Risk Preferences & Uncertainty Flashcards
What is the difference between risk & uncertainty?
Risk can be quantified. It is based on the fact that the decision maker has knowledge of possible outcomes based on past experience so can apply probability.
Uncertainty cannot be quantified. It exists when the future is unknown and there is no past experience upon which to base predictions.
What is a risk seeker?
An optimist.
A decision maker who is interested in the best outcomes no matter how small the chance that they will occur.
What does it mean to be risk neutral?
A decision maker who is concerned only with the most likely outcome - uses expected values.
What does it mean to be risk averse?
A pessimist.
A decision maker who acts on the assumption that the worst outcome may occur.
What is a expected value of an outcome?
The value calculated for a range of possible outcomes whereby probabilities are assigned to all outcomes and calculated as a weighted average.
What is the formula to determine expected values?
EV = SUM(px)
If we are faced with a number of alternative decisions for expected values, how do we choose the correct value?
The outcome with the highest EV should be chosen.
There are four main limitations of using expected values. What are they?
- EV is long term average so not suitable for short term or one off decisions
- Results are dependent on the accuracy of the probability distribution.
- EV takes no account of the risk associated with a decision.
- The EV itself may not represent a single possible outcome.
What is the aim of the maximin decision process and which type of decision maker is it applicable to?
Aims to maximise the minimum return of each decision.
Used by risk averse.
What are the limitations of the maximin?
- Doesn’t consider the probability of each outcome occurring
- Is conservative (doesn’t aim to maximise profit)
What is the aim of the maximax decision making process and which type of decision maker is it applicable to?
Aims for the best possible return.
Used by risk-seekers.
What are the limitations of the maximax?
- Doesn’t consider the probability of each outcome occurring
- Is overly optimistic.
What is the aim of the minimax regret decision rule?
To minimise the maximum opportunity cost from making the wrong decision.
What is perfect information?
If information is guaranteed to predict the future with certainty it is known as perfect information.
What is the benefit of perfect information?
It removes risk thus is valuable.
What is the pro forma for the Value of Perfect Information (VOPI)?
EV with PI - EV without PI = VOPI
When would we use joint probability tables?
When there are two or more uncertain values/variables.
What is the long formula for profit?
Proft = (Number of units x contribution) - Fixed Costs
How do we calculate joint probabilities?
Only multiply the two probabilities together
How do we calculate the expected values from a joint probability table?
Multiply the joint probability outcomes by the value outcomes.
When would we use a decision tree?
When there are several decisions and ranges of outcomes.
In which direction to we evaluate a decision tree?
From right to left.
What are the steps for evaluating a decision tree?
- evaluate from right to left
- calculate expected values at outcome points (circle)
- take highest benefit at decision points
- state clearly the decision to be made.
What are the two main techniques for dealing with uncertainty?
- Sensitivity Analysis
2. Simulation
What is sensitivity analysis?
Sensitivity analysis assesses the change in a variable before it would change the decision
What is simulation analysis?
Simulation uses software that assesses the probability when there are several uncertain variables.
