Managerial Economics

Managerial Economics
Risk vs. Uncertainty

• Risk
• Must make a decision for which the
outcome is not known with certainty
• Can list all possible outcomes & assign
probabilities to the outcomes
• Uncertainty
• Cannot list all possible outcomes
• Cannot assign probabilities to the
outcomes
15-1
Measuring Risk with Probability
Distributions
• Table or graph showing all
possible outcomes/payoffs for a
decision & the probability each
outcome will occur
• To measure risk associated with a
decision
• Examine statistical characteristics of
the probability distribution of
outcomes for the decision
15-2
Probability Distribution for Sales
(Figure 15.1)
15-3
Expected Value
• Expected value (or mean) of a
probability distribution is:
n
E( X )  Expected value of X   pi X i
i 1
Where Xi is the ith outcome of a decision,

pi is the probability of the ith outcome, and
n is the total number of possible outcomes
15-4
Expected Value
• Does not give actual value of the
random outcome
• Indicates “average” value of the
outcomes if the risky decision were to
be repeated a large number of times
15-5
Variance
• Variance is a measure of absolute risk
• Measures dispersion of the outcomes about the mean
or expected outcome
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
15-6
Identical Means but Different
Variances (Figure 15.2)
15-7
Standard Deviation
• Standard deviation is the square
root of the variance
 x  Variance(X)
• The higher the standard deviation,

the greater the risk
15-8
Probability Distributions with
Different Variances (Figure 15.3)
15-9
Coefficient of Variation
• When expected values of outcomes
differ substantially, managers should
measure riskiness of a decision relative
to its expected value using the
coefficient of variation
• A measure of relative risk
Standard deviation 
 
Expected value E( X )
15-10
Decisions Under Risk

• No single decision rule guarantees
profits will actually be maximized
• Decision rules do not eliminate risk
• Provide a method to systematically
include risk in the decision making
process
15-11
Summary of Decision Rules
Under Conditions of Risk
Expected Choose decision with highest expected value
value rule
Mean- Given two risky decisions A & B:
variance •If A has higher expected outcome & lower
rules 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 rule variation
15-12
Probability Distributions for
Weekly Profit (Figure 15.4)
E(X) = 3,500 A E(X) = 3,750 B
= 1,025 = = 1,545 =
0.29 0.41
E(X) = 3,500 C
= 2,062 =
0.59
15-13
Which Rule is Best?

• For a repeated decision, with
identical probabilities each time
• Expected value rule is most reliable to
maximizing (expected) profit
• Average return of a given risky course
of action repeated many times
approaches the expected value of that
action
15-14
Which Rule is Best?

• For a one-time decision under risk
• No repetitions to “average out” a bad
outcome
• No best rule to follow
• Rules should be used to help
analyze & guide decision making
process
• As much art as science
15-15
Expected Utility Theory

• Actual decisions made depend on
the willingness to accept risk
• Expected utility theory allows for
different attitudes toward risk-
taking in decision making
• Managers are assumed to derive
utility from earning profits
15-16
Expected Utility Theory

• Managers make risky decisions in a
way that maximizes expected utility
of the profit outcomes
E [U (  )]  p1U(  1 )  p2U (  2 )  ...  pnU (  n )
• Utility function measures utility

associated with a particular level of
profit
• Index to measure level of utility received
for a given amount of earned profit
15-17
Manager’s Attitude Toward Risk
• Determined by manager’s marginal

utility of profit:
MU profit  U (  ) 
• Marginal utility (slope of utility

curve) determines attitude toward
risk
15-18

• Risk averse
• If faced with two risky decisions with
equal expected profits, the less risky
decision is chosen
• Risk loving
• Expected profits are equal & the more
risky decision is chosen
• Risk neutral
• Indifferent between risky decisions
that have equal expected profit
15-19
• Can relate to marginal utility of

profit
• Diminishing MUprofit
• Risk averse
• Increasing MUprofit
• Risk loving
• Constant MUprofit
• Risk neutral
15-20
(Figure 15.5)
15-21
(Figure 15.5)
15-22
(Figure 15.5)
15-23
Finding a Certainty Equivalent for
a Risky Decision (Figure 15.6)
15-24
Manager’s Utility Function for
Profit (Figure 15.7)
15-25
Expected Utility of Profits

• According to expected utility theory,
decisions are made to maximize
manager’s expected utility of profits
• Such decisions reflect risk-taking
attitude
• Generally differ from those reached by
decision rules that do not consider risk
• For a risk-neutral manager, decisions are
identical under maximization of expected
utility or maximization of expected profit
15-26
Decisions Under Uncertainty

• With uncertainty, decision science
provides little guidance
• Four basic decision rules are provided
to aid managers in analysis of
uncertain situations
15-27
Summary of Decision Rules
Under Conditions of Uncertainty
Maximax rule Identify best outcome for each possible decision
& choose decision with maximum payoff.
Maximin rule Identify worst outcome for each decision &
choose decision with maximum worst payoff.
Minimax Determine worst potential regret associated
regret rule with each decision, where potential regret with
any decision & state of nature is the
improvement in payoff the manager could have
received had the decision been the best one
when the state of nature actually occurred.
Manager chooses decision with minimum worst
potential regret.
Equal Assume each state of nature is equally likely
probability to occur & compute average payoff for each.
rule Choose decision with highest average payoff.
15-28

Managerial Economics

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Managerial Economics

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Managerial Economics

Risk vs. Uncertainty

Where Xi is the ith outcome of a decision,

• The higher the variance, the greater

• The higher the standard deviation,

Decisions Under Risk

Which Rule is Best?

Which Rule is Best?

Expected Utility Theory

Expected Utility Theory

• Utility function measures utility

Manager’s Attitude Toward Risk

• Determined by manager’s marginal

• Marginal utility (slope of utility

Manager’s Attitude Toward Risk

Manager’s Attitude Toward Risk

• Can relate to marginal utility of

Expected Utility of Profits

Decisions Under Uncertainty

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