Chapter 10 - Risk And Uncertainty Flashcards
What are the risk preferences
Risk seeker-will be interested in the best possible outcome no matter how small the change as they may occur
Risk neutral-Will be concerned with the most likely or average outcome
Risk avoider - Makes decisions on the basis of the worst possible outcome That may occur
How to determine the Maximin
Pick the worst outcomes for each option And of the worst options pick the best. Remember I options we are picking the ones that we can choose rather than the ones that are uncertain for example the contract size we choose the Probability per demands is uncertain
How to calculate the maximax
Maxi maxi is calculated bye picking the best outcome per choice available And then putting the best outcome from those contract sizes or whatever choices
How to calculate the minimax regret
For each choice available (remember not Uncertain demand) we look at the best option and we put a zero as this option as if we were to choose this option then we would have zero regrets. For the other options minus the total away from the original best option to see what are the differences and this difference is the regret.
Then for each choice write down the worst outcome (maximum regrets) and out of these worst outcomes pick the best option. In other words if the worst outcome did happen we want to be minimise of the regrets
How to workout expected value
Like with Maximin Maxi Max and minimax regrets there is a fourth type which is expected value. This works on the probability that will be given in the exam. However this probability is pretty straightforward for example if the demand was 400 and the probability was 0.2 and all the probability together equalled 1 then we know that two weeks out of ten we will get 400 demand.
To work out the expected values look at the choice available in the question For example contract size 300 or 500 then look at the demand and times it by the probability to get the average for the 10 weeks do this all of the demands per each contract at them together and this is the expected value. For example for contract size 300 normal demand for 400 may have a probability of 0.2 and for 500 may have a probability amount of .4 times the totals by this an add them together
What are the limitations of expected values
Compared with the others (mini maxi maxi maxi etc) expected values makes the most sense because you are adding together the total value times by the probability for that week and of the choices available (contract sizes) we choose the one that gives us the best return(best average across all the probabilities) however there are two large limitations of expected values
- Accuracy of the probability estimates
- (Assume probabilities are correct) only valid for repeated occurrences. Doesn’t consider fluctuations in the demand per month (seasonal etc)
How much to pay in order to obtain perfect knowledge
This only relates to expected values (probabilities)
For expected values we choose the option based on normal demand and probabilities for that week but we don’t really know what it will be we are just making a guesstimate based on averages. Just suppose we could find out what the demand would be before we made a decision
How much would we pay the marketing company to give us assurance ?
Firstly the market research company will tell us with confidence if the demand is going to be 400 500 700 or 900 and that is what we’re paying them for as if we know the demand we know what contracts size to accept. So what we do is for each demand we look at what the maximum profit is as if that is the amount they tell us to go for. We also know the probability as it is in the question so like with expected value retains the amounts by the probability and add them up to give an average. Like I said because we are guaranteed One of those amounts because the demand is going to be guaranteed then we know the average now. We take the average and we deduct the figure we obtained from doing the expected values question (which is the amount of profits we would receive without doing market research) and the difference is the maximum we would pay to obtain perfect knowledge
How to do the decision tree
Drawing it has 3 steps:-
- draw outcomes and add narratives
- Add in costs unexpected returns
- Add in probability for outcomes for example if it give us is 2/3 being good then we assume one third is bad
Analysising
When analysing make sure you combine the good and bad together before deducting the cost. For example if there is a 2/3 chance it is good and one third chance it is Poor and the expected returns are 13.8 mil and 6.5 mil respectively then the amount for the outcome is 11.7 mil (13.5×2/3 equals nine and 6.5×1/3 equals 2.17) minus of any costs and this is the outcome.
Similarly if we are told by the market research that there is a 68% chance it is good and 32% chance it is Poor Then first of all the workings to get the totals and then times the totals for the good outcome and the bad outcome by the percentages and minus of any market research costs. The highest amounts is the one you choose as an outcome
How to know which to choose on the table
Yes asking for Maximin then find where the choice lies rather than the uncertainty and and use this. For example if the choice is in the rows Then the roses how we workout each and simile if the choice is in the columns then each cell in the column is compatible with each other.
With Maximin regret it is the opposite we work on the Uncertainty factor. For example if demand was 450 (uncertainty) then which of the supplies should we have chosen. Once we do the regret table off the uncertainty within with the back to the supply section and pick the options. So for example if supply was 450 which is a demands has the biggest regret
