Question

Discuss the differences among decision-making under certainty, decision-making under risk, and decision-making under uncertainty.

Using the EMV criterion with a decision tree, describe how you would determine the best decision.

Briefly discuss how a utility function can be assessed. What is a standard gamble, and how is it used in determining utility values?

Answer 1

Decision-making under Certainty:

A condition of certainty exists when the decision-maker knows with reasonable certainty what the alternatives are, what conditions are associated with each alternative, and the outcome of each alternative. Under conditions of certainty, accurate, measurable, and reliable information on which to base decisions is available.The cause and effect relationships are known and the future is highly predictable under conditions of certainty. Such conditions exist in case of routine and repetitive decisions concerning the day-to-day operations of the business.

Decision-making under Risk:

When a manager lacks perfect information or whenever an information asymmetry exists, risk arises. Under a state of risk, the decision maker has incomplete information about available alternatives but has a good idea of the probability of outcomes for each alternative.

While making decisions under a state of risk, managers must determine the probability associated with each alternative on the basis of the available information and his experience.

Decision-making under Uncertainty:

Most significant decisions made in today’s complex environment are formulated under a state of uncertainty. Conditions of uncertainty exist when the future environment is unpredictable and everything is in a state of flux. The decision-maker is not aware of all available alternatives, the risks associated with each, and the consequences of each alternative or their probabilities.

Decision Trees:

These are considered to be one of the best ways to analyze a decision. A decision-tree approach involves a graphic representation of alternative courses of action and the possible outcomes and risks associated with each action.

By means of a “tree” diagram depicting the decision points, chance events and probabilities involved in various courses of action, this technique of decision-making allows the decision-maker to trace the optimum path or course of action.

Preference or Utility Theory:

This is another approach to decision-making under conditions of uncertainty. This approach is based on the notion that individual attitudes towards risk vary. Some individuals are willing to take only smaller risks (“risk averters”), while others are willing to take greater risks (“gamblers”). Statistical probabilities associated with the various courses of action are based on the assumption that decision-makers will follow them.

WE CAN ACCESS A UTILITY FUNCTION AS:-

A utility function can be assessed in a number of differentways. A common way is to use a standard gamble. With a standardgamble, the best outcome is assigned a utility of 1, and the worstoutcome is assigned a utility of 0. Then, intermediate outcomes areselected and the decision maker is given a choice between havingthe intermediate outcome for sure and a gamble involving the bestand worst outcomes. The probability that makes the decision makerindifferent between having the intermediate outcome for sure and agamble involving the best and worst outcomes is determined. Thisprobability then becomes the utility of the intermediate value. Thisprocess is continued until utility values for all economic conse-quences are determined. These utility values are then placed on autility curve.

When a utility curve is to be used in the decision-makingprocess, utility values from the utility curve replace all monetaryvalues at the terminal branches in a decision tree or in the body ofa decision table. Then, expected utilities are determined in thesame way as expected monetary values. The alternative with thehighest expected utility is selected as the best decision.

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