MANAGERIAL DECISION MAKING

C.  Decision Making Under Uncertainty

1.  Concepts

a.  Uncertainty (risk) - more than one possible outcome for a decision

More dispersed outcomes => greater uncertainty

b.  Probability (P) - odds or chance that an outcome will occur

(1)  Long-run frequency

P = X / T

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(2)  Subjective view - assigned by a particular person

• Approach used when situation can't be repeated

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c.  Probability distribution - listing of possible outcomes and the probability that they occur

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d.  Expected value - average monetary outcome if situation repeated indefinitely

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2.  Decision tree

• Represent decisions, chance events, and possible outcomes

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• Expected-value criterion - choose course of action that generates the greatest expected profit

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• Good and bad decisions vs. good and bad outcomes

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• Multiple risks

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3.  Sequential decisions

• Sequence of decisions made over time

Ex. - Single choice

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Ex. - Simultaneous development

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Ex. - Sequential development

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4.  Attitudes toward risk

• Risk neutral - follows expected-value criterion

• Individuals and firms not neutral towards risks that are large relative to financial resources

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• Certainty equivalent (CE) - amount of money for certain needed to make an individual or firm exactly indifferent to the risky prospect

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• Risk averse - CE less than expected value

Ex. - Insurance

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