standard deviation, the greater the risk

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Managerial Economics

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Managerial Economics

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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Managerial Economics

No single decision rule guarantees profits will actually be maximized Decision rules do not eliminate risk

Provide a method to systematically include risk in the decision making process

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Managerial Economics

Expected value rule Choose decision with highest expected value Given two risky decisions A & B: If A has higher expected outcome & lower variance than B, choose decision A If A & B have identical variances (or standard deviations), choose decision with higher expected value If A & B have identical expected values, choose decision with lower variance (standard deviation)

Meanvariance rules

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Managerial Economics

E(X) = 3,500 A = 1,025 = 0.29 E(X) = 3,750 B = 1,545 = 0.41

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Managerial Economics

For a repeated decision, with identical probabilities each time

Expected value rule is most reliable to maximizing (expected) profit Average return of a given risky course of action repeated many times approaches the expected value of that action

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Managerial Economics

For a one-time decision under risk

No repetitions to average out a bad outcome No best rule to follow

Rules should be used to help analyze & guide decision making process

As much art as science

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Managerial Economics

Actual decisions made depend on the willingness to accept risk Expected utility theory allows for different attitudes toward risktaking in decision making

Managers are assumed to derive utility from earning profits

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Managerial Economics

Managers make risky decisions in a way that maximizes expected utility of the profit outcomes

E [U( )] p1U( 1 ) p2U( 2 ) ... pnU( n )

Index to measure level of utility received for a given amount of earned profit

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Managerial Economics

Determined by managers marginal utility of profit:

MU profit U ( )

Marginal utility (slope of utility curve) determines attitude toward risk

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Managerial Economics

Risk averse

If faced with two risky decisions with equal expected profits, the less risky decision is chosen Expected profits are equal & the more risky decision is chosen Indifferent between risky decisions that have equal expected profit

Risk loving

Risk neutral

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Managerial Economics

Can relate to marginal utility of profit Diminishing MUprofit

Risk averse Risk loving

Risk neutral

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Managerial Economics

(Figure 15.5)

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Managerial Economics

(Figure 15.5)

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Managerial Economics

(Figure 15.5)

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Managerial Economics

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Managerial Economics

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Managerial Economics

According to expected utility theory, decisions are made to maximize managers expected utility of profits Such decisions reflect risk-taking attitude

Generally differ from those reached by decision rules that do not consider risk For a risk-neutral manager, decisions are identical under maximization of expected utility or maximization of expected profit

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Managerial Economics

With uncertainty, decision science provides little guidance

Four basic decision rules are provided to aid managers in analysis of uncertain situations

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Managerial Economics

Maximax rule Identify best outcome for each possible decision & choose decision with maximum payoff. Maximin rule Minimax regret rule Identify worst outcome for each decision & choose decision with maximum worst payoff.

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.

15-29

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