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Decision Making Under Risk Uncertainty

Decision making

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Govind Mg
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32 views20 pages

Decision Making Under Risk Uncertainty

Decision making

Uploaded by

Govind Mg
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 PPTX, PDF, TXT or read online on Scribd
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Decision making

Under Risk &


Uncertainty.
PAWAN
MADUSHANKA
MADUSH
Probability

The term of “Probability “ refer to the likelihood or change that


certain event will occur, with potential values ranging from 0 (the
event will not occur) to 1 (the event will definitely occur).
What is risk and uncertainty ?

 Risk
We don’t know what is going to happen next, but we do know what
the distribution looks like. There is a relevant past experiences with
statistical evidence enabling a qualified degree of possible outcome.

 Uncertainty
We don’t know what is going to happen next and we don’t know what
the possible distribution looks like. There is little previous statistical
evidence to enable the possible outcomes to be predicted.
Decision Making models

Identified Objective

Identified alternatives

Identified states of nature

Possible outcomes

Measurement of the value of payoffs

Select the best course of action


Subjective Probability

“A probability derived from an individual's personal judgment


about whether a specific outcome is likely to occur. Subjective
probabilities contain no formal calculations and only reflect the
subject's opinions and past experience.”

http://www.investopedia.com/terms/s/subjective_probability.asp
Objective Probability

“The probability that an event will occur based an analysis in which each
measure is based on a recorded observation, rather than a subjective estimate.
Objective probabilities are a more accurate way to determine probabilities than
observations based on subjective measures, such as personal estimates.”

http://www.investopedia.com/terms/o/objective-probability.asp
Expected Value
n
E( X )  Expected value of X  pi X i
i 1

where Xi is the i t h outcome of a decision, pi is the probability of the i t h outcome, and n is the
total number of possible outcomes in the probability distribution

 The expected value of a distribution does not give the actual value of the random outcome,
but rather indicates the “average” value of the outcomes if the risky decision were to be
repeated a large number of times
Variance
The variance (a measure of absolute risk) of a probability distribution
measures the dispersion of the outcomes about the mean or expected
outcome. The variance is calculated as

n
Variance(X) =   pi ( X i  E( X ))
2
X
2

i 1

The higher the variance, the greater the risk associated with a probability distribution.
Standard Deviation

 The standard deviation is the square root of the variance:

 X  Variance( X )

The higher the standard deviation, the greater the risk


Coefficient of Variance

Standard deviation 
 
Expected value E( X )

When the expected values of outcomes differ substantially, managers should


measure the riskiness of a decision relative to its expected value using the
coefficient of variation (a measure of relative risk)
Summary of Decision Rules Under
Conditions of Risk

While no single decision rule guarantees that profits will actually be


maximized, there are number of decision rules that managers can use
to help them make decisions under risk. Decision rules do not eliminate
the risk surrounding a decision, they just provide a method of
systematically including risk in the process of decision making. The
three rules presented in this presentation are (1) the expected value
rule, (2) the mean-variance rules, and (3) the coefficient of variation
rule. These three rules are summarized below:
Expected value rule Choose decision with highest expected value

Mean-variance Given two risky decisions A & B:


rules • 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)

Coefficient of Choose decision with smallest coefficient of variation


variation rule
Expected Utility Theory

 Expected utility theory postulates that managers make risky


decisions in a way that maximizes the expected utility of the
profit outcomes, where the expected utility of a risky decision is
the sum of the probability-weighted utilities of each possible
profit outcome

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


Payoff Table
The application of probability concept to business decision
making, pay off table refer to a matrix that provides pay-offs
for all the possible combinations of decision alternatives and
events

This can be used to solve problems that involve only


one decision variable.
3,000,00 2,500,00 2,000,00 1,500,00 0.2
0 0 0 05,000,00
3,000,00 6,000,00 5,500,00 0.3
0 0 0 0
3,000,00 6,000,00 9,000,00 8,500,00 0.4
0 0 0 0
3,000,00 6,000,00 9,000,00 12,000,00 0.1
0 0 0 0

3,000,00 5,300,00 6,550,00 6,400,00


0 0 0 0
Thank You

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