11.1 Decision-making under uncertainty and risk

Decision-making involves navigating uncertainty and risk. Uncertainty lacks outcome probabilities, while risk uses known probabilities. This distinction shapes how we approach choices in various scenarios, from new markets to investment portfolios.

Different criteria help make decisions under uncertainty. Maximax focuses on best outcomes, maximin on worst-case scenarios, and minimax regret minimizes potential regret. Expected value and risk aversion also play crucial roles in shaping our choices and preferences.

Decision-Making Concepts

Uncertainty vs risk in decisions

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• Decision-making under uncertainty involves no knowledge of outcome probabilities and limited information available leads to challenges when entering new markets or developing products (electric cars)

• Decision-making under risk utilizes known or estimable outcome probabilities and more information available enables informed choices for insurance policies or investment portfolios (stocks)

• Key differences stem from probability information availability affects ability to quantify potential outcomes and shapes analysis methods used (Monte Carlo simulation)

Decision criteria for uncertainty

• Maximax criterion focuses on best possible outcome selects alternative with highest potential payoff suits optimistic decision-makers (venture capital investments)

• Maximin criterion emphasizes worst possible outcome chooses alternative with best worst-case scenario appeals to conservative decision-makers (emergency preparedness)

• Minimax regret criterion aims to minimize potential regret calculates difference between best possible and actual outcomes selects alternative with lowest maximum regret (career choices)

• Application steps:

  1. Identify alternatives and possible outcomes
  2. Create payoff matrix
  3. Apply chosen criterion
  4. Select best alternative

Expected value in decision-making

• Expected value (EV) represents weighted average of all possible outcomes calculated using formula $EV = \sum_{i=1}^{n} p_i \times v_i$ where $p_i$ is probability of outcome i $v_i$ is value of outcome i and n is number of possible outcomes

• Steps to calculate EV:

  1. Identify all possible outcomes
  2. Determine probability of each outcome
  3. Assign value to each outcome
  4. Multiply outcome value by probability
  5. Sum all products

• Decision rule suggests choosing alternative with highest expected value but has limitations assumes risk neutrality may not account for extreme outcomes (lottery tickets)

Risk aversion's impact

• Risk aversion reflects preference for certainty over uncertainty leads individuals to accept lower expected value to avoid risk influences decisions in financial planning (conservative vs aggressive portfolios)

• Utility theory measures satisfaction or desirability of outcomes accounts for individual risk preferences helps explain seemingly irrational choices (insurance purchases)

• Risk premium represents amount decision-maker willing to pay to avoid risk calculated as difference between expected value and certainty equivalent affects pricing of financial instruments (bonds)

• Impact on decision-making causes risk-averse individuals to choose safer alternatives may lead to suboptimal decisions based solely on expected value (missed investment opportunities)

• Methods to incorporate risk aversion include utility functions risk-adjusted discount rates and scenario analysis with sensitivity testing enhance decision-making process in uncertain environments (project evaluations)