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Expected Value Is A Fundamental Concept in Probability Theory

Expected value is a fundamental concept in probability theory that helps guide decision-making under uncertainty. It is calculated by multiplying each possible outcome by its probability and summing the results. For example, an investor considering investing in one of two restaurants calculated the expected value of each option. Option A had a 40% chance of earning $50,000 and 60% chance of losing $20,000, yielding an expected value of $8,000. Option B had a 30% chance of earning $60,000 and 70% chance of losing $30,000, yielding an expected value of -$3,000. Based on the higher expected value, the investor chose Option A.

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121 views

Expected Value Is A Fundamental Concept in Probability Theory

Expected value is a fundamental concept in probability theory that helps guide decision-making under uncertainty. It is calculated by multiplying each possible outcome by its probability and summing the results. For example, an investor considering investing in one of two restaurants calculated the expected value of each option. Option A had a 40% chance of earning $50,000 and 60% chance of losing $20,000, yielding an expected value of $8,000. Option B had a 30% chance of earning $60,000 and 70% chance of losing $30,000, yielding an expected value of -$3,000. Based on the higher expected value, the investor chose Option A.

Uploaded by

Tharindra Nishadini
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as DOCX, PDF, TXT or read online on Scribd
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Expected value is a fundamental concept in probability theory.

Could you explain how expected value is


calculated and how it can guide decision-making? Provide an example involving a decision under
uncertanity

Expected value is a fundamental concept in probability theory and it helps to decide the long-term
average/mean value of each option it directs to take the decisions under uncertainty.

Expected Value Calculation:

Multiplying each variable by each probability and adding total values of each option can be calculated
the expected value.

EV(X) = Σ (X * P(x) )
EV(X)= Expected Value
Σ = Sum
X = possible outcomes
P(x) = probability of each outcomes

Example of Calculating Expected Value:

ABC investor is going to invest his money and there are 02 options.

Option A: Investing money in a small restaurant which is going to open in Vancouver Downtown.
There is 40% probability of gain profit of CAD 50,000 and 60% probability of loss of CAD 20,000.

Option B: Investing money in a small restaurant which is going to open in Whistler. There is 30%
probability of gain profit of CAD 60,000 and 70% probability of loss of CAD 30,000.

Let’s calculate the expected values of Option A & B

Option A:

EV(X) = Σ (X * P(x) )
= (50,000 * 0.40) + (-20,000 * 0.60)
= 20,000 – 12,000
= CAD 8,000

Option B:

EV(X) = Σ (X * P(x) )
= (60,000 * 0.30) + (-30,000 * 0.70)
= 18,000 – 21,000
= CAD - 3,000

According to this calculation, ABC investor decided to open a restaurant in Vancouver Downtown
since the highest expected value has shown in option A CAD 8,000 than Option B.
Expected value calculation guides decision making and by calculating expected value it directs to make
comparing easy in between the two or more options. According to the above example high value is
showing in option A than option B and investor can easily go with his investor decision with opening
restaurant in Vancouver Downtown.

Further, by considering expected value people can assess the risk level of each option since final value is
indicating as positive or negative. Therefore, decision makers can use this as potential gain or loss of the
options. A positive value indicates a future beneficial result and A negative expected value indicates a
future loss. According to the above example, option A has positive value and it shows as potential gain
and option B has a negative value it indicates that investing of option B is not healthy decision
potentially.

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