Bidding first wins: The Dutch auction

Chapter 15: Risk Analysis: Walking Through the Fog

✓ A subjective probability is determined by an individual based upon the individual’s knowledge, information, and expertise. ✓ An expected probability is a theoretical probability based upon assumptions. For example, the 50-percent probability that a flipped coin comes up “heads” assumes you have a fair, two-sided coin.

The sum of the probabilities for all possible outcomes must equal 1.

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Considering Factors In and Out of Your Control

If only you could control everything, decision-making would be easy. But you can’t, so it’s important to differentiate between the things you can and can’t control. The terms actions and states of nature make a distinction between factors that are within or outside your control.

✓ Actions represent alternatives that you can choose. These are the things you control. In the decision-making process, you evaluate the desirability of alternative actions. Examples of actions include your firm’s pricing and advertising policies. ✓ States of nature also affect your outcome. However, states of nature are things outside your control. Examples of states of nature are the advertising and pricing policies of rival firms, or whether or not the economy goes into a recession.

Payoff refers to the consequence or result of the simultaneous occurrence of a particular action and a specific state of nature. A payoff matrix includes all possible payoffs for several actions and several states of nature. Figure 15-1 illustrates a possible payoff matrix. The top of the matrix lists the three possible actions for Global Airlines: reduce fares, charge the same fares, and raise fares. These actions represent the alternatives that Global’s managers can choose.

The four possible states of nature are on the side of the payoff matrix. These states of nature represent what happens to the price of oil. Because Global’s managers can’t determine what happens to the price of oil, they’re uncertain about which state of nature will occur.

Assume that the payoffs in the payoff matrix represent Global Airline’s annual profit in millions of dollars for various scenarios. For example, if Global decides to reduce fares and oil prices increase by 10 percent, Global’s annual profit is $43 million. Similarly, if Global raises fares and oil prices don’t change, Global’s annual profit is $48 million.