Lecture 2.6 - Risk and uncertainty

Question 2

Risk

Answer 2

Where the probabilities of the outcomes are known
Things we know we don’t know
Know what the underlying probability distribution looks like
Future predicted on past events

Question 3

Uncertainty

Answer 3

Don’t know what the underlying probability distribution is like
Cannot reliably predict the future based on past events

Question 4

Expected value

Answer 4

Weighted average value of outcomes based on probabilities
Weighted value calculated by weighting each of the possible outcomes by probability
The sum of the weighted value is the expected value

Question 5

Decision tree shapes and meanings

Answer 5

Squares = Decisions
Circles = Environmental changes

Question 6

Maximax

Answer 6

Maximise the maximum achievable payoff
Pick the best of the best

Question 7

Maximin

Answer 7

Maximise the minimum achievable payoff
Pick the best of the worst

Question 8

Criterion of regret

Answer 8

If you select an alternative that is not the best option
Opportunity cost of not having made the best decision for a given outcome

Question 9

Strengths of probabilistic decision analysis

Answer 9

Forces management to recognise the potential for risk and uncertainty and to try to quantify their impact

Improves the decision making process

Question 10

Weaknesses of probabilistic decision analysis

Answer 10

Probabilities are subjective
Predicted outcomes and probabilities are a simplification
Need to consider wider implications of a decision and cost/benefit