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Decision Making Under Risk and Uncertainty

1) The document discusses decision making under risk and uncertainty. Risk refers to situations where outcomes and probabilities are known, while uncertainty refers to situations where outcomes or probabilities are unknown. 2) Under risk, decisions can be evaluated using expected value, mean-variance analysis, and coefficient of variation analysis which consider the central tendency and dispersion of potential outcomes. Expected utility theory also sums the probability-weighted utilities of outcomes. 3) Under uncertainty, decisions can be guided by maximax, maximin, minimax regret, and equal probability criteria by considering the best, worst, or average outcomes of decisions.

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Jade Lyndon
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171 views

Decision Making Under Risk and Uncertainty

1) The document discusses decision making under risk and uncertainty. Risk refers to situations where outcomes and probabilities are known, while uncertainty refers to situations where outcomes or probabilities are unknown. 2) Under risk, decisions can be evaluated using expected value, mean-variance analysis, and coefficient of variation analysis which consider the central tendency and dispersion of potential outcomes. Expected utility theory also sums the probability-weighted utilities of outcomes. 3) Under uncertainty, decisions can be guided by maximax, maximin, minimax regret, and equal probability criteria by considering the best, worst, or average outcomes of decisions.

Uploaded by

Jade Lyndon
Copyright
© © All Rights Reserved
Available Formats
Download as PPTX, PDF, TXT or read online on Scribd
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DECISION MAKING

UNDER RISK AND


UNCERTAINTY
JADE LYNDON MATA
MPMG 2 - A
RISK
A Decision-making condition under which a
manager can list all outcomes and assign
probabilities to each outcome.
RISK – HOW CAN IT BE MEASURED?
1. WITH PROBABILITY DISTRIBUTION
- Table or graph showing all possible outcomes or payoffs of a decision and the probabilities that each
outcome will occur. Their main characteristics are:

CENTRAL TENDENCY

EXPECTED VALUE: The weighted average of


MEAN OF DISTRIBUTION: The expected value
each
outcome serving as the respective weights. of the distribution.
n
E( X )  Expected value of X   pi X i
i 1
RISK – HOW CAN IT BE MEASURED?
1. WITH PROBABILITY DISTRIBUTION
- Table or graph showing all possible outcomes or payoffs of a decision and the probabilities that each
outcome will occur. Their main characteristics are:

DISPERSION

VARIANCE: The dispersion of a distribution STANDARD DEVIATION: The square root of


about mean.. variance.
 X  Variance( X )
n
Variance(X) =  X2   pi ( X i  E( X ))2
i 1
RISK – HOW CAN IT BE MEASURED?
1. WITH PROBABILITY DISTRIBUTION
- Table or graph showing all possible outcomes or payoffs of a decision and the probabilities that each
outcome will occur. Their main characteristics are:

DISPERSION

COEFFICIENT OF VARIATION:The standard deviation divided by


the expected value of the probability distribution.
Standard deviation 
 
Expected value E( X )
DECISION UNDER RISK
MAXIMIZATION OF EXPECTED VALUE

• Expected Value Rule: Choosing the decision with the highest expected value.

• Mean - Variance Analysis: Method decision making that employs both the
mean and the variance to make decisions.

• Coefficient Of Variation Analysis: Decision-making rule that the decision to be


chosen is the one with the smallest coefficient of variation.
EXPECTED UTILITY
 A theory of decision making under risk.

 Sum of the probability-weighted utilities of each possible


profit outcome.

E  U (  )  p1U ( 1 )  p2U ( 2 )  ...  pnU ( n )


MARGINAL UTILITY PROFIT
Amount by which total utility increases with an
additional dollar of profit earned by a firm.
MU profit  U(  ) 
CERTAIN EQUIVALENT: the dollar amount that manager would be
just willing to trade for the opportunity to engage in a risky
decision.
UNCERTAINTY
A decision-making condition under which a
manager cannot list all possible outcomes and/or
cannot assign probabilities to the various
outcomes.
DECISION UNDER UNCERTAINTY
MAXIMAX CRITERION
MAXIMAX RULE: Decision-making guide that calls for identifying the
best outcome for each possible decision and choosing the
decision with the maximum payoff of all the best outcome.

MAXIMIN CRITERION
MAXIMIN RULE: Decision-making guide that calls for identifying the
worst outcome for each decision and choosing the decision
with the maximum worst payoff.
DECISION UNDER UNCERTAINTY
MINIMAX REGRET CRITERION
MINIMAX REGRET RULE: Decision-making guide that calls for determining the
worst potential regret associated with each decision then choosing the decision
with the minimum worst potential regret.

EQUAL PROBABILITY CRITERION


EQUAL PROBABILITY RULE: Decision-making guide that calls for assuming
each state of nature is equally likely to occur, computing the average payoff for
each equally likely possible state of nature and choosing the decision with the
highest average payoff.

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