Principal–Agent Problem #1: When Managers and Owners Disagree

282 Part IV: Anticipating Surprises: Risk and Uncertainty

2. Calculate the expected utility for expanding.

3. Choose the action with the highest expected utility.

You shouldn’t expand. The expected utility of not expanding is 130, which is higher than the expected utility of expanding, which is only 45.

Major advantages of the expected utility criterion include its incorporation of all possible outcomes and the probability of an outcome occurring. In addition, the reliance on utility enables you to incorporate risk preferences in the decision-making process. The primary disadvantage associated with this criterion is its reliance on a subjective measure. Risk preferences and utility functions vary from individual to individual; therefore, it’s impossible to make comparisons between different people. This concern is crucial when more than one person is involved in the decision.

Using Auctions

There’s nothing like an eBay auction. First, you can find almost anything on eBay — from accordions to z-scale model trains. And there’s nothing like bidding. You hover over the computer as the seconds tick off, waiting to get in that last bid. But be careful — get too excited and you may pay more than the item is worth to you.

Auctions are situations where potential buyers compete for the right to own a good, or anything of value. As in any situation, the seller in an auction wants the highest possible price, while the buyer wants the lowest possible price. What makes an auction different is the competition among buyers, which can lead to a higher price for the seller.

Bidding last wins: The English auction

An English auction is the auction you’re probably most familiar with. In an English auction, the auction starts at a low price set by the seller. Potential buyers, or bidders, incrementally raise the price until no one is willing to bid the price higher. At that point, the item is sold to the last individual to bid.

In an English auction, you know what other bidders are willing to pay at any given point. Your decision on whether or not to bid is simply determined by whether or not you’re willing to pay a higher amount.