Using the expected utility criterion

In this part . . . Business decisions are made in an uncertain environment. Because of uncertainty, you can’t know future outcomes and profit for sure, so you require techniques for decision-making with unknown or uncertain payoffs. This is especially important when budgeting for capital investments. I also consider how members of a business organization may have different goals and examine the actions managers and owners can take to “get everyone on the same page.” Finally, I consider the government policy’s impact on business.

Chapter 15 Risk Analysis: Walking Through the Fog

In This Chapter

▶ Playing with odds ▶ Making decisions with uncertain outcomes ▶ Developing decision-making criteria ▶ Determining the value of information ▶ Incorporating risk preferences ▶ Bidding to win

You may remember Mattel’s Magic 8 Ball. It’s a black globe that answers questions about the future. You hold it, ask a question, turn it over, and in a window the answer to your question appears. The answer I always seem to get is “Reply hazy, try again.” Such is the future — hazy. Or consider Yogi Berra’s contribution to planning, “If you don’t know where you’re going, you might wind up someplace else.”

To this point, I’ve examined decision-making in a certain or known environment. However, frequently the consequences or payoffs resulting from a decision or action are uncertain, depending upon factors outside your control. Therefore, it’s essential to develop criteria that are used to evaluate different actions.

In an uncertain environment, decision-making criteria don’t guarantee you the highest payoff, because the payoff is influenced by factors outside of your control. These criteria, however, allow you to systematically evaluate alternative actions with variable and uncertain payoffs.

This chapter develops decision-making rules for environments where outcomes aren’t known in advance with certainty. The chapter starts with two simple decision-making criteria — the maxi-min and the mini-max regret rules. A more sophisticated criterion — expected monetary value — bases decisions