Lecture 9 Flashcards
Explain the term of risk
Refers to a state of uncertainty ssociated with the outcomes that may have different effects (sometimes undesirable)
Explain the term of uncertainty
Lack of knowledge or predictability about future events or outcomes
What is contingency?
Refers to a future event that is possible but not certain to occur.
What is probability the occurence?
Refers to the likelihood that a specific event or outcome will happen.
What is the role of risk, uncertainty, contingency and probability of occurence in CBA?
These terms help decision-makers in CBA understand, quantify, and manage risks associated with projects or policies, enabling them to make informed decisions that consider uncertainties and potential challenges.
What is risk neutral?
Indifferent to the level of the uncertainty because individuals are concerned with maximizing expected utility
What is risk avers?
Unwilling to take on risk
What is risk seeking?
Prioritize the potential reward; Willing to accept highest levels of risk
Explain the concept of expected values in CBA
Represent the average outcome that is anticipated based on the probabilities of different scenarios occurring.
An example of expected values in CBA
Suppose a government is considering two alternative transportation projects: Project A and Project B.
Project A:
Favorable Outcome: $10 million in benefits and $5 million in costs
Probability of Favorable Outcome: 0.7
Unfavorable Outcome: $2 million in benefits and $4 million in costs
Probability of Unfavorable Outcome: 0.3
Project B:
Favorable Outcome: $8 million in benefits and $6 million in costs
Probability of Favorable Outcome: 0.5
Unfavorable Outcome: $1 million in benefits and $3 million in costs
Probability of Unfavorable Outcome: 0.5
To calculate the expected value for each project, we multiply the benefits and costs of each outcome by their respective probabilities and sum them together:
Expected Value of Project A:
(0.7×$10 million)+(0.3×$2 million)= $7.6 million
Expected Value of Project B:
(0.5×$8 million)+(0.5×$1 million)=$4.5 million
Based on the expected values, Project A has a higher expected value ($7.6 million) compared to Project B ($4.5 million). Therefore, the government may choose Project A as it is expected to generate greater overall benefits, considering the probabilities of different outcomes.
Why expected values are treated like certain amounts?
Decision-makers can assess the potential outcomes of a project or policy in probabilistic terms and make informed decisions by considering both the likelihood and impact of different scenarios
Explain the role of dependent probabilities of occurence in CBA
Refer to situations where the likelihood of one event is influenced by the occurrence of another event
how can dependent probabilities be analyzed?
Using various techniques, including probabilistic modeling, sensitivity analysis, scenario analysis, and simulation methods
What is value information?
Refers to the benefit gained from acquiring additional knowledge that reduces uncertainty and improves decision-making
Example of value information
Let’s consider a simple example of a farmer deciding whether to plant wheat or corn for the upcoming season. The farmer’s decision depends on the weather forecast, as wheat performs better in dry conditions, while corn thrives in wetter conditions. However, the weather forecast is uncertain.
Without Information: Without any information about the weather forecast, the farmer may have to make a decision based on historical averages or guesswork, leading to a higher risk of choosing the wrong crop and potentially lower profits.
With Information: If the farmer invests in acquiring a reliable weather forecast, they can make a more informed decision based on the likelihood of dry or wet conditions. If the forecast predicts dry weather, the farmer may choose to plant wheat, while if it predicts wet weather, the farmer may opt for corn. By having better information about the weather, the farmer can increase the likelihood of choosing the more profitable crop and reduce the risk of losses.
