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Part IV: Anticipating Surprises: Risk and Uncertainty The expected value of the consultant’s report is determined by comparing the EMV for the consultant with the EMV for the best action determined based on prior probabilities. Based upon prior probabilities used in the previous example, Global Airlines charged the same fares with an expected monetary value of $48.65 million. If Global Airlines hires the consultant and acts on the consultant’s report, the expected monetary value increases to $48.8601. The difference between the expected monetary value given the consultant’s report and the expected monetary value based on prior probabilities is the maximum amount Global Airlines is willing to pay the consultant. This difference is $0.2101 million or $210,100 — $48.8601 minus $48.65.
Taking Chances with Risk Preferences Individuals have different risk preferences. Some people buy lottery tickets all the time, while others never buy them. Some people invest millions in the newest innovation, while others stay with the tried and true. Different risk preferences result from differences in individual satisfaction or dissatisfaction arising from risk. As I note in Chapter 5, utility is a subjective measure of satisfaction that’s unique to an individual. A utility function is an index or scale that measures the relative utility of various outcomes. Economists use utils to measure the amount of an individual’s satisfaction. The concept of utility enables individual risk preferences to be incorporated in decision-making criteria.
Constructing a utility function Because utility is subjective, one individual’s utility function can’t be compared to another individual’s utility function. You must construct a utility function by determining the individual’s utility associated with each possible outcome. To construct a utility function, you need to compare two alternatives. One alternative is called the standard lottery. The standard lottery has two possible outcomes, such as a payoff of $A occurring with probability P and a payoff of $B occurring with probability 1 – P. The second alternative is called the certainty equivalent. This alternative has a certain payoff of $C. You’re indifferent when the expected utility from the certainty equivalent (first alternative) equals the expected utility from the standard lottery (second alternative). Mathematically, an individual is indifferent if