CHAPTER 3

Risk and Uncertainty in Decision Making

1 Distinguishing between risk and uncertainty

A number of decision making criteria exist which take into account the risk preferences of the decision maker. These are summarised in the following table. Decision makers attitude towards risk Risk-seeking Risk-averse Risk-neutral Decision making criterion used Maximax Maximin Maximising expected values

The distinction between risk and uncertainty

If decisions are made under risk or under uncertainty, in each case there are several possible outcomes from a particular course of action rather than a single fixed outcome. If decisions are made under uncertainty, the various outcomes are known, but their probabilities are unknown; if they are made under risk, both the outcomes and their associated probabilities are unknown.

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ACCA PAPER F5- FOCUS NOTES

Decision making in conditions of uncertainty

Conditional profit tables

In decision making under uncertainty it is assumed that all possible actions and outcomes are known, but that there is no information available concerning the probabilities of the different outcomes (or the probabilities are ignored).

Example
A fruiterer has to decide how many pounds of apples he needs to buy from the market, and has assessed the possible daily demand levels as being either 120, 200, 250 or 350 lb He can buy quantities of 100, 200, 300, or 400 lb at a price of 2 per 10 lb. The selling price is 50p per lb and unsold apples have to be thrown away. Required How many should he buy?

Solution
Conditional profit tables are used to identify and record all the possible outcomes (or payoffs) in problems where the action taken affects the outcomes. It is possible, but unlikely, that the examiner will insist on the presentation of such a table in the exam.

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Chapter 3 Risk and Uncertainty in Decision Making

The following proforma is recommended for the conditional profit table. Conditional profit table Uncertain event Courses of action Decision 1 Decision 2 Etc. In the present example, the number of apples sold (and therefore the contribution made) depends partly on the level of demand, but also on the number that the fruiterer decides to buy. All possible contributions are shown in the following conditional profit table (and some of the contribution calculations are explained). Make sure that you can calculate all the figures in the table. Note the following points. If he buys 200 lb, demands of 250 lb or 350 lb will still only result in sales of 200 lb. Contribution per lb bought and sold is 30p per lb. Event 1 Event 2 Etc.

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ACCA PAPER F5- FOCUS NOTES

Conditional profit table Buy (lb) 120 100 200 300 400 30 (W1) 20 (W2) (20) Daily demand levels (lb) 200 30 60 40 20 250 30 60 (W3) 65 45 350 30 60 90 95

(W1) If the fruiterer purchases 100 lb, they are certain to be sold (since the lowest demand level is 120 lb. Revenue at all possible levels of demand (100 x 50p) Cost (100 x 20p) Contribution 50 20 ___ 30 ___

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Chapter 3 Risk and Uncertainty in Decision Making

(W2) If the fruiterer purchases 200 lb and demand is 120 lb. Revenue Cost (120 x 50p) (200 x 20p) 60 (40) ___ 20 ___

Contribution

(W3) If the fruiterer purchases 200 lb and demand is 250 lb, he will sell 200 lb (remember that he cannot sell more than he has bought). Revenue Cost (200 x 50p) (200 x 20p) 100 (40) ___ 60 ___

Contribution

Having constructed our table we need to extract the maximum possible contribution and the minimum possible contribution arising under each decision taken by the fruiterer. This information is as follows. Minimum Maximum contribution contribution Fruiterer buys 100lb Fruiterer buys 200lb Fruiterer buys 300lb Fruiterer buys 400lb 30 60 90 95 30 20 Nil (20)

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ACCA PAPER F5- FOCUS NOTES

Having identified all possible actions (amounts of apples bought) and all possible outcomes (levels of contribution), we must rank the actions in light of the criterion selected by the manager. We look at the maximin criterion (sometimes called the pessimists criterion) and the maximax criterion (sometimes called the optimists criterion).

The maximin criterion

The action taken is that which maximises the smallest possible payoff for each action. The manager who employs this criterion is assuming that whatever action he takes, the worst will happen (pessimist) a very risk-averting approach. So for the fruiterer: the highest minimum contribution arises from buying 100 lb (a contribution of 30).

The maximax criterion

The action taken is that which has the highest maximum possible payoff. The manager who employs this criterion is assuming that, whatever action he takes, the best will happen (optimist). For the fruiterer, the highest maximum contribution arises from buying 400 lb (a contribution of 95). He will, of course, be running the risk of lower returns up to a loss of 20 if he takes this action.

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Chapter 3 Risk and Uncertainty in Decision Making

Decision making in conditions of risk

Expected values
When making decisions subject to risk, the criterion used is that of maximising expected monetary return. If there are a number of outcomes, with probabilities p1, p2, ,p n each yielding returns of R1, R2, ,Rn then Expected return = Ripi

Example
We will refer to the example used earlier, in which the fruiterer decides how many apples to buy, but we will specify the probability of each possible level of demand. Apples demanded in lb 120 200 250 350 Probability 0.2 0.4 0.3 0.1

The fruiterer can buy 100, 200, 300 or 400 lb at a price of 2 per 10 lb. The selling price is 50p per lb and unsold apples have to be thrown away. How many should he buy, and what will be his expected contribution?

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ACCA PAPER F5- FOCUS NOTES Solution

If we add the probabilities and the expected value to the conditional profit table we have a table as follows. Conditional and expected profit table
Buy (lb) Lb 120 100 200 300 400 30 20 (20) Prob 0.2 Daily demand levels (lb) Lb 200 30 60 40 20 Prob 0.4 Lb 250 30 60 65 45 Prob 0.3 Lb 350 30 60 90 95 Pro b 0.1 30 (W1) 52 (W2) 44.5 (W3) 27 (W4) Expected value

Note that, as before, the expected demand will not necessarily give us expected sales if the amount purchased by the fruiterer is insufficient. Contribution per lb bought and sold is 30p. (W1) If 100 lb are bought by the fruiterer they are certain to be sold, yielding contribution of 30. The expected values is therefore 30. (W2) If 200 lb are bought by the fruiterer there are two possible levels of contribution, depending on demand. Demand 120 lb 200 lb 250 lb 350 lb Probability p 0.2 0.4 0.3 0.1 Contribution () R 20 60 60 60 Rp 36 Rp 4 24 18 6 __ 52 __

Chapter 3 Risk and Uncertainty in Decision Making

(W3) If 300 lb are bought by the fruiterer, expected values are as follows. Demand Probability p 0.2 0.4 0.3 0.1 Contribution () R Nil 40 65 90 Rp Rp Nil 16.0 19.5 9.0 ____ 44.5 ____

120 lb 200 lb 250 lb 350 lb

(W4) If 400 lb are bought by the fruiterer, expected values are as follows. Demand 120 lb 200 lb 250 lb 350 lb Probability p 0.2 0.4 0.3 0.1 Contribution () R (20) 20 45 95 Rp Rp (4.0) 8.0 13.5 9.5 ____ 27.0 ____

Therefore, to maximise expected contribution, the fruiterer should buy 200 lb of apples, making an expected contribution of 52.

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ACCA PAPER F5- FOCUS NOTES Decision trees

The notation used in decision trees is as follows. 0.4 0.5 0.1 Continue production Scrap machine A chance fork showing the possible outcomes at any stage, with their probabilities (the probabilities should always sum to 1) A decision fork where the decision maker chooses the best action (based on expected values)

Example
A company is undertaking a two-year project for which it can either use an existing machine or trade it in for a new one. The existing machine costs 3,500 each year to operate and will have scrap values of 2,000 in one years time and nil in two years time. The new machine costs 2,500 each year to operate and will have scrap values of 4,000 in one years time and nil in two years time. The net cost of the new machine, after trade-in allowance, is 4,500. Revenues for the next two years have been estimated as follows:

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Chapter 3 Risk and Uncertainty in Decision Making

Year 1 Probabilit y 0.7 Old machine 0.3 5,000 0.4 0.4 0.5 8,500 0.6 New machine 0.3 0.3 0.2 (a) (b) Draw the decision tree Calculate the EMV at point D of the answers. 7,000 0.7 Nil 1 8,000 Nil 9,000 9,000 5,000 10,000 Revenue Year 2 Probability 0.5 6,000 0.5 0.6 5,500 5,500 Revenu e 8,000

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ACCA PAPER F5- FOCUS NOTES Solution

(a)
Proceed 0.5

0.4 (+10,000) 0.6 (+9,000)

D
(+8,500) (+7,000) Scrap

(-2,500) (+4,000) Proceed

0.3

0.3 (+9,000) 0.7 (+8,000)

0.2 N (-4,500) ew (-2,500)

E
N &scrap il (+4,000) Scrap

(-2,500) (+4,000)

A
O (-3,500) ld Proceed (-3,500)

0.5 (+8,000) 0.5 (+5,500)

F
0.7 (+6,000)

Scrap

(+2,000) 0.6 (+5,500)

K C
0.3 (+5,000) Proceed (-3,500) 0.4 (+5,000)

Scrap

(+2,000)

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Chapter 3 Risk and Uncertainty in Decision Making

(b) First consider the expected monetary values (EMV) at H (0.4 x 10,000) + (0.6 x 9,000) EMV (scrap) EMV (proceed) = = = = 4,000 EMV H 2,500 9,400 2,500 6,900 = 9,400 EMV H = At D:

Thus the decision at D will be to proceed, giving EMVD = 6,900

Sensitivity analysis
We may wish to know by how much these estimates could change before the decision would have changed. The approach is as follows. Assign the varying estimates a letter instead of its current value. Find the point in your previous decision calculations where this estimate first entered. Replace the current value with the letter. Rework the rest of the calculation algebraically to find what value the letter would have to take for the decision to be reversed.

Limitations of expected values

An expected value is a long-run average, applicable to situations where the same decision is being taken repeatedly, a large number of times. Its application to one-off decisions is limited.

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A decision using expected values is often made on the basis of a value that cannot actually occur. For example, refer back to the first paragraph of this chapter: the only two outcomes that can actually occur are 100 and 50, and yet we calculate an expected value of 80. The degree of variability of the possible returns around the average (expected) value of the risk is not taken into account. To illustrate this, suppose you are faced with a decision between two options, both with varying outcomes (say with equal probabilities). Possible returns Expected return Option A Option B 200 750 800 1,400 800 850 800 800

Using expected values, these two options would be viewed with equal merit but Option B is clearly less risky than Option A.

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