Ajaz ECO 204 2018-2019 Uncertainty-1 PDF

University of Toronto, Department of Economics (STG). ECO 204, S. Ajaz Hussain. Do not distribute.
Department of Economics (STG), ECO 204, Sayed Ajaz Hussain

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DECISION MAKING UNDER UNCERTAINTY1

Updated: 11/11/2018
1. Introduction
Business – is rife with uncertainty:
In this chapter, we will discuss how to make “decisions under uncertainty”. In reality, agents make “meta-decisions under
uncertainty” in which they choose whether to make the decision under uncertainty with or without prior costly testing:
1 Thanks: Matthew Oh. Feedback welcome: please e-mail eco.204@utoronto.ca.
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ECO 204 CHAPTER: UNCERTAINTY– PART ONE. © Ajaz Hussain, sayed.hussain@utoronto.ca
For example, suppose that a company is debating whether to enter the Chinese market and earn uncertain profits or stay out of
the Chinese market altogether. In reality, such companies face a “meta-decision”: make the decision to {enter Chinese market,
stay out of Chinese market} on the basis of costly prior testing2 or on the basis of no prior testing (note that the company
must decide whether to opt for testing prior to test results):
Enter Chinese market and earn uncertain profits?

+ Test Result: {
Company must decide Costly Prior Tests: { Stay out of the Chinese market?
whether to enter Enter Chinese market and earn uncertain profits?
− Test Results: {
or stay out of the Stay out of the Chinese market?
Chinese market Enter Chinese market and earn uncertain profits?
No Costly Prior Tests: {
on the basis of: { Stay out of the Chinese market?
This meta-decision is depicted below where “oval/circular” nodes represent “uncertain” outcomes (don’t worry about the
probabilities for now):
2
In this case, prior testing means “test marketing”. For simplicity, assume that test results can be + or – with known probabilities.
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2. Decision Making Under Uncertainty Without Option of Prior Testing

Suppose an agent must choose whether to not invest in a project (and make $0 for sure) or invest in a project with a 60%
chance of earning $600m (“success” = S) and a 40% chance of losing $200m (“failure” = F):
In decision trees, the agent chooses what happens next at “Square/rectangular” nodes and “nature/uncertainty” decides what
happens next at “circular/oval” node. Starting from left to right:
The agent Invest in a risky project: { a success with 60% probability yielding $600m
must decide { a failure with 40% probability yielding − $200m
whether to: Don′ t invest and get $0m
As in consumer theory and financial economics, agents decide on the basis of “utility”. We solve decision making under
uncertainty problems like the one above by going “backwards”:
The investor will invest if the “Utility” of investing is ≥ “Utility” of not investing
The investor will not invest if the “Utility” of not investing > “Utility” of investing
To compute the “utility” of each option we need two things: first, the utility of each outcome (in the example above, we would
need the 𝑈($600𝑚), 𝑈($0𝑚), 𝑈(−$200𝑚)) and second, a way to compute the utility of uncertain situations (in the example
above, we would need the “utility” of investing in an uncertain situation where the agent will get 𝑈($600𝑚) with 60%
probability and get 𝑈($0𝑚) with 40% probability).
We assume that the decision maker knows her utility function in terms of money $𝑋 where (we will see how derive utility
functions for decision making under uncertainty in real life):
𝑈($𝑋) = Utility of $𝑋 such that 𝑈($𝑋2 ) > 𝑈($𝑋1 ) whenever $𝑋2 > $𝑋1
As we’ll see below, an agent’s utility function (the utility values she attaches to monetary outcomes) is specific to a particular
decision making under uncertainty problem.
Assuming we know the agent’s utility function, how would we calculate the “utility of an uncertain situation” (such as the
utility of investing in a project which yields 𝑈($600𝑚) with a 60% probability and 𝑈($0𝑚) with a 40% probability)? Answer:
by the “expected utility” of getting 𝑈($600𝑚) with a 60% probability and 𝑈($0𝑚) with a 40% probability.
To see how to compute expected utility, consider an uncertain situation where you can get either $600𝑚 with 60% probability
or −$200𝑚 with 40% probability:
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Suppose you faced this uncertain situation repeatedly (forever, like true love): 60% of the time you’d make $600m and 40% of
the time you’d lose -$200m, so that on average you’d earn:
Expected Value = 𝐸𝑉 = 0.6($600𝑚) + 0.4(−$200𝑚) = $280𝑚
The expected value represents the “value of facing an uncertain situation”. By the same logic, we can compute the “utility of
facing an uncertain situation”. Suppose you faced the uncertain situation above repeatedly: 60% of the time you’d get
𝑈($600m) and 40% of the time you’d get 𝑈(−$200m) so that on average:
𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑈𝑡𝑖𝑙𝑖𝑡𝑦 = 𝐸𝑈 = 0.6 𝑈($600𝑚) + 0.4 𝑈(−$200𝑚)
The expected utility represents the “utility of facing an uncertain situation”.
Suppose the agent’s utility function for the following decision making under uncertainty problem is 𝑈(𝑋) = √200 + 𝑋:
Now, the agent’s “utility” from not investing is:
𝑈(𝑁𝑜𝑡 𝐼𝑛𝑣𝑒𝑠𝑡𝑖𝑛𝑔) = 𝑈($0𝑚) = √200 + 0 = 14.14
What about the agent’s “utility” from investing? Working backwards, were she to invest, the agent would get 𝑈($600𝑚) =
√200 + 600 = 28.28 with 60% probability and 𝑈(−$200𝑚) = √200 − 200 = 0 with 40% probability so that the
expected utility of investing is:
𝐸𝑈 = 0.6𝑈($600𝑚) + 0.4𝑈(−$200𝑚) = 0.6 √200 + 600 + 0.4 √200 − 200 = 16.97
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Since the “Expected Utility” of investing is ≥ “Utility” of not investing, this particular agent should invest:
How sensitive is this particular agent’s decision to invest to changes in a parameter (holding all other parameters constant).
There’s a very good practical reason for asking this question: the parameters in a decision making under uncertainty problem
may be “estimates” (and thus possibly “off” from the “true” value).
For example, in the problem above, the estimated probability of success is 60% -- what if the actual probability of success is
(say) 58%? Would this particular agent still invest in the risky project? As a practical matter, we would like to know the range
of parameters values for which the agent makes the decision as the initial set of parameter values. For example, what is the
range of the probability of success over which this particular agent will invest in the project? Denoting the probability of
success as 𝑝, the decision tree above becomes:
This particular agent will invest so long as:
𝐸𝑈(Invest) ≥ 𝑈(Not Invest)
𝑝𝑈(600) + (1 − 𝑝)𝑈(−200) ≥ 𝑈(0)
𝑝√200 + 600 + (1 − 𝑝)√200 − 200 ≥ √200 + 0
𝑝 ≥ 0.50
Given this answer, it seems that the optimal decision to invest at the current estimate of the probability of success is 0.6 is
quite robust – the agent’s estimate of the probability of success would have to be off by −10% for her to make the opposite
decision. That seems like a comfortable margin; had the ”threshold” probability of success been 0.59 we wouldn’t be secure
about investing at 60% chance of success. Groovy.
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Here’s another example: what is the range of the value of success over which the agent will invest in the project? Letting the
value of success be $𝑋 the decision tree becomes:
This agent will invest so long as:
𝐸𝑈(Invest) ≥ 𝑈(Not Invest)
0.6𝑈(𝑋) + 0.4𝑈(−200) ≥ 𝑈(0)
0.6√200 + 𝑋 + 0.4√200 − 200 ≥ √200 + 0
𝑋 ≥ $355.56𝑚
Given this answer, it seems that the optimal decision to invest at the current estimate of the value of success of $600m is quite
robust – the agent’s estimate of the value of success would have to be off by a lot in order for her decision to be wrong. As an
exercise, you should work out the range of other parameters where the agent makes the optimal decision to invest.
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__________________________________________________________________________________________________
Let’s generalize the concepts of 𝐸𝑉 and 𝐸𝑈: suppose an agent faces the uncertain situation $𝑋1 with probability 𝑝1 , $𝑋2 with
probability 𝑝2 , .. , $𝑋𝑁 with probability 𝑝𝑁 (succinctly denoted by: {$𝑋1 , $𝑋2 , . . , $𝑋𝑁 ; 𝑝1 , 𝑝2 , . . , 𝑝𝑁 }):
Here’s a tip for plotting 𝐸𝑉. Consider the uncertain situation {$600, − $200; 0.6, 0.4}. Its expected value is:
𝐸𝑉 = 0.6($600) + 0.4(−$200) = $280
We can plot the outcomes and the 𝐸𝑉 on the numbers line:
The 𝐸𝑉 = 280 is a weighted average of the outcomes -$200 and $600 and as such it has to be between the two outcomes. But
in what ratio? Does 𝐸𝑉 = 280 divide the distance between -$200 and $600 in a 40:60 or a 60:40 ratio? Well:
 The distance between -$200 and $600 is $800

 The distance between -$200 and $280 is $480
480
Therefore, the distance between -$200 and $280 is 800 = 0.6 of the distance between -$200 and $600 which means that the
𝐸𝑉 divides the line connecting -$200 and $600 in a 60:40 ratio:
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Notice that the probability of -$200 is 40% and the probability of $600 is 60% but that the 𝐸𝑉 divides this line in a 60:40 ratio
– this has to be the case because the 𝐸𝑉 is closer to $600 because it occurs with a higher probability.
3. Decision Making Under Uncertainty: Characterizing “Attitude Towards Risk”

Intuitively, the solution to a decision making under uncertainty problem should depend on the decision maker’s “attitude
towards risk” (intuitively: “risk averse”, “risk neutral”, or “risk loving”). We are about to show that:
a) An agent’s utility function varies from one decision making problem to another (we will see how real life risk managers
derive utility functions in real life);
b) Given a particular decision making under uncertainty problem, the “shape” of an agent’s utility function reflects her
“attitude towards risk” (and vice versa):
“Attitudes Towards Risk” in a Particular Decision Making Under Uncertainty Problem:

“Risk Averse Agents” have a Strictly “Risk Neutral Agents” have a Concave & “Risk Loving Agents” have a Strictly
Concave Utility Function (and vice versa) Convex Utility Function (and vice versa) Convex Utility Function (and vice versa)
To show these results, suppose that agents “A”, “B”, and “C” face the uncertain situation {$600𝑚, −$200𝑚; 0.6, 0.4}:
Example: Three Agents “A”, “B”, “C” Facing the Uncertain Situation {$𝟔𝟎𝟎𝒎, −$𝟐𝟎𝟎𝒎; 𝟎. 𝟔, 𝟎. 𝟒}
Agent “A” has the Concave & Convex Agent “B” has the Strictly Concave Utility Agent “C” has the Strictly Convex Utility
Utility Function 𝑈 = 200 + 𝑋 Function 𝑈 = √200 + 𝑋 Function 𝑈 = (200 + 𝑋)2
The following graphs show the expected utility (𝐸𝑈) and the utility of the expected value (𝑈(𝐸𝑉)) when agents “A”, “B”, and
“C” face the the uncertain situation {$600𝑚, −$200𝑚; 0.6, 0.4}:
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Example A: Agent A’s 𝐸𝑈 vs. 𝑈(𝐸𝑉) of facing the uncertain situation {$600𝑚, −$200𝑚; 0.6, 0.4}. Note that 𝐸𝑈 = 𝑈(𝐸𝑉).
Example B: Agent B’s 𝐸𝑈 vs. 𝑈(𝐸𝑉) of facing the uncertain situation {$600𝑚, −$200𝑚; 0.6, 0.4}. Note that 𝐸𝑈 < 𝑈(𝐸𝑉).
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Example C: Agent C’s 𝐸𝑈 vs. 𝑈(𝐸𝑉) of facing the uncertain situation {$600𝑚, −$200𝑚; 0.6, 0.4}. Note that 𝐸𝑈 > 𝑈(𝐸𝑉).
Combing these examples, we see that:
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Next, we’re going to show that the “shape” of the utility function has to do with the agent’s “attitude towards risk”. Suppose
that an agent faces the uncertain situation {$𝑋1 , $𝑋2 ; 𝑝1 , 𝑝2 }. Now suppose we ask this agent the following question: “Would
you rather face the uncertain situation {$𝑋1 , $𝑋2 ; 𝑝1 , 𝑝2 } or avoid this uncertain situation by receiving the expected value of
this uncertain situation?”:
Arguably:
Since risk averse agents “hate” risk, they’ll prefer the 𝐸𝑉 of an uncertain situation over facing that uncertain situation. That is,
for risk averse agents: 𝑈(𝐸𝑉) > 𝐸𝑈
Since risk loving agents “thrive” on risk, they’ll prefer an uncertain situation over the 𝐸𝑉 of that uncertain situation. That is,
for risk loving agents: 𝑈(𝐸𝑉) < 𝐸𝑈
Since risk neutral agents neither love nor hate risk, they’ll be indifferent between facing an uncertain situation and the 𝐸𝑉 of
that uncertain situation. That is, for risk neutral agents 𝑈(𝐸𝑉) = 𝐸𝑈
Thus, we conclude that:
So far, we have characterized agents facing uncertainty to be either risk averse, or risk neutral, or risk loving. But it’s possible
that an agent is risk averse over some values of $𝑋 and risk loving over other values of $𝑋. For example, here’s the graph of
an agent with the utility function 𝑈 = 15𝑋 3 − 2𝑋 + 10√𝑋:
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4. Decision Making Under Uncertainty for Risk Neutral Agents

Agents make decisions under uncertainty on the basis of “utility”. It turns out that risk neutral agents will arrive at the same
decision whether they decide on the basis of “utility” or on the basis of “value”. To see this, consider the following decision
tree where the agent has to choose either situation 𝑋 = {$𝑋1 , $𝑋2 ; 𝑝1𝑥 , 𝑝2𝑥 } or situation 𝑌 = {$𝑌1 , $𝑌2 ; 𝑝1𝑌 , 𝑝2𝑌 } (the following
proof has nothing to do with the fact that options 𝑋 and 𝑌 each have two outcomes; our result holds even if situation 𝑋, for
example, has 3 outcomes while situation 𝑌, for example, has 2 outcomes):
To make her decision, any type of agent (risk averse, risk neutral, or risk loving) must compare:
𝐸𝑈(Situation 𝑋) 𝑣𝑠. 𝐸𝑈(Situation 𝑌)
𝑦 𝑦
𝑝1𝑥 𝑈(𝑋1 ) + 𝑝2𝑥 𝑈(𝑋2 ) 𝑣𝑠. 𝑝1 𝑈(𝑌1 ) + 𝑝2 𝑈(𝑌2 )
Now suppose the agent is risk neutral, i.e. has a linear utility function (say) 𝑈 = 𝑎 + 𝑏𝑋 (with 𝑏 > 0) . As such, the risk neutral
will make her decision by comparing:
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𝑦 𝑦
𝑦 𝑦
𝑝1𝑥 (𝑎 + 𝑏𝑋1 ) + 𝑝2𝑥 (𝑎 + 𝑏𝑋2 ) 𝑣𝑠. 𝑝1 (𝑎 + 𝑏𝑌1 ) + 𝑝2 (𝑎 + 𝑏𝑌2 )
Re-arranging we have:
𝑦 𝑦 𝑦 𝑦
𝑎(𝑝1𝑥 + 𝑝2𝑥 ) + 𝑏(𝑝1𝑥 𝑋1 + 𝑝2𝑥 𝑋2 ) 𝑣𝑠. 𝑎(𝑝1 + 𝑝2 ) + 𝑏(𝑝1 𝑌1 + 𝑝2 𝑌2 )
𝑦 𝑦
But 𝑝1𝑥 + 𝑝2𝑥 = 1 and 𝑝1 + 𝑝2 = 1 so that the risk neutral agent needs to compare:
𝑦 𝑦
𝑝1𝑥 𝑋1 + 𝑝2𝑥 𝑋2 𝑣𝑠. 𝑝1 𝑌1 + 𝑝2 𝑌2
But notice this is tantamount to comparing:
𝐸𝑉(Situation 𝑋) 𝑣𝑠. 𝐸𝑉(Situation 𝑌)
Thus, we have shown that risk neutral agents can decide either on the basis of “utility” OR on the basis of “Value”. Clearly, it’s easier to
use the “Value” criterion for decision making under uncertainty by risk neutral agents. Don’t forget this when answering tests.
On the other hand, risk averse and risk loving agents must decide solely on the basis of “utility” and not “value”. Here is a
simple “proof”. Once again suppose agent has to choose either situation 𝑋 = {$𝑋1 , $𝑋2 ; 𝑝1𝑥 , 𝑝2𝑥 } or situation 𝑌 =
{$𝑌1 , $𝑌2 ; 𝑝1𝑌 , 𝑝2𝑌 }. To make her decision, any type of agent (risk averse, risk neutral, or risk loving) must compare:
𝐸𝑈(Situation 𝑋) 𝑣𝑠. 𝐸𝑈(Situation 𝑌)
𝑦 𝑦
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Now suppose the agent is risk averse, i.e. has a strictly concave utility function (say) 𝑈 = 𝑎 + 𝑏𝑋 2 (with 𝑏 > 0). As such, the
risk averse agent will make her decision by comparing:
𝑦 𝑦
1 1 1 1
𝑦 𝑦
𝑝1𝑥 (𝑎 + 𝑏𝑋12 ) + 𝑝2𝑥 (𝑎 + 𝑏𝑋22 ) 𝑣𝑠. 𝑝1 (𝑎 + 𝑏𝑌12 ) + 𝑝2 (𝑎 + 𝑏𝑌22 )
1 1 1 1
𝑦 𝑦 𝑦 𝑦
𝑎(𝑝1𝑥 + 𝑝2𝑥 ) + 𝑏 (𝑝1𝑥 𝑋12 + 𝑝2𝑥 𝑋22 ) 𝑣𝑠. 𝑎(𝑝1 + 𝑝2 ) + 𝑏 (𝑝1 𝑌12 + 𝑝2 𝑌12 )
𝑦 𝑦
But 𝑝1𝑥 + 𝑝2𝑥 = 1 and 𝑝1 + 𝑝2 = 1 so that this risk averse agent needs to compare:
1 1 1 1
𝑥 2 𝑥 2 𝑦 𝑦
𝑝 𝑝1 𝑌12 + 𝑝2 𝑌12
⏟1 𝑋1 + 𝑝2 𝑋2 𝑣𝑠. ⏟
≠𝐸𝑉(𝑆𝑖𝑡𝑢𝑎𝑡𝑖𝑜𝑛 𝑋) ≠𝐸𝑉(𝑆𝑖𝑡𝑢𝑎𝑡𝑖𝑜𝑛 𝑌)
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But this NOT the same as comparing the 𝐸𝑉(Situation 𝑋) 𝑣𝑠. 𝐸𝑉(Situation 𝑌).
5. Certainty Equivalence (𝑪𝑬) of an Uncertain Situation

Suppose an agent faces the uncertain situation {$𝑋1 , $𝑋2 ; 𝑝1 , 𝑝2 }. The expected value of this uncertain situation is 𝐸𝑉 = 𝑝1 𝑋1 +
𝑝2 𝑋2 and the expected utility (“utility”) of this uncertain situation is 𝐸𝑈 = 𝑝1 𝑈(𝑋1 ) + 𝑝2 𝑈(𝑋2 ). The “Certainty Equivalence”
(𝐶𝐸) of an uncertain situation is an amount of money such that 𝑈(𝐶𝐸) = 𝐸𝑈 (i.e. the utility of 𝐶𝐸 is equal to 𝐸𝑈 (the
“utility” of facing an uncertain situation).
For example, suppose an agent with 𝑈 = √200 + 𝑋 faces the uncertain situation {$600, −$200; 0.6, 0.4}:
What is the 𝐶𝐸 for an agent with 𝑈 = √200 + 𝑋 facing the uncertain situation {$600, −$200; 0.6, 0.4}?
𝑈(𝐶𝐸) = Utility of facing the uncertain situation {$600, −$200; 0.6, 0.4}
𝑈(𝐶𝐸) = 𝐸𝑈 = 0.6 𝑈($600𝑚) + 0.4 𝑈(−$200𝑚)
√200 + 𝐶𝐸 = 0.6 √200 + 600 + 0.4 √200 − 200
𝐶𝐸 ≈ $88𝑚 (𝑏𝑒𝑙𝑜𝑤, 𝑓𝑜𝑟 𝑐𝑜𝑛𝑣𝑒𝑛𝑖𝑒𝑛𝑐𝑒, 𝑠𝑒𝑡 𝐶𝐸 = $88𝑚)
The following graph shows the 𝐶𝐸 for an agent with 𝑈 = √200 + 𝑋 facing the uncertain situation {$600, −$200; 0.6, 0.4}:
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Notice that 𝐶𝐸 < 𝐸𝑉 for the agent with 𝑈 = √200 + 𝑋 (notice that this agent is risk averse) facing the uncertain situation
{$600, −$200; 0.6, 0.4}. Now, notice that:
Suppose we ask the risk averse agent with 𝑼 = √𝟐𝟎𝟎 + 𝑿 facing the
Response:
uncertain situation {$𝟔𝟎𝟎, −$𝟐𝟎𝟎; 𝟎. 𝟔, 𝟎. 𝟒} on whether:
Since 𝑈(𝐸𝑉) > 𝐸𝑈, this risk agent prefers receiving an
She prefers the uncertain situation {$600, −$200; 0.6, 0.4} or avoid the
amount greater than the 𝐶𝐸 over facing the uncertain
uncertain situation by receiving its 𝐸𝑉 = $280 > 𝐶𝐸 for sure
situation
Since 𝑈(𝐸𝑉 − $1) > 𝐸𝑈, this risk agent prefers
receiving an amount greater than the 𝐶𝐸 over facing the
uncertain situation by receiving its 𝐸𝑉 − $1 = $279 > 𝐶𝐸 for sure
uncertain situation
…. ….
Since 𝑈(𝐸𝑉 − $191) > 𝐸𝑈, this risk agent prefers
receiving an amount greater than the 𝐶𝐸 over facing the
uncertain situation by receiving its 𝐸𝑉 − $191 = $89 > 𝐶𝐸 for sure
uncertain situation
Since 𝑈(𝐸𝑉 − $192) = 𝐸𝑈, this risk agent is
indifferent between receiving the 𝐶𝐸 or facing the
uncertain situation by receiving its 𝐸𝑉 − $192 = $88 = 𝐶𝐸 for sure
uncertain situation
Since 𝑈(𝐸𝑉 − $193) < 𝐸𝑈, this risk agent is prefers
facing the uncertain situation over receiving an amount
uncertain situation by receiving its 𝐸𝑉 − $193 = $87 < 𝐶𝐸 for sure
less than the 𝐶𝐸
Notice that relative the expected value, the risk averse agent is willing to avoid uncertainty by instead receiving any amount of
money ≥ 𝐶𝐸. The difference 𝐸𝑉 − 𝐶𝐸 is known as the “discount due to risk” and represents now much “wealth” a risk
averse agent will give up (vis a vis the 𝐸𝑉) in order to avoid uncertainty.
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The concept of “discount due to risk” enables us to compare two or more risk averse agents and characterize which agent is
relatively more risk averse. For example, suppose two agents (“red” and “blue”) face the uncertain situation {$𝑋1 , $𝑋2 ; 𝑝1 , 𝑝2 }:
Notice the “red” agent’s discount due to risk is greater than the “blue” agent’s discount due to risk: thus, the red agent is more
averse to risk than the blue agent.
Having shown how to compute the 𝐶𝐸 and discount due to risk for risk averse agents, it is easy to show that:
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That is:
 Risk averse agents will happily avoid an uncertain situation by instead settling for an amount greater than or equal to
the 𝐶𝐸 where the 𝐶𝐸 < 𝐸𝑉.
 Risk neutral agents will happily avoid an uncertain situation by instead settling for an amount greater than or equal to
the 𝐶𝐸 where the 𝐶𝐸 = 𝐸𝑉.
 Risk loving agents will happily avoid an uncertain situation by instead settling for an amount greater than or equal to
the 𝐶𝐸 where the 𝐶𝐸 > 𝐸𝑉.
𝑪𝑬: Application #1
Consider the single-contestant TV game show Deal or No Deal.
The player chooses one of 26 numbered briefcases at the start of the game. These cases, carried by identically dressed female
models, each hold a different cash amount from $0.01 to $1,000,000:
On the stage is a video wall that displays the amounts still in play at any given moment. The player's chosen case is brought
onto the stage and placed on a podium before him/her and the host.
In the first round, the player chooses six cases to eliminate from play, one at a time. Each case is opened as it is chosen, and
the amount inside is removed from the board. After the sixth pick, a cordless telephone on the podium rings and the host
answers it to speak with "The Banker" - a male figure, visible only as a dimly lit silhouette, who sits in a skybox overlooking
the studio. The Banker's face is never seen, and his voice is never heard; after the call ends, the host relays the Banker's offer
to buy the player's case. The player can accept the offer and end the game by saying "deal" and pressing a red button on the
podium, or reject it by saying "no deal" and closing a hinged cover over the button.
Each time the player rejects an offer, he/she must play another round, eliminating progressively fewer cases: five in the second
round, four in the third, three in the fourth, two in the fifth. Beyond the fifth round, the player eliminates one case at a time,
receiving a new offer from the Banker after each. The ninth and final offer comes when there are only two cases left in play,
the one originally chosen by the player and one other. If the player rejects this final offer, he/she may either keep the chosen
case or trade it for the other one, and receives the amount in the case he/she decides to take.
The Banker's offer is typically a percentage of the average of the values still in play at the end of each round. This percentage is
small in the early rounds, but increases as the game continues and can even exceed 100% in very late rounds. At times, an
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offer includes a prize tailored to the player's interests, either in addition to cash or instead of it. In addition, prizes are
occasionally substituted for some of the cash amounts on the board. Starting with the Banker's offer in the second round, the
player can bring a "cheering section" (a few friends/family members/colleagues) to the edge of the stage for advice on case
selection and whether to accept offers. However, only the player's decisions are counted as part of the game.
If a player accepts one of the Banker's offers, and if time permits, the host encourages him/her to play through additional
rounds to see what would have happened. If time runs short, the highest remaining value is eliminated, or if there are only two
cases remaining, all of the remaining cases are opened at once3.
Suppose that you are a contestant on the game show Deal or No Deal and face the following uncertain situation (the “bright”
suitcases and the suitcase containing $10 have been opened (“eliminated”) while the dark suitcases (excluding $10) have yet to
be eliminated:
Notice that the expected value of “no deal” or continuing to play the game is4:
1
𝐸𝑉 = [1 + 5 + 50 + 75 + 100 + 200 + 400 + 750 + 1,000 + 5,000 + 10,000 + 25,000 + 75,000 + 300,000
15
+ 1,000,000] = $94,505.40
How much money will the “Banker” have to offer you to “take the deal” (i.e. cease playing the game by taking the bankers
(certain) offer)? In reality, the show can “guess” your utility function by comparing you to “similar” contestants (see “Deal or
No Deal? Decision Making Under Risk in a Large Payoff Game Show”) – suppose that the banker estimates your utility
function to be 𝑈 = √𝑋. The banker will make an offer greater than your 𝐶𝐸 to this game. To do that, the banker must
calculate your expected utility were you to continue playing the game:
3
Source: https://en.wikipedia.org/wiki/Deal_or_No_Deal_(U.S._game_show)
1
4
The probability of opening any of the 15 remaining suitcases is 15
18
1
𝐸𝑈 = [√1 + √5 + √50 + √75 + √100 + √200 + √400 + √750 + √1,000 + √5,000 + √10,000 + √25,000
15
+ √75,000 + √300,000 + √1,000,000 ] = 151.50
Your certainty equivalence of playing the uncertain game is:
𝑈(𝐶𝐸) = 𝐸𝑈
√𝐶𝐸 = 151.5
𝐶𝐸 = 151.52 = $22,952.25
The banker’s offer can be an amount greater than or equal to $22,952.25. In reality, the banker will offer you slightly more
than $22,952.25. If the calculations are correct, you will take the “deal” (and save the show from possibly dishing out an
amount greater than $22,952.25).
𝑪𝑬: Application #2
A standard “asset valuation” method in finance is the “Discounted Cash Flow” (DCF) method. Suppose that we are in period
“0” and that from period 1 through period 𝑇 the asset’s free cash flow in each period is uncertain with 𝐸[𝐹𝐶𝐹𝑡 ] =
Expected Free cash flow in period 𝑡. This asset can be valued by discounting the expected cash flows by a “𝑟 = risk
adjusted discount rate”:
𝐸[𝐹𝐶𝐹1 ] 𝐸[𝐹𝐶𝐹2 ] 𝐸[𝐹𝐶𝐹𝑇 ]

Value of Asset = + 2
+ …+
1+𝑟 (1 + 𝑟) (1 + 𝑟)𝑇
In Corporate Finance, assets with uncertain free cash flows can be alternatively valued using the “Certainty Equivalence”
approach. Suppose that we are in period “0” and that from period 1 through period 𝑇 the certainty equivalence of an asset’s
free cash flow in each period is 𝐶𝐸[𝐹𝐶𝐹𝑡 ] = 𝐶𝐸 of Free cash flow in period 𝑡. This asset can be valued by discounting the
expected cash flows by a “𝑟𝑓 = risk free rate”:
𝐶𝐸[𝐹𝐶𝐹1 ] 𝐶𝐸[𝐹𝐶𝐹2 ] 𝐶𝐸[𝐹𝐶𝐹𝑇 ]

Value of Asset = + 2 + …+ 𝑇
1 + 𝑟𝑓 (1 + 𝑟 ) (1 + 𝑟 )
𝑓 𝑓
Example: Suppose that we are in period “0” and that from period 1-10 the asset’s free cash flow in each period is
{$600𝑚, −$200𝑚; 0.6, 0.4}. Suppose that the utility function of the entity holding the asset is 𝑈 = √200 + 𝑋:
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Then:
𝑫𝑪𝑭 Approach to Valuing an Asset with uncertain free cash flows:
𝑟 = Risk adjusted discount rate
𝐸[𝐹𝐶𝐹𝑡 ] = Expected Free cash flow in period 𝑡.

10 10
𝐸[𝐹𝐶𝐹1 ] 𝐸[𝐹𝐶𝐹2 ] 𝐸[𝐹𝐶𝐹10 ] 𝐸[𝐹𝐶𝐹𝑡 ] $280𝑚
Value of Asset = + 2
+ …+ 10
= ∑ 𝑡
=∑
1+𝑟 (1 + 𝑟) (1 + 𝑟) (1 + 𝑟) (1 + 𝑟)𝑡
𝑡=0 𝑡=0
𝑫𝑪𝑭 Approach to Valuing an Asset with uncertain free cash flows – the “certainty equivalence” approach:
𝑟𝑓 = Risk free rate
𝐶𝐸(𝐹𝐶𝐹𝑡 ) = Certainty Equivalence of Free cash flow in period 𝑡

10 10
𝐶𝐸[𝐹𝐶𝐹1 ] 𝐶𝐸[𝐹𝐶𝐹2 ] 𝐶𝐸[𝐹𝐶𝐹10 ] 𝐶𝐸[𝐹𝐶𝐹𝑡 ] $88𝑚
Value of Asset = + 2 + …+ 10 =∑ 𝑡 =∑ 𝑡
1 + 𝑟𝑓 (1 + 𝑟 ) (1 + 𝑟 ) (1 + 𝑟 ) (1 + 𝑟 )
𝑓 𝑓 𝑡=0 𝑓 𝑡=0 𝑓
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6. How to Derive “Utility Values” for Decision Making Under Uncertainty

Risk averse/loving agents making decisions under uncertainty need to know their utility function for that particular uncertain
situation. How do we this in real life?
Start by noting that to make decisions under uncertainty, the agent need only know the utility of each outcome in the “decision
tree” (i.e. she doesn’t need to have an equation per se). Given any decision making problem under uncertainty, it is very easy for
an agent to impute “utility values” for all outcomes in that decision problem.
For illustrative purposes, suppose an agent faces the following decision making under uncertainty problem -- notice that this
time around we want to derive the utility of each outcome:
Recall from consumer theory that utility is measured on an ordinal scale. As such, we can set the utility scale as:
𝑈(Highest outcome in decision tree) = 100
𝑈(Lowest outcome in decision tree) = 0
Having “found” the utilities of the smallest and highest outcomes in the decision tree we now must calculate the utility values
of all “intermediate” amounts. Taking each intermediate amount one at a time, the agent needs to “impute” the probability
𝑝 such that she is indifferent between the intermediate amount and the hypothetical uncertain situation
{$Highest outcome, $Lowest outcome; 𝑝, 1 − 𝑝}:
21
Once the agent imputes the value of 𝑝 then by definition of certainty equivalence, the utility of the intermediate amount $𝑋 is:
𝑈($𝑋) = 𝑝𝑈(ℎ𝑖𝑔ℎ𝑒𝑠𝑡 𝑜𝑢𝑡𝑐𝑜𝑚𝑒) + (1 − 𝑝)𝑈(𝑙𝑜𝑤𝑒𝑠𝑡 𝑜𝑢𝑡𝑐𝑜𝑚𝑒) = 𝑝100 + (1 − 𝑝)0 = 100𝑝
Example: Suppose an agent face the following decision making problem under uncertainty:
In the example above we will set (it’s a coincidence that the highest and lowest outcomes are “branches” of the same tree; in
fact, the lowest/highest outcomes can be anywhere in the decision problem):
𝑈($600m = Highest outcome in decision tree) = 100
𝑈(−$200m = Lowest outcome in decision tree) = 0
To find the utility value of the (only) intermediate outcome, the agent needs to impute” the probability 𝑝 such that she is
indifferent between the intermediate amount and the hypothetical uncertain situation {$600m, −$200m; 𝑝, 1 − 𝑝}:
22
The “answer” for 𝑝 is agent-specific: after all, in real life, decision makers have varying attitudes towards risk. As such, it is
possible that:
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8. Meta-Decision Making Under Uncertainty with Option for Costly Prior Tests
In reality, agents make “meta-decisions under uncertainty” in which they choose whether to make the decision under
uncertainty with or without prior costly testing:
For example:
 A company must decide whether to enter or stay out of the Chinese market. If the company enters China the business
may be a success or a failure. The company can hire an investment bank to “test” the market conditions in China
where the test results may be positive or negative. Should the company hire the investment bank and if so what will it
do if the test results are positive or negative? Or should it make the decision without test results?
 An oil driller must decide whether to drill or not drill for oil. If the oil driller drills for oil it may or may not strike oil.
The oil driller can hire a geological engineering company to “test” soil samples in the drill area and the test results may
be positive or negative. Should the oil driller hire the testing company and if so what will it do if the test results are
positive or negative? Or should it make the decision without test results?
 An individual suspects he has a tumor (say in his head). He must decide whether or not to have surgery. If there is
surgery, there’s a chance surgeons do not find a tumor. The individual can hire a laboratory or an MRI center to
conduct medical “tests” where the test results may be positive, neutral, or negative. Should this individual hire the
laboratory to conduct tests and if so what will he do if the test results are positive, neutral, or negative? Or should he
make the decision without test results?
For the discussion on meta-decision making, assume that the agent is risk neutral. Then: a risk neutral agent will pick “meta-
decision making under uncertainty on the basis of costly prior test information” if:
𝐸𝑉[Decision with Test] − 𝐸𝑉[Decision without Test] ≥ Cost of the Test

⏟
𝐸𝑉𝐼 = Expected Value of Test Information
Example: Suppose that a company is debating whether to invest in a project with uncertain profits or not invest. The
company’s “meta-decision” is: make the decision to {Invest, Not Invest} on the basis of costly prior testing5 or on the basis of
no prior testing (note that the company must decide whether to opt for testing prior to test results):
5
In this case, prior testing means “test marketing”. For simplicity, assume that test results can be + or – with known probabilities.
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Invest and earn uncertain profits?

+ Test Result: {
Don′ t Invest?
Company must decide Costly Prior Tests: { Invest and earn uncertain profits?
whether to Invest − Test Results: {
Don′ t Invest?
or Not Invest Invest and earn uncertain profits?
{ No Costly Prior Tests: {
Don′ t Invest?
This meta-decision is depicted below:
Here the risk neutral decision maker can make the decision to {Invest, Not Invest} without conducting prior tests or on the
basis of costly prior tests conducted by a testing agency. Suppose the testing agency reports test results as + or −. The risk
neutral decision maker knows that the test results can be + or – and that it can make the decision to {Invest, Not Invest} after
the test results (that is why we use the conditional probabilities 𝑃(𝑆|+), 𝑃(𝐹|+), 𝑃(𝑆|−), 𝑃(𝐹|−). Now, the real decision here
is: should the company make its decision by hiring this testing agency? The hiring decision has to be made prior to knowing the test
results. For this, we need to know the following probabilities:
𝑃(+), 𝑃(−), 𝑃(𝑆|+), 𝑃(𝐹|+); 𝑃(𝑆|−), 𝑃(𝐹|−)
The company should ask the testing agency for their past track record which suppose is:
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Testing Agency’s Track Record of Previous Tests

Entries are # of outcomes Investment Success (S) Investment Failure (F) Total
Positive Test Result + 30 20 50
Negative Test Result - 10 40 50
Total 40 60 100
Here is how you read this table: 50% of past tests were reported to be positive and 50% reported to be negative. In actuality,
40% were successful and 60% were a failure. That is, the test is imperfect (sometimes wrong). For example, the test is positive
50% of the time but the actual number of successes is 30% -- the remaining 20% were actually failures (the same thing
happens in medical tests: one may test positive for a disease but in reality not have it; or one may test negative for a disease but
in reality have the disease). From the table above, note that:
30
𝑃(𝑆 +) = = 0.3
100
20
𝑃(𝐹 +) = = 0.2
100
10
𝑃(𝑆 −) = = 0.1
100
40
𝑃(𝐹 −) = = 0.4
100
50
𝑃(+) = = 0.5
100
𝑃(−) = 0.5
From these we have:
𝑃(𝑆 +) 0.3 3
𝑃(𝑆|+) = = = = 0.6
𝑃(+) 0.5 5
𝑃(𝐹 +) 0.2 2
𝑃(𝐹|+) = = = = 0.4
𝑃(+) 0.5 5
Notice that 𝑃(𝑆|+) + 𝑃(𝐹|+) = 1. Similarly:
𝑃(𝑆 −) 0.1 1
𝑃(𝑆|−) = = = = 0.2
𝑃(−) 0.5 5
𝑃(𝐹 −) 0.4 4
𝑃(𝐹|−) = = = = 0.8
𝑃(−) 0.5 5
Notice that 𝑃(𝑆|−) + 𝑃(𝐹|−) = 1.
Notice that testing will partially resolve uncertainty and facilitates an informed decision. Before testing, the chance of success
was 40% and the chance of failure was 60%. If the test is positive, the chance of success rises to 60% while if the test is
26
negative, the chance of failure rises to 80%. That is, the test is “detecting” (albeit imperfectly) the true state of success and
failure.
The decision tree becomes:
We now solve the decision tree by working backwards and see that the 𝐸𝑉 of making the decision with information is $140m
and the 𝐸𝑉 of the decision without information is $120m. Thus, the expected value of information is:
𝐸𝑉𝐼 = 𝐸𝑉 of Decision with information – 𝐸𝑉 of Decision without information
𝐸𝑉𝐼 = $140𝑚 − $120𝑚
𝐸𝑉𝐼 = $20𝑚
The investor should decide on the basis of test information so long as the test does not cost more than $20m. This highlights
the fact that even if the information resolves some (or even all) uncertainty, one has to consider the cost of information. Also
observe that had the 𝐸𝑉𝐼 < 0 it would mean that the test is of “poor quality”.
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PRACTICE PROBLEMS
Question 1 (2007 - 2008 Final Exam Question)

In professional tennis, there is often a large gap between the first and second prize. A few years ago, some tennis players
accused certain players of “splitting” the total pot6. For example, in a match with a first prize of $100,000 and a second prize
of $32,000 it was alleged that the winner and loser would split the prize so each player would get ($100,000 + $32,000)/2 =
$66,000.
(a) If a risk loving player believes she has a 50-50 chance of winning, will she “split” a first prize of $100,000 and second prize
of $32,000?
(b) Suppose Patrick Crafter has the following utility function 𝑈 = −17.459 + 7.9423 ln 𝑋 where specifically:
$X U($X)
32 10
66 16
100 19
Suppose that the first prize is $100,000 and the second prize is $32,000. Will Patrick be willing to split the prizes if he believes
that he has a 50-50 chance of winning?
(c) For an upcoming match with Jen vs. Arthur, some tennis players wonder if Jen will split the prize with Arthur because she
has been winning recent matches. What must Jen’s probability of winning this match be for her to reject splitting the prize?
Assume the prizes are $100,000 and $32,000 and Jen has the same utility function as Patrick Crafter in part (b).
6
The book Freakonomics discusses a similar scandal in Sumo wrestling.
28
Question 2
Jenn Studios is thinking of producing a film “Ajax and the Order of Commerce”. Analysts predict that the film can be a hit or a
flop. Worse, it’s hard to predict profits since the director of the movie, Ajax Kurosawa, is needy, temperamental, egoistical and
totally lacking in financial discipline.
Based on his previous films, “The Commerce Identity”, “Commercinator 2”, “Beautiful People with Beautiful Indifference Curves”, “The Bald
and the Beautiful” and “The Eco-Watch-Man”, analysts estimate that production will have low and high costs with equal
probability. The probability of high demand is 0.4. Jenn Studios estimates profits to be:
Profits (Low Cost & Strong Demand ) = $80m
Profits (Low Cost & Weak Demand ) = $40m
Profits (High Cost & Strong Demand ) = $0m
Profits (High Cost & Weak Demand ) = -$80m
(a) Draw the decision tree.
(b) Should the studio produce the film?
(c) Due to frivolous demands such as fresh squeezed Durian juice, access to VIP room at Circa, Brr! Yani at all hours of day—
Jenn studio fears that Ajax’s costs may spiral out of control. The studio now insists on a contractual clause giving it the right to
terminate the project after the first $30m has been spent because by this time the studio will know for certain whether the
costs are high or low. How much is this contractual clause worth?
29
Question 3
In this problem you will make a decision under uncertainty where the choices are not mutually exclusive. I hope it makes you
think harder about how to setup a problem.
You are the CEO of a pharmaceuticals company “Economics-Man Genetics” which has replicated Economics-Man’s genes7.
The company must decide whether to commercialize Economics-Man genes (aimed at students studying for Economics tests
and the final exam (just like you!)) using a Biochemical or Biogenetic R&D approach.
Suppose the profits and probabilities of the competing approaches are:
R&D Approach Investment Outcome Gross Profit Probabilities
Large Success $90m 0.7

Biochemical $10m
Small Success $50m 0.3
Success $200m 0.2

Biogenetic $20m
Failure $0m 0.8
Observe how the Biogenetic approach is more “risky”: it has a high upside but also a low downside. In contrast, the
Biochemical approach is less risky but also less lucrative.
Find the best approach to commercialize the Economics-Man’s genes. In the event that both approaches are successful,
assume that you can only take one product to market. Hint: the R&D programs are not mutually exclusive.
7
No relation to Eco-man.
30
Question 4 (2007-2008 Test Question)

“Hey-Jazz Mining Company” has the option to purchase land. The seller’s best and final price is $3 million. If the land has
commercial mineral deposits, “Hey-Jazz Mining Company” estimates its value at $5 million. If there are no deposits, the
estimated value is $2 million. “Hey-Jazz Mining Company” believes that the chance of mineral deposits is 50-50. Assume the
company is risk neutral and the value of not buying the land is $0.
(a) Should “Hey-Jazz Mining Company” purchase the land?
(b) The seller has agreed to let “Hey-Jazz Mining Company” take samples from the land. Based on past experience, if there
are minerals present, the samples will be “positive” 80% of the time. If no minerals are present, the samples will (falsely) give a
favorable reading 40% of the time. Fill the table below and determine whether “Hey-Jazz Mining Company” should purchase
the land and how much it should pay for the test.
Minerals No Minerals Total

Positive (+)
Negative (-)
Total 50 50 100
Question 5 (2007-2008 Final Exam Question)

You’re a dealer for a brand of luxury cars “Lamb-boo-Genie”8 Sales of Lamb-boo-Genie cars are pro-cyclical: in a growing (G)
economy, sales increase and in a recessionary (R) economy, sales decrease. You have to place an order tomorrow afternoon for
either 50 or 100 cars. Your profits depend on the state of the economy:
Lamb-boo-Genie Dealership Profits

Order Size Growth (G) Recession (R)
50 Cars $225m $100m
100 Cars $350m -$150m
(a) Suppose the probability of growth is 𝑃(𝐺) = 0.6. How many cars should you order? Assume you’re a risk neutral
decision maker.
To help decide how many cars to order, you pay money to acquire some information about the stock market which better
informs you whether the economy will grow or contract. The following table gives the probability of stocks rising and falling
and the economy growing and contracting:
Table of Probabilities
Stock Market Growth (G) Recession (R) Total
Stocks Rise (+) 0.4875 0 0.4875
Stocks Fall (-) 0.1125 0.4 0.5125
Total 0.6 0.4 1.000
(b) What is the value of your decision if you use the stock market as a “test” for whether the economy will grow or go into a
recession? How much is the stock market information above worth to you? Again, assume you are risk neutral. Show all
calculations clearly.
8
No relation to Lamborghini.
31
Question 6 (Summer 2009 Final Exam)

Proctor and Grumble (P&G), a risk neutral decision maker, must decide whether to develop and release a new shampoo “Shine
on you” targeted at bald men. If P&G does not develop the shampoo the outcome is $0m. If P&G develops the shampoo R&D
costs will be $100m and when released into the market, it will be a success (S) with probability 0.6 or a failure (F) with
probability 0.4.
If the shampoo is a success, gross revenues (before R&D costs) are estimated to be $500m. On the other hand, if the
shampoo is a failure, gross revenues (before R&D costs) are estimate to be $0m.
(a) Draw P&G’s decision tree and indicate whether the shampoo should be developed.
(b) P&G’s statistics consultant thinks the probability of success may not be accurate (i.e. there is some margin of error). What
is the lowest probability of success where P&G will choose to develop and release the shampoo product?
(c) [This part can be answered without answering parts (a) - (b)]. Suppose a marketing company has developed a perfect (100%
accurate) test for new products. The test results can be positive (+) or negative (-). Fill in the entries in the two way
classification table below:
S F Total
+ Test Result
− Test Result
Total 100
(d) Should P&G make the decision to develop the shampoo on the basis of the perfect test or without the perfect test? What
is the value of a “perfect test”? Show your calculations.
Question 7
You’ve received a letter from the Canadian Revenue Agency (CRA) stating that you made a mistake in your 2010 tax returns
and that you owe the CRA $5,000 in back taxes. You must choose one of the following two (mutually exclusive) decisions:
❶ Either pay the CRA $5,000 in back taxes
❷ Or request the CRA for an audit of your 2010 tax returns. The audit process will cost you $500 in expenses and
may result in one of two uncertain outcomes:
5
o With probability 𝑝 = the audit will agree with the CRA and you will have to pay the back taxes plus 50% of
8
back taxes (don’t forget you’ll also pay the $500 audit expenses)
o With probability 1 − 𝑝 the audit will reject the CRA’s claim in which case you will owe no back taxes and the
CRA will reimburse you the $500 in audit expenses.
(a) Please graph the decision tree for this decision making problem under uncertainty and solve for the optimal decision with
the assumption that you are a risk neutral decision maker. Show all calculations.
Now suppose that you can make your decision whether to pay the back taxes or request an audit after meeting with an
accountant who (for a testing fee) will conduct a “test” on your tax returns and tell you the probabilities that the audit will side
with the CRA (a “positive test result”) or whether the audit will side with you (a “negative test result”). The following
probability table shows the accountant’s track record in the past:
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Actual Probabilities of Audit Outcomes
Audit agreed with CRA Audit rejected the CRA Total Probabilities
1 𝟏
Positive Test Result (+)
10 𝟐
Negative Test Result (-)
𝟓
Total Probabilities 1
𝟖
(b) Please graph the decision tree for this decision making problem under uncertainty with “testing”. What is the maximum
testing fee that the accountant can charge you? Assume you are a risk neutral decision maker and show all calculations.
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Question 8
Ajax Inc. wants to raise capital by issuing stocks through an IPO (“initial public offering”). The board of directors must
decide whether to issue stock either at a price of $100 per share or at $50 per share. There is uncertainty about the number of
shares that will be sold at each price. Suppose the board of directors believes that:
 If the stock is issued at $100 per share then the market will buy either 2𝑚 shares with probability 𝑝 or 1𝑚 shares
with probability (1 − 𝑝).
 If the stock is issued at $50 per share then the market will buy either 3𝑚 shares with probability 𝑞 or 2.5𝑚 shares
with probability (1 − 𝑞).
(a) Graph the decision tree for this decision making under uncertainty problem.
1
(b) Suppose 𝑞 = 5. If Ajax is to issue shares at a price of $100 a share, what must the probability of selling 2𝑚 shares be?
Assume Ajax is risk neutral. Show all calculations and state any assumptions.
1
(c) Suppose 𝑞 = 5. If Ajax is to issue shares at a price of $100 a share, what must the probability of selling 2𝑚 shares be?
Assume Ajax is risk averse and has the utility function 𝑈 = √𝑋 (where 𝑋 is millions of dollars). Show all calculations and state
any assumptions.
1
(d) Suppose 𝑞 = 5 and 𝑝 = # calculated in part (c). Assuming Ajax is risk averse and has the utility function 𝑈 = √𝑋 (where
𝑋 is millions of dollars) what is the certainty equivalence to the uncertainty of issuing stocks at a price of $100 per share?
Show all calculations and state any assumptions.
1
(e) Suppose 𝑞 = 5 and 𝑝 = # calculated in part (c). Assuming Ajax is risk averse and has the utility function 𝑈 = √𝑋 (where
𝑋 is millions of dollars) what is the certainty equivalence to the uncertainty of issuing stocks at a price of $50 per share? Show
all calculations and state any assumptions
Question 9
Eco-woman has been sued by University of Two-ron-too (UT) for charging students for past exams. She must decide between
a trial and an out of court settlement.
If she goes to trial, the trial lawyers estimate the following judgments against her:
{$1𝑚, $0.6𝑚, $0; 0.2, 0.5, 0.3}
That is, she will be asked to pay U Two-ron-too $1m with probability 0.2, $0.6m with probability 0.5 and $0m with probability
0.3. If Eco-woman goes to court, her trial lawyers will charge $0.1m in legal fees.
Alternatively, Eco-woman can engage another legal team to negotiate a settlement. The settlement legal team estimates that the
University will seek:
{$0.9𝑚, $0.4𝑚; 0.5, 0.5}
That is, she will settle for $0.9m or $0.4m with equal probability, which Eco-woman can accept or reject (and go to trial). The
settlement legal team charges $0.05m.
(a) Assume Eco-woman is risk neutral. Should Eco-woman go to trial or attempt to settle out of court?
34
(b) Assume Eco-woman has the utility function 𝑈(𝑋) = −√𝑋 where 𝑋 is millions of dollars. Should Eco-woman go to trial
or attempt to settle out of court?
Question 10
Suppose that you’ve failed the driver’s license test and are now debating whether to bribe a senior official of the transportation
ministry to illegally issue you a driver’s license. In order to obtain the license illegally, you will need to pay a $1,000 bribe. If the
(honest) police catches you bribing the dishonest official, you’ll be fined $10,000. The cost of trying to obtain a driver’s
license legally is $2,000. What must be the probability of getting caught for you to not bribe the official?
Question 11
[This question is loosely based on the Ivey Business School case “Gold Claims at Sturgeon Lake”]
This question consists of three parts “A”, “B”, and “C”. Answer all parts to two decimal places.
Andrew McKendry, a geologist, has been hired by a Toronto based mining company to advise them about the following two
mutually exclusive decisions regarding gold mining operations at Sturgeon Lake (near Thunder Bay, Ontario):
∎ “Road → Drill”: First attempt to build a permanent road to the drill site at Sturgeon Lake and if the road project is
successful to then drill for gold. The cost of constructing the road is $33,484.56 and there’s a 70% chance that the road
construction project will be a success. The cost of drilling is $98,154.02 and there’s a 22% chance of finding gold. If the road
construction project and drilling are both successful then the 𝑃𝑉 of mining profits (before construction and drilling costs) is
$2,194,937.12.
∎ “Drill → Road”: First build a temporary ice road (with a 100% chance of success) and drill for gold. The ice road costs
nothing to build. The cost of drilling is $98,154.02 and the probability of drilling for gold is 0.22. If drilling is successful the
mining company will attempt to build a permanent road; the cost of constructing the permanent road is $33,484.56 and there’s
a 70% chance that the road construction project will be a success. If both drilling and road construction are successful, then
the 𝑃𝑉 of mining profits (before drilling and construction costs) is $2,194,937.12.
For your convenience, here is a summary of the numbers:
Cost of building permanent road = $33,484.56
𝑃(Road project is successful) = 0.7
Cost of drilling = $98,154.02
𝑃(Drilling for gold is successful) = 0.22
𝑃𝑉(Gold mine provided road and drilling are successful) = $2,194,937.12

⏟
excludes
drilling
and
road costs
(a) Draw the decision tree for this problem. Do NOT solve the decision tree just yet. HINT: You might want to first sketch
the decision tree on a worksheet at the back of this test before drawing the “final” version below.
35
Part A
(b) Suppose that the Toronto based gold mining company is “risk neutral”: what are its optimal decision and optimal course of
action? Show all calculations and state all assumptions.
(c) [This part is independent of all other parts below] Let 𝑝 = probability that drilling for gold is a success. For what
values of 𝑝 will the mining company make the same decision as your answer to part (b)? Show all calculations and state all
assumptions.
Part B
[Part B is independent of Part C below]
(d) Return to the original numbers at the beginning of the question:
𝑃(Drilling is successful) = 0.22
For this question you should use the decision tree in part (a). Now suppose that the Toronto based gold mining company is
“risk averse” and its board of directors is of the opinion that:
($2,194,937.12 − $98,154.02) is the 𝐶𝐸 to the risky situation {$2,194,937.12

⏟ ⏟ − $33,484.56 , −$98,154.02; 0.9, 0.1}
$2,096,783.10 $2,161,452.56
−$33,484.56 is the 𝐶𝐸 to the risky situation {$2,194,937.12

⏟ − $33,484.56 , −$98,154.02; 0.6, 0.4}
$2,161,452.56
What is the optimal decision and the optimal course of action? Show all calculations and state all assumptions.
36
QUESTION 12
A risk averse agent must decide whether to invest in “Project A” or in “Project B”. Both projects are characterized by
uncertainty where:
Project 𝐴 = {$7,800, −$300; 0.6, 0.4}
Project 𝐵 = {$9,700, −$200; 0.3, 0.7}

1
(a) Suppose this decision maker’s utility function is 𝑈($𝑋) = (𝑎 + 𝑋)𝑏 where 𝑎, 𝑏 > 0 are parameters and 𝑋 is measured in
dollars. Show that 𝑎 = 300 and 𝑏 = 2 and use these parameter values throughout this question (i.e. assume 𝑈($𝑋) =
1
(300 + 𝑋)2 ) . State all salient assumptions and show all essential calculations.
(b) True or false: -$200 is the certainty equivalence to the hypothetical “gamble”:
{Highest outcome in the decision making problem, Lowest outcome in the decision making problem; 0.1, 0.9}?
State all salient assumptions and show all essential calculations.
(c) Graph the decision tree below and solve the decision making under uncertainty problem to show that Project A is the
1
optimal choice. State all salient assumptions and show all essential calculations. Hint: Remember that 𝑈($𝑋) = (300 + 𝑋)2
(d) Calculate and interpret the “discount due to risk” of Project 𝐴 = {$7,800, −$300; 0.6, 0.4}. State all salient assumptions
1
and show all essential calculations. Hint: Remember that 𝑈($𝑋) = (300 + 𝑋)2
37
PRACTICE PROBLEM SOLUTIONS
Question 1 (2007 - 2008 Final Exam Question)

In professional tennis, there is often a large gap between the first and second prize. A few years ago, some tennis players
accused certain players of “splitting” the total pot6. For example, in a match with a first prize of $100,000 and a second prize
of $32,000 it was alleged that the winner and loser would split the prize so each player would get ($100,000 + $32,000)/2 =
$66,000.
(a) If a risk loving player believes she has a 50-50 chance of winning, will she “split” a first prize of $100,000 and second prize
of $32,000?
Answer:
The risk loving player will choose whichever option gives her greater utility. If she were to split the prize, she would receive
$66,000 for sure. But observe that $66,000 is also the EV since:
𝐸𝑉 = 0.5($100,000 + $32,000) = $66,000
Now, a risk lover is someone for whom 𝑈(𝐸𝑉) < 𝐸𝑈. If she plays the match with uncertain outcomes she’ll have a utility of
𝐸𝑈 while if she splits the prize evenly her utility will be the 𝑈(𝐸𝑉). Being a risk lover, she’ll derive greater utility from facing a
50-50 gamble between $100,000 and $32,000 than the utility of having a split prize of $66,000. Thus, she will not split the
prize.
(b) Suppose Patrick Crafter has the following utility function 𝑈 = −17.459 + 7.9423 ln 𝑋 where specifically:
$X U($X)
32 10
66 16
100 19
Suppose that the first prize is $100,000 and the second prize is $32,000. Will Patrick be willing to split the prizes if he believes
that he has a 50-50 chance of winning?
Answer:
The EV of a 50-50 chance of $100,000 and $32,000 is $66,000. Given the utility function above, Patrick’s 𝑈(𝐸𝑉) > 𝐸𝑈,
since:
𝑈(𝐸𝑉) = 𝑈($66,000) = 16 > 0.5(𝑈($32,000) + 𝑈($100,000)) = 0.5(10 + 19) = 14.5
Thus, Patrick will split the prize (being risk averse, this is to be expected).
38
(c) For an upcoming match with Jen vs. Arthur, some tennis players wonder if Jen will split the prize with Arthur because she
has been winning recent matches. What must Jen’s probability of winning this match be for her to reject splitting the prize?
Assume the prizes are $100,000 and $32,000 and Jen has the same utility function as Patrick Crafter in part (b).
Answer:
If Jen splits the prize, then since her utility is identical to Patrick’s, her utility from splitting the prize is 16. Her utility from
playing a match in which she receives $100,000 with probability 𝑝 and $32,000 with probability (1 – 𝑝) is:
𝐸𝑈 = 𝑝 𝑈($100,00) + (1 – 𝑝) 𝑈($32,000)
𝐸𝑈 = 19 𝑝 + (1 – 𝑝)10 = 9 𝑝 + 10
If Jen rejects splitting the prize, it’s because the expected utility from the match is greater than the utility of the split (sure)
prize:
𝐸𝑈 > 16
9𝑝 + 10 > 16
6 2
𝑝 > =
9 3
Jen’s probability of winning must be at least 2/3 for her to reject splitting the prize.
39
Question 2
Jenn Studios is thinking of producing a film “Ajax and the Order of Commerce”. Analysts predict that the film can be a hit or a
flop. Worse, it’s hard to predict profits since the director of the movie, Ajax Kurosawa, is needy, temperamental, egoistical and
totally lacking in financial discipline.
Based on his previous films, “The Commerce Identity”, “Commercinator 2”, “Beautiful People with Beautiful Indifference Curves”, “The Bald
and the Beautiful” and “The Eco-Watch-Man”, analysts estimate that production will have low and high costs with equal
probability. The probability of high demand is 0.4. Jenn Studios estimates profits to be:
Profits (Low Cost & Strong Demand ) = $80m
Profits (Low Cost & Weak Demand ) = $40m
Profits (High Cost & Strong Demand ) = $0m
Profits (High Cost & Weak Demand ) = -$80m
(a) Draw the decision tree.
Answer:
Here is the tree, where “S” denotes strong demand and “W” denotes weak demand:
40
(b) Should the studio produce the film?
Answer:
Assuming the studio is risk neutral, it needs to compute the EV of not making the movie vs. the EV of making the movie –
see decision tree below. Based on the EV criterion, the studio should produce the movie. Ajax will be famous. Nice.
(c) Due to Ajax’s frivolous demands (such as fresh squeezed Durian juice, access to VIP room at Pacha NYC, and Brr! Yani
on demand) Jenn studio is afraid that Ajax’s costs may spiral out of control. The studio now insists on a contractual clause
giving it the right to terminate the project after the first $30m has been spent because by this time the studio will know for
certain whether the costs are high or low. How much is this contractual clause worth?
Answer:
This type of contractual clause is common in construction, defense, and projects with uncertainty. In fact, one of the reasons
why many cities have “bland” architecture is because there is very little uncertainty in repeating a design. As such, many real
estate investment banks, like JP Morgan, do not favor novel architecture because they fear the potential high costs stemming
from uncertainty.
41
One way companies protect themselves against uncertainty is through a contractual clause which gives them the right to
terminate the project if they think the costs are liable to be high. If the contractor “burns” through funding quickly, then it’s
plausible to argue that costs are likely to be high. Let’s draw a tree with the contractual clause:
Note how after the first $30m is spent the studio has the option to stop and absorb a loss of $30m or the studio can continue
and face demand uncertainty. Now, we need to compute the EV of making the movie with the contractual clause.
Start from the end of the tree. Say that after the first $30 are spent, the studio knows costs are low (for example, maybe the
$30m were spent slowly- this of course raises a game theory issue that Ajax can deliberately spend slowly at first to “fool” the
studio that costs are low). If costs are low, the studio can stop and the payoff will be -$30m. If it continues, it will expect to
make:
EV of continuing if cost low = 0.4($80m) + 0.6($40m) = $56m
If the studio stops, the studio will make a loss of $30m. Thus, if costs are low, the studio should not exercise the clause and
produce the movie. Hence, the EV of low cost is $56m.
On the other hand, if costs are high then if the studio makes the movie:
EV go if cost high = 0.4($0m) + 0.6 (-$80m) = -$48m
This is worse than exercising the clause and incurring a loss of $30m. Thus, the EV of making the movie is:
42
EV Making Movie = 0.5($56m) + 0.5(-$30m) = $13m.
Thus, the studio should make the movie. Ajax will be famous. Nice. However, this solution so different from the previous
question in one respect: the studio has a contingent plan. Produce the movie and watch what happens over the first $30m. If
costs are revealed to be low, continue production. But if costs are revealed to be high, cease production.
Note how the EV with the clause is $9m higher than the EV without the clause. Hence, inserting this contractual clause is
worth $9m for the studio. On the flip side, it implies that legal services for writing this clause should not cost more than $9m.
43
Question 3
In this problem you will make a decision under uncertainty where the choices are not mutually exclusive. I hope it makes you
think harder about how to setup a problem.
You are the CEO of a pharmaceuticals company “Economics-Man Genetics” which has replicated Economics-Man’s genes9.
The company must decide whether to commercialize Economics-Man genes (aimed at students studying for Economics tests
and the final exam (just like you!)) using a Biochemical or Biogenetic R&D approach.
Suppose the profits and probabilities of the competing approaches are:
R&D Approach Investment Outcome Gross Profit Probabilities
Biochemical $10m Large Success $90m 0.7
Small Success $50m 0.3
Biogenetic $20m Success $200m 0.2
Failure $0m 0.8
Observe how the Biogenetic approach is more “risky”: it has a high upside but also a low downside. In contrast, the
Biochemical approach is less risky but also less lucrative. Find the best approach to commercialize the Economics-Man’s
genes. In the event that both approaches are successful, assume that you can only take one product to market. Hint: the R&D
programs are not mutually exclusive.
Answer:
Because the approaches are not mutually exclusive, the options available are:
 Do not invest at all

 Only Biochemical
 Only Biogenetic
 Biochemical and Biogenetic simultaneously
 Biochemical first followed by Biogenetic
 Biogenetic first followed by Biochemical.
The decision tree is:
9
No relation to Eco-man.
44
We need to give a value for each of these branches and choose option with the highest value. This entails drawing trees for
each of these branches.
“No R&D” Branch:

The value is $0
“Biochemical Only” Branch:
45
“Biogenetic Only” Branch
Biogenetic & Biochemical Simultaneously Branch

There are four uncertain possibilities each of which cost a total of $30m
Biochemical Biogenetic Probabilities
Large Success Success 0.7*0.2 = 0.14
Small Success Success 0.3*0.2 = 0.06
Large Success Failure 0.7*0.8 = 0.56
Small Success Failure 0.3*0.8 = 0.24
Here we have used the fact that for two independent events 𝐴 and 𝐵:
𝑃(𝐴 and 𝐵 ) = 𝑃(𝐴)𝑃(𝐵)
These possibilities are drawn in order below where the figures are net profits (gross profits - total cost):
46
Here is what’s happening branch by branch:
Biochemical Large Success & Biogenetic Success: If both programs succeed we have to decide which one to commercialize (recall you
can only commercialize one). If we commercialize Biochemical we get $60m and if we commercialize Biogenetic we get
$170m. Thus, we choose to commercialize Biogenetic-- notice how we fill the value of the decision in the decision node.
Biochemical Small Success & Biogenetic Success: With two successes, we again face a decision. We choose to commercialize
Biogenetics because it has the greater value -- notice how we fill the value of the decision in the decision node.
Biochemical Large Success & Biogenetic Failure: There is no decision here-- with a failure in Biogenetic R&D (with gross profits $0)
and a large success in Biochemical, we commercialize biochemical. The value of this $90m - $30m = $60m.
Biochemical Small Success & Biogenetic Failure: There is no decision here-- with a failure in Biogenetic R&D (with gross profits $0)
and a small success in Biochemical, we commercialize biochemical. The value of this $50m - $30m = $20m.
Since these four possibilities are uncertain, the EV of simultaneous development is:
EV(Biochemical and Biogenetic R&D) = 0.14($170m) + 0.06($170m) + 0.56($60m) + 0.24($20m)
EV(Biochemical and Biogenetic R&D) = $72.4m.
47
“Sequential R&D: Biochemical First” Branch

The decision tree is below:
Start with biochemical. If it is a large success, you can go to market and make a net profit of $80m. Or, you can pursue
biogenetic (because if it succeeds, you could make $170m!) and see what happens. If so, biogenetic could succeed and you
make net profit of $170m ($200 - $10 - $20), or, biogenetic could fail, in which case you can “go back” to the biochemical
large success and net $80 - $20 = $60m. Note that even though the outcome of a biogenetic failure is $0m, because you have
the option of commercializing biochemical the value of biogenetic failure is not 0. The remainder of the tree follows the same
logic. Thus:
EV(Biochemical first) = $72.4m
Indeed, there is no added value by doing biochemical first versus doing biochemical and biogenetic simultaneously. (Maybe
you want to think why this is so).
48
“Sequential R&D: Biogenetic First” Branch
The tree follows the same logic as biochemical first. The big difference is that if you have a biogenetic success, you don’t need
to explore the option of biochemical R&D because the value of a large success of a biochemical product is always less than
value of biogenetic success. Thus: EV(Biogenetic first) = $74.4m.
In sum:
49
Of all the options, Sequential R&D with biogenetics first is the best R&D decision. If it succeeds, take product to market. If it
fails, pursue biochemical R&D.
50
Question 4 (2007-2008 Test Question)

“Hey-Jazz Mining Company” has the option to purchase land. The seller’s best and final price is $3 million. If the land has
commercial mineral deposits, “Hey-Jazz Mining Company” estimates its value at $5 million. If there are no deposits, the
estimated value is $2 million. “Hey-Jazz Mining Company” believes that the chance of mineral deposits is 50-50. Assume the
company is risk neutral and the value of not buying the land is $0.
(a) Should “Hey-Jazz Mining Company” purchase the land?
Answer:
Since:
𝐸𝑉(Purchasing land) > 𝐸𝑉(Not purchasing land)
“Hey-Jazz Mining Company” should purchase the land.
51
(b) The seller has agreed to let “Hey-Jazz Mining Company” take samples from the land. Based on past experience, if there
are minerals present, the samples will be “positive” 80% of the time. If no minerals are present, the samples will (falsely) give a
favorable reading 40% of the time. Fill the table below and determine whether “Hey-Jazz Mining Company” should purchase
the land and how much it should pay for the test.

Positive (+)
Negative (-)
Total 50 50 100
Answer:
First, fill in the table. We know that if there are minerals, the test is “+” 80% of the time. Thus: 𝑃(+|𝑀) = 0.8. This implies:

Positive (+) 40
Negative (-)
Total 50 50 100
In turn, this implies:

Positive (+) 40
Negative (-) 10
Total 50 50 100
Next, we know that when there are no minerals the test gives a false “+” reading 40% of the time. Thus:

Positive (+) 40 20 60
Negative (-) 10
Total 50 50 100
From which:

Positive (+) 40 20 60
Negative (-) 10 30 40
Total 50 50 100
Now, we need to compare the EV of purchasing land with information versus the EV of purchasing land without information
(part (a)). The decision tree and solution is:
52
Please note cost of purchasing land has been subtracted from expected payoffs. The company should purchase the land as
long as the test does not cost more than $0.6m - $0.5m = $0.1m.
53
Question 5 (2007-2008 Final Exam Question)

You’re a dealer for a brand of luxury cars “Lamb-boo-Genie”10 Sales of Lamb-boo-Genie cars are pro-cyclical: in a growing (G)
economy, sales increase and in a recessionary (R) economy, sales decrease. You have to place an order tomorrow afternoon for
either 50 or 100 cars. Your profits depend on the state of the economy:
Lamb-boo-Genie Dealership Profits

Order Size Growth (G) Recession (R)
50 Cars $225m $100m
100 Cars $350m -$150m
(a) Suppose the probability of growth is 𝑃(𝐺) = 0.6. How many cars should you order? Assume you’re a risk neutral
decision maker.
Answer:
The optimal decision is to order 50 cars.
10
No relation to Lamborghini.
54
To help decide how many cars to order, you pay money to acquire some information about the stock market which better
informs you whether the economy will grow or contract. The following table gives the probability of stocks rising and falling
and the economy growing and contracting:
Table of Probabilities
Stock Market Growth (G) Recession (R) Total
Stocks Rise (+) 0.4875 0 0.4875
Stocks Fall (-) 0.1125 0.4 0.5125
Total 0.6 0.4 1.000
(b) What is the value of your decision if you use the stock market as a “test” for whether the economy will grow or go into a
recession? How much is the stock market information above worth to you? Again, assume you are risk neutral. Show all
calculations clearly.
Answer:
From the probability table, we have:
𝑃(𝐺+) 𝑃(𝑅+)
𝑃(𝐺|+) = 𝑃(+)
= 1, 𝑃(𝑅|+) = 𝑃(+)
=0
𝑃(𝐺−) 𝑃(𝑅−)
𝑃(𝐺|−) = 𝑃(−)
= 0.22, 𝑃(𝑅|−) = 𝑃(−)
= 0.78
55
Here is how the values in the tree were computed. Suppose you have a “+” result. Then the expected value of ordering 50 cars
is:
𝐸𝑉(50 𝐶𝑎𝑟𝑠|+) = 𝑃(𝐺|+)($225𝑚) + 𝑃(𝑅|+)($100𝑚)
0.4875 0
𝐸𝑉(50 𝐶𝑎𝑟𝑠|+) = ( ) ($225𝑚) + ( ) ($100𝑚) = $225𝑚
0.4875 0.4875
The expected value of ordering 100 cars is:
𝐸𝑉(100 𝐶𝑎𝑟𝑠|+) = 𝑃(𝐺|+)($350𝑚) + 𝑃(𝑅|+)(−$150𝑚)
0.4875 0
𝐸𝑉(100 𝐶𝑎𝑟𝑠|+) = ( ) ($350𝑚) + ( ) (−$150𝑚) = $350𝑚
0.4875 0.4875
Since 𝐸𝑉(100 𝐶𝑎𝑟𝑠|+) > 𝐸𝑉(50 𝐶𝑎𝑟𝑠|+): if the test result is “+” then you should order 100 cars.
Now, suppose you have a “-“ result. Then the expected value of ordering 50 cars is:
𝐸𝑉(50 𝐶𝑎𝑟𝑠|−) = 𝑃(𝐺|−)($225𝑚) + 𝑃(𝑅|−)($100𝑚)
0.1125 0.4
𝐸𝑉(50 𝐶𝑎𝑟𝑠|−) = ( ) ($225𝑚) + ( ) ∗ ($100𝑚) = $127.5𝑚
0.5125 0.5125
The expected value of ordering 100 cars is:
𝐸𝑉(100 𝐶𝑎𝑟𝑠|−) = 𝑃(𝐺|−)($350𝑚) + 𝑃(𝑅|−)(−$150𝑚)
𝐸𝑉(100 𝐶𝑎𝑟𝑠|−) = 0.22($350𝑚) + 0.78(−150𝑚) = −$40𝑚
Since 𝐸𝑉(100 𝐶𝑎𝑟𝑠|−) < 𝐸𝑉(50 𝐶𝑎𝑟𝑠|−): if the test result is “-” then you should order 50 cars.
What is the value of the decision with the test? The EV of your decision with the test is:
𝐸𝑉(𝑑𝑒𝑐𝑖𝑠𝑖𝑜𝑛 𝑤𝑖𝑡ℎ 𝑡𝑒𝑠𝑡) = 0.4875($350𝑚) + 0.5125($127.5𝑚) = $236𝑚
The expected value of information is:
𝐸𝑉𝐼 = 𝐸𝑉(Decision with Test) – 𝐸𝑉(Decision without Test) = $236𝑚 − $175𝑚 = $61𝑚
So long as the test does not cost more than $61m, you should make the decision with a test. If the test result is positive you
should order 100 cars while if the test result is negative you should order 50 cars.
56
Question 6 (Summer 2009 Final Exam)

Proctor and Grumble (P&G), a risk neutral decision maker, must decide whether to develop and release a new shampoo “Shine
on you” targeted at bald men. If P&G does not develop the shampoo the outcome is $0m. If P&G develops the shampoo R&D
costs will be $100m and when released into the market, it will be a success (S) with probability 0.6 or a failure (F) with
probability 0.4.
If the shampoo is a success, gross revenues (before R&D costs) are estimated to be $500m. On the other hand, if the
shampoo is a failure, gross revenues (before R&D costs) are estimate to be $0m.
(a) Draw P&G’s decision tree and indicate whether the shampoo should be developed.
Answer
See the decision tree below – P&G should develop the shampoo and will expect to make $200m
(b) P&G’s statistics consultant thinks the probability of success may not be accurate (i.e. there is some margin of error). What
is the lowest probability of success where P&G will choose to develop and release the shampoo product?
Answer
Let us calculate the “threshold” probability of success needed to make the decision to develop and release the shampoo.
Suppose we denote the probability of success as 𝑃(𝑆) = 𝑝 and the probability of failure as 𝑃(𝐹) = 1 − 𝑝. What is the
lowest 𝑝 for P&G to develop and release the shampoo? It is:
𝐸𝑉[Develop and release] > 0
400 𝑝 + (1 − 𝑝)(−100) > 0
100
𝑝 > = 0.2
500
Thus, as long as the probability of success is at least 20%, P&G’s decision will be to develop and release the shampoo.
Similarly, if the 𝑃(𝑆) > 1 P&G will again decide to develop and release the shampoo.
Thus the decision to develop and release the shampoo is “robust” to 𝑝 = 0.6 ± 0.4 or a 40% margin of error in the
probability of success. P&G would have to be really off in their estimate of P(S) to make the wrong decision.
57
(c) [This part can be answered without answering parts (a) - (b)]. Suppose a marketing company has developed a perfect (100%
accurate) test for new products. The test results can be positive (+) or negative (-). Fill in the entries in the two way
classification table below:
S F Total
+
-
Total 100
Answer
First we know from the beginning of the question that:
𝑃(𝑆) = 0.6 or 60%
𝑃(𝐹) = 0.4 or 40%
Since the test is 100% accurate, it must be “+” 60% of the time and “-“ 40% of the time. Thus, the entries should be:
S F Total
+ 60 0 60
- 0 40 40
Total 60 40 100
(d) Should P&G make the decision to develop the shampoo on the basis of the perfect test or without the perfect test? What
is the value of a “perfect test”? Show your calculations.
Answer
P&G’s decision tree is:
58
From:
S F Total
+ 60 0 60
- 0 40 40
Total 60 40 100
𝑃(𝑆 +) 60
𝑃(𝑆|+) = = =1
𝑃(+) 60
𝑃(𝐹 +) 0
𝑃(𝐹|+) = = =0
𝑃(+) 60
𝑃(𝑆 −) 0
𝑃(𝑆|−) = = =0
𝑃(−) 40
𝑃(𝐹 −) 40
𝑃(𝐹|−) = = =1
𝑃(−) 40
𝑃(+) = 0.6
𝑃(−) = 0.4
The decision tree and decisions are:
59
The EV of making a decision with a perfect test is $240m. From part (a), the EV of the decision without a test was $200m.
Hence:
Value of Information = EV(Decision with Information) - EV(Decision without information)
Value of perfect test = $240m - $200m = $40m
As long as the test does not cost more than $40m, P&G should make its decision after test marketing.
60
Question 7
You’ve received a letter from the Canadian Revenue Agency (CRA) stating that you made a mistake in your 2010 tax returns
and that you owe the CRA $5,000 in back taxes. You must choose one of the following two (mutually exclusive) decisions:
❶ Either pay the CRA $5,000 in back taxes
❷ Or request the CRA for an audit of your 2010 tax returns. The audit process will cost you $500 in expenses and
may result in one of two uncertain outcomes:
5
o With probability 𝑝 = 8 the audit will agree with the CRA and you will have to pay the back taxes plus 50% of
back taxes (don’t forget you’ll also pay the $500 audit expenses)
o With probability 1 − 𝑝 the audit will reject the CRA’s claim in which case you will owe no back taxes and the
CRA will reimburse you the $500 in audit expenses.
(a) Please graph the decision tree for this decision making problem under uncertainty and solve for the optimal decision with
the assumption that you are a risk neutral decision maker. Show all calculations.
Answer:
If you ask for audit and the audit agrees with the CRA (and rules against you) you have to pay:
Back taxes + 50% of back taxes + $500 in audit expenses = $5000 + 0.5($5,000) + $500 = $8,000
Given that, the decision tree for this decision making problem is provided below:
Since you are a risk-neutral decision maker, you will decide on the basis of EV.
5 3
𝐸𝑉(No audit) = (8,000) + (0) = $5,000
8 8
𝐸𝑉(Audit) = $5,000
Note that, these expected values are expected outflows. Therefore, you will choose the option where you make the least
payment. Given that the expected values of total payments are $5,000 under both circumstances, you will be indifferent
between requesting the CRA for the audit and paying the back taxes.
61
Now suppose that you can make your decision whether to pay the back taxes or request an audit after meeting with an
accountant who will – for a fee -- conduct a “test” on your tax returns and tell you the probabilities that the audit will side with
the CRA (a “positive test result”) or whether the audit will side with you (a “negative test result”). The following probability
table shows the accountant’s track record in the past:
Actual Outcome of Audits

1 𝟏
Positive Test Result (+)
10 𝟐
Negative Test Result (-)
𝟓
Total Probabilities 1
𝟖
(b) Please graph the decision tree for this decision making problem under uncertainty with “testing”. What is the maximum
testing fee that the accountant can charge you? Assume you are a risk neutral decision maker and show all calculations.
Answer:
Let’s first fill in the probability table (note that the new entries are in italics):
Actual Outcome of Audits

Positive Test Result (+) 0.4 0.1 0.5
Negative Test Result (-) 0.275 0.5

0.225
Total Probabilities 0.625 0.375 1
Given this probability table, the decision tree for this decision making problem with the test is provided below:
62
Note that, these expected values are expected outflows. Therefore, you will choose the option where you make the least payment.
Suppose you have a + result. Then:
𝐸𝑉(Audit|+) = 𝑃(𝑎𝑔𝑟𝑒𝑒|+)($8,000) + 𝑃(𝑟𝑒𝑗𝑒𝑐𝑡|+)($0)
0.4 0.1
𝐸𝑉(Audit|+) = ( ) ($8,000) + ( ) ($0)
0.5 0.5
𝐸𝑉(Audit|+) = $6,400
𝐸𝑉(No audit|+) = $5,000
Thus, if the result is +, you should pay the back taxes (no audit) with 𝐸𝑉 = $5,000. Now, suppose you have a – result. Then:
𝐸𝑉(Audit|−) = 𝑃(𝑎𝑔𝑟𝑒𝑒|−)($8,000) + 𝑃(𝑟𝑒𝑗𝑒𝑐𝑡|−)($0)
0.225 0.275
𝐸𝑉(Audit|−) = ( ) ($8,000) + ( ) ($0)
0.5 0.5
𝐸𝑉(audit|−) = $3,600
𝐸𝑉(no audit|−) = $5,000
Thus, if the result is – you should request the CRA for the audit with 𝐸𝑉 = $3,600.
63
Not knowing the results of the test, the EV of your decision with the test is:
𝐸𝑉(decision with test) = 0.5 ∗ $5,000 + 0.5 ∗ $3,600 = $4,300
Note that without the test, your expected payment is $5,000 and with the test, your expected payment is $4,300.Thus, the value
of the test to you is $700. Therefore, the maximum testing fee the accountant can charge you is $700.
64
Question 8
Ajax Inc. wants to raise capital by issuing stocks through an IPO (“initial public offering”). The board of directors must
decide whether to issue stock either at a price of $100 per share or at $50 per share. There is uncertainty about the number of
shares that will be sold at each price. Suppose the board of directors believes that:
 If the stock is issued at $100 per share then the market will buy either 2𝑚 shares with probability 𝑝 or 1𝑚 shares
with probability (1 − 𝑝).
 If the stock is issued at $50 per share then the market will buy either 3𝑚 shares with probability 𝑞 or 2.5𝑚 shares
with probability (1 − 𝑞).
(a) Graph the decision tree for this decision making under uncertainty problem.
Answer:
65
1
(b) Suppose 𝑞 = . If Ajax is to issue shares at a price of $100 a share, what must the probability of selling 2𝑚 shares be?
5
Assume Ajax is risk neutral. Show all calculations and state any assumptions.
Answer:
1
With 𝑞 = 5 the decision tree becomes:
If Ajax is risk neutral and issued shares at $100/shares, then it must be that:
𝐸𝑉[IPO at $100/share ] ≥ 𝐸𝑉[IPO at $50/share ]
𝑝200 + (1 − 𝑝)100 ≥ 𝑞150 + (1 − 𝑞)125
30
𝑝≥
100
That is, as long the chance of selling 2m shares at a price of $100/share is at least 30%, Ajax will issue shares at $100/share.
66
1
(c) Suppose 𝑞 = . If Ajax is to issue shares at a price of $100 a share, what must the probability of selling 2𝑚 shares be?
5
Assume Ajax is risk averse and has the utility function 𝑈 = √𝑋 (where 𝑋 is millions of dollars). Show all calculations and state
any assumptions.
Answer:
1
With 𝑞 = 5 the decision tree becomes:
If Ajax is risk averse and issued shares at $100/shares, then it must be that:
𝐸𝑈[IPO at $100/share ] ≥ 𝐸𝑈[IPO at $50/share ]
𝑝𝑈(200) + (1 − 𝑝)𝑈(100) ≥ 𝑞𝑈(150) + (1 − 𝑞)𝑈(125)
1 4
𝑝√200 + (1 − 𝑝)√100 ≥ ( ) √150 + ( ) √125
5 5
1 4
( ) √150 + ( ) √125 − 10
𝑝≥ 5 5 = 0.336484
√200 − 10
Now that Ajax is risk averse, for him to issue shares at $100/share, the probability of selling 2m shares at a price of $100/share
must be at least 33.6484% (higher than the 30% probability when Ajax was risk neutral).
67
1
(d) Suppose 𝑞 = and 𝑝 = # calculated in part (c). Assuming Ajax is risk averse and has the utility function 𝑈 = √𝑋 (where
5
𝑋 is millions of dollars) what is the certainty equivalence to the uncertainty of issuing stocks at a price of $100 per share?
Show all calculations and state any assumptions.
Answer:
Assume 𝑝 = 0.336484. The decision tree becomes:
By definition, the certainty equivalence to any uncertainty is 𝑈(𝐶𝐸) = 𝐸𝑈. Thus, for the $100/share IPO:
𝑈(𝐶𝐸) = 0.336484𝑈(200) + (0.663516)𝑈(100)
√𝐶𝐸 = 0.336484 √200 + (0.663516)√100
𝐶𝐸 = 11.42 ≈ 130
68
1
(e) Suppose 𝑞 = and 𝑝 = # calculated in part (c). Assuming Ajax is risk averse and has the utility function 𝑈 = √𝑋 (where
5
𝑋 is millions of dollars) what is the certainty equivalence to the uncertainty of issuing stocks at a price of $50 per share? Show
all calculations and state any assumptions.
Answer:
Assume 𝑝 = 0.336484. The decision tree becomes:
By definition, the certainty equivalence to any uncertainty is 𝑈(𝐶𝐸) = 𝐸𝑈. Thus, for the $50/share IPO:
1 4
𝑈(𝐶𝐸) = 𝑈(150) + 𝑈(125)
5 5
1 4
√𝐶𝐸 = √150 + √125
5 5
√𝐶𝐸 = 11.4
Notice the 𝐸𝑈 for $50/share IPO is the same as the 𝐸𝑈 for $100/share because we calculated the 𝐸𝑈 for $100/share at the
probabilities 𝑝, 1 − 𝑝 for which Ajax was indifferent between the $50/share and $100/share IPO.
𝐶𝐸 = 11.42 ≈ 130
69
Question 9
Eco-woman has been sued by University of Two-ron-too (UT) for charging students for past exams. She must decide between
a trial and an out of court settlement.
If she goes to trial, the trial lawyers estimate the following judgments against her:
{$1𝑚, $0.6𝑚, $0; 0.2, 0.5, 0.3}
That is, she will be asked to pay U Two-ron-too $1m with probability 0.2, $0.6m with probability 0.5 and $0m with probability
0.3. If Eco-woman goes to court, her trial lawyers will charge $0.1m in legal fees.
Alternatively, Eco-woman can engage another legal team to negotiate a settlement. The settlement legal team estimates that the
University will seek:
{$0.9𝑚, $0.4𝑚; 0.5, 0.5}
That is, she will settle for $0.9m or $0.4m with equal probability, which Eco-woman can accept or reject (and go to trial). The
settlement legal team charges $0.05m.
(a) Assume Eco-woman is risk neutral. Should Eco-woman go to trial or attempt to settle out of court?
Answer:
Eco-woman can go to trial or attempt a settlement. Note that negotiations over settlement need not be successful and are not
binding (this is why many labor disputes have a binding arbitration clause). What you should be careful about is the fact that if
a settlement is rejected, the case goes to trial, but you shouldn’t “draw” the trial tree again. Here is the decision tree:
$1m + $0.1m
(0.2)
$0.6m + $0.1m
Trial Chance (0.5)
$0 + $0.1m
(0.3)
Trial or
Settle? Reject
High Go to Trial
(0.5)
Accept
Settle Chance
Reject
Low Go to Trial
(0.5)
Accept
The trial decision sub-tree includes the trial lawyers legal cost. We have purposely omitted the outcomes for the settle sub-tree.
This is because we first need to calculate the EV trial (inclusive of trial lawyer expenses). This yields:
70
$1m + $0.1m
(0.2)
Trial $0.6m + $0.1m

EV = $0.6m
$0.6m (0.5)
$0 + $0.1m
(0.3)
Trial or Settle? Reject

High Go to Trial
(0.5)
Accept
Settle Chance
Reject
Low Go to Trial
(0.5)
Accept
Now we can fill some parts of the settlement decision tree:
$1m + $0.1m
(0.2)
Trial $0.6m + $0.1m

EV = $0.6m
$0.6m (0.5)
$0 + $0.1m
(0.3)

$0.6m + $0.05m
High
(0.5)
Accept
$0.9m + $0.05m
Settle Chance
Reject
$0.6m + $0.05m
Low
(0.5)
Accept
$0.4m + $0.05m
Notice that if Eco-woman rejects any settlement then she has no choice but to go to trial. Notice also how the legal fees have
been added to amounts she may have to pay.
71
If the University asks for a high offer ($0.9m) Eco-woman is better off rejecting the high settlement as the EV of going to trial
is still lower than $0.95m. On the other hand, if the University asks for a low offer ($0.4m) Eco-woman is better off accepting
the low settlement as the EV of going to trial is higher than $0.45m.
$1m + $0.1m
(0.2)
Trial $0.6m + $0.1m

EV = $0.6m
$0.6m (0.5)
$0 + $0.1m
(0.3)

High = $0.65m $0.65m
(0.5) Accept
$0.95m
Settle Chance
Reject
Low = $0.45m $0.65m
(0.5) Accept
$0.45m
Reasoning backwards we have the expected value of settling out of court:
$1m + $0.1m
(0.2)
Trial $0.6m + $0.1m

EV = $0.6m
$0.6m (0.5)
$0 + $0.1m
(0.3)
$0.65m
High = $0.65m
(0.5)
Accept
$0.95m
Settle EV
= $0.55m = $0.55m
Reject
$0.65m
Low = $0.45m
(0.5)
Accept
$0.45m
72
Seeking to minimize expected value, she will choose to settle out of court:
$1m + $0.1m
(0.2)
Trial $0.6m + $0.1m

EV = $0.6m
$0.6m (0.5)
$0 + $0.1m
(0.3)
Settle Reject
$0.65m
High = $0.65m
(0.5)
Accept
$0.95m
Settle EV
= $0.55m = $0.55m
Reject
$0.65m
Low = $0.45m
(0.5)
Accept
$0.45m
(b) Assume Eco-woman has the utility function 𝑈(𝑋) = −√𝑋 where 𝑋 is millions of dollars. Should Eco-woman go to trial
or attempt to settle out of court?
Answer:
Notice that the utility function is decreasing by cost. Hence the larger the utility the worse of Eco-woman will be and thus she
will choose the option that gives here the smaller number.
Substituting the given values
𝑈𝑡𝑟𝑎𝑖𝑙 = 0.2(−√1) + 0.5(−√0.6) + 0.3(−√0) + (√0.1) ≈ 0.90353
𝑈𝑠𝑒𝑡𝑡𝑙𝑒𝑚𝑒𝑛𝑡 = 0.5(−√0.9) + 0.5(−√0.4) + (−√0.05) ≈ 1.0142
Since utility is reduced by approximately 0.11067 (1.0142 − 0.90353) more when Eco-woman is settling out of court, she
will go to trial.
73
Question 11
[This question is loosely based on the Ivey Business School case “Gold Claims at Sturgeon Lake”]
This question consists of three parts “A”, “B”, and “C”. Answer all parts to two decimal places.
Andrew McKendry, a geologist, has been hired by a Toronto based mining company to advise them about the following two
mutually exclusive decisions regarding gold mining operations at Sturgeon Lake (near Thunder Bay, Ontario):
∎ “Road → Drill”: First attempt to build a permanent road to the drill site at Sturgeon Lake and if the road project is
successful to then drill for gold. The cost of constructing the road is $33,484.56 and there’s a 70% chance that the road
construction project will be a success. The cost of drilling is $98,154.02 and there’s a 22% chance of finding gold. If the road
construction project and drilling are both successful then the 𝑃𝑉 of mining profits (before construction and drilling costs) is
$2,194,937.12.
∎ “Drill → Road”: First build a temporary ice road (with a 100% chance of success) and drill for gold. The ice road costs
nothing to build. The cost of drilling is $98,154.02 and the probability of drilling for gold is 0.22. If drilling is successful the
mining company will attempt to build a permanent road; the cost of constructing the permanent road is $33,484.56 and there’s
a 70% chance that the road construction project will be a success. If both drilling and road construction are successful, then
the 𝑃𝑉 of mining profits (before drilling and construction costs) is $2,194,937.12.
For your convenience, here is a summary of the numbers:
𝑃(Drilling for gold is successful) = 0.22

⏟
excludes
drilling
and
road costs
74
(a) Draw the decision tree for this problem. Do NOT solve the decision tree just yet. HINT: You might want to first sketch
the decision tree on a worksheet at the back of this test before drawing the “final” version below.
Answer
The decision tree is (see below for how to calculate figures):
75
Part A
(b) Suppose that the Toronto based gold mining company is “risk neutral”: what are its optimal decision and optimal course of
action? Show all calculations and state all assumptions.
Answer
If the gold mining company is risk neutral then it can decide on the basis of “value” and/or the “utility”. Clearly, the “value”
criterion is easier. We now compute the “value” of “Road  Drill” and “Drill  Road”.
∎ “Road → Drill”: We are looking at the branch:
Build Road → Cost $33,484.56

Road Success {→ Drill → Cost $98,154.02 → {Drill Success → PV = $2,194,937.12
→{ Drill Failure
Road Failure → 𝑃𝑉 = $0
Working backwards (“backward induction”) we see that the expected value of drilling is:
Build Road → Cost $33,484.56

𝐃𝐫𝐢𝐥𝐥 𝐒𝐮𝐜𝐜𝐞𝐬𝐬 → 𝐏𝐕 = $𝟐, 𝟏𝟗𝟒, 𝟗𝟑𝟕. 𝟏𝟐
Road Success {→ 𝐃𝐫𝐢𝐥𝐥 → 𝐂𝐨𝐬𝐭 $𝟗𝟖, 𝟏𝟓𝟒. 𝟎𝟐 → {
→{ 𝐃𝐫𝐢𝐥𝐥 𝐅𝐚𝐢𝐥𝐮𝐫𝐞
𝐸𝑉(Drilling) = 𝑃(𝑆) (𝑁𝑃𝑉 of Success) + (1 − 𝑃(𝑆)) (𝑁𝑃𝑉 of Failure)
Let’s include the cost of drilling into the 𝑁𝑃𝑉 calculations:
𝐸𝑉(Drilling) = 𝑃(𝑆) (𝑃𝑉 of Success − Cost of Drilling) + (1 − 𝑃(𝑆)) (𝑃𝑉 of Failure − Cost of Drilling)
𝐸𝑉(Drilling) = 0.22($2,194,937.12 − $98,154.02 ) + (1 − 0.22) (0 − $98,154.02 ) = $384,732.15
Road Success{→ Drill → EV[Drill] = $384,732.15

Build Road → Cost $33,484.56 → {
Working one more step backwards we have the expected value of building the road:
𝐑𝐨𝐚𝐝 𝐒𝐮𝐜𝐜𝐞𝐬𝐬 → 𝐃𝐫𝐢𝐥𝐥 → 𝐄𝐕[𝐃𝐫𝐢𝐥𝐥 ] = $𝟑𝟖𝟒, 𝟕𝟑𝟐. 𝟏𝟓

𝐁𝐮𝐢𝐥𝐝 𝐑𝐨𝐚𝐝 → 𝐂𝐨𝐬𝐭 $𝟑𝟑, 𝟒𝟖𝟒. 𝟓𝟔 → {
𝐑𝐨𝐚𝐝 𝐅𝐚𝐢𝐥𝐮𝐫𝐞 → 𝐏𝐕 = $𝟎
𝐸𝑉(Road) = 𝑃(𝑆) (𝑁𝑃𝑉 of Success) + (1 − 𝑃(𝑆)) (𝑁𝑃𝑉 of Failure)
Let’s include the cost of building the road into the 𝑁𝑃𝑉 calculations:
𝐸𝑉(Road) = 𝑃(𝑆) (𝑃𝑉 of Success − Cost of Road) + (1 − 𝑃(𝑆)) (𝑃𝑉 of Failure − Cost of Road)
𝐸𝑉(Road) = 0.7($384,732.15 − $33,484.56 ) + (1 − 0.7) (0 − $33,484.56 ) = $235,827.95
The 𝑵𝑷𝑽 of the “Road → Drill” decision is $𝟐𝟑𝟓, 𝟖𝟐𝟕. 𝟗𝟓.
∎ “Drill → Road”: We are looking at the branch:
76
Drill → Cost $98,154.02

Road Success → PV = $2,194,937.12
Drill Success → {Build Road → Cost $33,484.56 → {
→{ Road Failure → 𝑃𝑉 = $0
Drill Failure → 𝑃𝑉 = $0
Working backwards (“backward induction”) we see that the expected value of building the road is:
Drill → Cost $98,154.02

𝐑𝐨𝐚𝐝 𝐒𝐮𝐜𝐜𝐞𝐬𝐬 → 𝐏𝐕 = $𝟐, 𝟏𝟗𝟒, 𝟗𝟑𝟕. 𝟏𝟐
Drill Success → {𝐁𝐮𝐢𝐥𝐝 𝐑𝐨𝐚𝐝 → 𝐂𝐨𝐬𝐭 $𝟑𝟑, 𝟒𝟖𝟒. 𝟓𝟔 → {
→{ 𝐑𝐨𝐚𝐝 𝐅𝐚𝐢𝐥𝐮𝐫𝐞 → 𝑷𝑽 = $𝟎
𝐸𝑉(Road) = 0.7($2,194,937.12 − $33,484.56 ) + (1 − 0.7) (0 − $33,484.56 ) = $1,502,971.42
Working one more step backwards we have:
Drill Success → {𝐁𝐮𝐢𝐥𝐝 𝐑𝐨𝐚𝐝 → 𝑬𝑽 = $1,502,971.42

Drill → Cost $98,154.02 → {
The expected value of drilling is:
𝐃𝐫𝐢𝐥𝐥 𝐒𝐮𝐜𝐜𝐞𝐬𝐬 → 𝐁𝐮𝐢𝐥𝐝 𝐑𝐨𝐚𝐝 → 𝑬𝑽 = $𝟏, 𝟓𝟎𝟐, 𝟗𝟕𝟏. 𝟒𝟐

𝐃𝐫𝐢𝐥𝐥 → 𝐂𝐨𝐬𝐭 $𝟗𝟖, 𝟏𝟓𝟒. 𝟎𝟐 → {
𝐃𝐫𝐢𝐥𝐥 𝐅𝐚𝐢𝐥𝐮𝐫𝐞 → 𝑷𝑽 = $𝟎
𝐸𝑉(Drilling) = 0.22($1,502,971.42 − $98,154.02 ) + (1 − 0.22) (0 − $98,154.02 ) = $232,499.69
The 𝑵𝑷𝑽 of the “Drill → Road” decision is $𝟐𝟑𝟐, 𝟒𝟗𝟗. 𝟔𝟗
Summarizing the 𝑁𝑃𝑉 of each option we have:
∎ “Road → Drill”: the value of this decision is $235,827.95
∎ “Drill → Road”: the value of this decision is $232,499.69
The risk neutral gold mining company should first attempt to build the permanent road and if it is successful, then drill for
gold. Below is the final decision tree:
77
78
(c) [This part is independent of all other parts below] Let 𝑝 = probability that drilling for gold is a success. For what
values of 𝑝 will the mining company make the same decision as your answer to part (b)? Show all calculations and state all
assumptions.
Answer
In part (b), the optimal decision was to build the road first and if successful to then drill for gold. Let 𝑝 = the probability that
drilling for gold is a success. We will build the road first and drill later as opposed to drill first and build road later whenever:
𝑁𝑃𝑉[Road → Drill] > 𝑁𝑃𝑉[Drill → Road]
Now 𝑁𝑃𝑉[Road → Drill] can be re-stated as follows: working backwards (“backward induction”) we see that the expected
value of drilling is:
𝐸𝑉(Drilling) = 𝑝($2,194,937.12 − $98,154.02 ) + (1 − 𝑝) (0 − $98,154.02 )
𝐸𝑉(Drilling) = 𝑝($2,194,937.12 − $98,154.02 + $98,154.02 ) − $98,154.02
𝐸𝑉(Drilling) = 𝑝($2,194,937.12 ) − $98,154.02
If the road construction is successful, we will drill so long as 𝐸𝑉(Drilling) ≥ 𝐸𝑉(Stopping) which will happen so long as
98,154.02
𝑝 ≥ 2,194,937.12 ≈ 4.47%. However, this is not the value of 𝑝 at which building road first is better than drilling first.
𝐸𝑉(Road) = 0.7(𝑝($2,194,937.12 ) − $98,154.02 − $33,484.56 ) + (1 − 0.7) (0 − $33,484.56 )
𝐸𝑉(Road) = 0.7(𝑝($2,194,937.12 ) − $98,154.02 − $33,484.56 + $33,484.56 ) − $33,484.56
𝐸𝑉(Road) = 0.7(𝑝($2,194,937.12 ) − $98,154.02) − $33,484.56
The 𝑵𝑷𝑽 of the “Road → Drill” decision is = 𝟎. 𝟕(𝒑($𝟐, 𝟏𝟗𝟒, 𝟗𝟑𝟕. 𝟏𝟐 ) − $𝟗𝟖, 𝟏𝟓𝟒. 𝟎𝟐) − $𝟑𝟑, 𝟒𝟖𝟒. 𝟓𝟔
Next, the 𝑁𝑃𝑉[Drill → Road] can be re-stated as follows: working backwards (“backward induction”) we see that the
expected value of building the road is:
79
𝐸𝑉(Road) = 0.7($2,194,937.12 − $33,484.56 ) + (1 − 0.7) (0 − $33,484.56 ) = $1,502,971.42
𝐸𝑉(Drilling) = 𝑝($1,502,971.42 − $98,154.02 ) + (1 − 𝑝) (0 − $98,154.02 )
𝐸𝑉(Drilling) = 𝑝($1,502,971.42 − $98,154.02 + $98,154.02) − $98,154.02
𝐸𝑉(Drilling) = 𝑝($1,502,971.42) − $98,154.02
The 𝑵𝑷𝑽 of the “Drill → Road” decision is = 𝒑($𝟏, 𝟓𝟎𝟐, 𝟗𝟕𝟏. 𝟒𝟐) − $𝟗𝟖, 𝟏𝟓𝟒. 𝟎𝟐.
Now, we will build the road first and drill later whenever:
𝑁𝑃𝑉[Road → Drill] > 𝑁𝑃𝑉[Drill → Road]
0.7(𝑝($2,194,937.12 ) − $98,154.02) − $33,484.56 ≥ 𝑝($1,502,971.42) − $98,154.02
(𝑝($1,536,455.984 ) − $68,707.81) − $33,484.56 ≥ 𝑝($1,502,971.42) − $98,154.02
𝑝(33,484.56) ≥ 4,038.35
𝑝 ≥ 0.12
It is optimal to build the road and if that is successful to then drill for gold so long as the chance of finding gold is at least
12%.
With this value of 𝑝, we see that if the road project is a success, then we’ll always choose to drill instead of stopping.
80
Part B
[Part B is independent of Part C below]
(d) Return to the original numbers at the beginning of the question:
𝑃(Drilling is successful) = 0.22
For this question you should use the decision tree in part (a). Now suppose that the Toronto based gold mining company is
“risk averse” and its board of directors is of the opinion that:
($2,194,937.12
⏟ − $98,154.02) is the 𝐶𝐸 to the risky situation {$2,194,937.12
⏟ − $33,484.56 , −$98,154.02; 0.9, 0.1}
$2,096,783.10 $2,161,452.56

⏟ − $33,484.56 , −$98,154.02; 0.6, 0.4}
$2,161,452.56
What is the optimal decision and the optimal course of action? Show all calculations and state all assumptions.
Answer
If the gold mining company is risk averse then it should decide on the basis of “utility”. To do this, we need the utilities of the
following monetary outcomes in the decision tree (reproduced here from above):
81
Notice that the outcomes in the tree are (in ascending order):
$ (98,154.02)
$ (33,484.56)
$2,194,937.12 − $98,154.02 = $2,096,783.10
$2,194,937.12 − $33,484.56 = $2,161,452.56
Now, the lowest outcome can be assigned a utility of zero, while the highest outcome can be assigned a utility of 100:
Outcome Utility
$ (98,154.02) 0
$ (33,484.56) ?
$ 2,096,783.10 ?
$ 2,161,452.56 100
To get the utilities of the “intermediate” outcomes, we use the fact that:
($2,194,937.12 − $98,154.02) is the 𝐶𝐸 to the risky situation {$2,194,937.12

⏟ ⏟ − $33,484.56 , −$98,154.02; 0.9, 0.1}
$2,096,783.10 $2,161,452.56

⏟ − $33,484.56 , −$98,154.02; 0.6, 0.4}
$2,161,452.56
82
By the definition of 𝐶𝐸 (i.e. 𝑈(𝐶𝐸) = 𝐸𝑈):
Outcome Utility
$ (98,154.02) 0
$ (33,484.56) 𝑈($2,096,783.10) = 𝐸𝑈 of {$2,194,937.12

⏟ − $33,484.56 , −$98,154.02; 0.6, 0.4}
$2,161,452.56
$2,096,783.10 𝑈(−$33,484.56 ) = 𝐸𝑈 of {$2,194,937.12

⏟ − $33,484.56 , −$98,154.02; 0.9, 0.1}
$2,161,452.56
$2,161,452.56 100
First:
($2,194,937.12
⏟ − $98,154.02) is the 𝐶𝐸 to the risky situation {$2,194,937.12
⏟ − $33,484.56 , −$98,154.02; 0.9, 0.1}
$2,096,783.10 $2,161,452.56
Implies that:
𝑈($2,096,783.10) = 0.9𝑈($2,161,452.56) + 0.1𝑈(−$98,154.02) = 0.9(100) + 0.1(0) = 90
Next,

⏟ − $33,484.56 , −$98,154.02; 0.6, 0.4}
$2,161,452.56
Implies that:
𝑈(−$33,484.56 ) = 0.6𝑈($2,161,452.56) + 0.4𝑈(−$98,154.02) = 0.6(100) + 0.4(0) = 60
Thus:
Outcome = $𝑿 𝑼($𝑿)
$ (98,154.02) 0
$ (33,484.56) 60
$ 2,096,783.10 90
$ 2,161,452.56 100
Even though the question doesn’t ask for it, here is the utility “function” (curve connecting the four utility points):
83
Thus, the decision tree in terms of utilities is:
We now compute the “utility” of “Road  Drill” and “Drill  Road”.
∎ “Road → Drill”: Working backwards (“backward induction”) we see that the expected utility of drilling is:
𝐸𝑈(Drilling) = 𝑃(𝑆) (𝑈 of Success) + (1 − 𝑃(𝑆)) (𝑈 of Failure)
𝐸𝑈(Drilling) = 0.22(90) + (1 − 0.22) (0 ) = 19.8
84
This is better than the utility of stopping and so the optimal decision is to drill. Working one more step backwards we have:
𝐸𝑈(Road) = 𝑃(𝑆) (𝑈 of Success) + (1 − 𝑃(𝑆)) (𝑈 of Failure)
𝐸𝑈(Road) = 0.7(19.8) + (1 − 0.7) (60) = 31.86
The 𝑼(𝐑𝐨𝐚𝐝 → 𝐃𝐫𝐢𝐥𝐥) decision is 𝟑𝟏. 𝟖𝟔.
∎ “Drill → Road”: Working backwards (“backward induction”) we see that the expected utility of building the road is:
𝐸𝑈(Road) = 𝑃(𝑆) (𝑈 of Success) + (1 − 𝑃(𝑆)) (𝑈 of Failure)
𝐸𝑈(Road) = 0.7(100) + (1 − 0.7) (60) = 88
This is better than the utility of stopping and the so the optimal decision is to build the road. Working one more step
backwards we have:
𝐸𝑈(Drilling) = 𝑃(𝑆) (𝑈 of Success) + (1 − 𝑃(𝑆)) (𝑈 of Failure)
𝐸𝑈(Drilling) = 0.22(88) + (1 − 0.22) (0 ) = 19.36
The 𝑼(𝐃𝐫𝐢𝐥𝐥 → 𝐑𝐨𝐚𝐝) decision is 19.36.
Summarizing the “utility” of each option we have:
∎ “Road → Drill”: the “utility” of this decision is 31.86
∎ “Drill → Road”: the “utility” of this decision is 19.36
The risk averse gold mining company should first attempt to build the permanent road and if it is successful, then drill for
gold.
85
86
QUESTION 12
A risk averse agent must decide whether to invest in “Project A” or in “Project B”. Both projects are characterized by
uncertainty where:
Project 𝐴 = {$7,800, −$300; 0.6, 0.4}
Project 𝐵 = {$9,700, −$200; 0.3, 0.7}

1
(a) Suppose this decision maker’s utility function is 𝑈($𝑋) = (𝑎 + 𝑋)𝑏 where 𝑎, 𝑏 > 0 are parameters and 𝑋 is measured in
dollars. Show that 𝑎 = 300 and 𝑏 = 2 and use these parameter values throughout this question (i.e. assume 𝑈($𝑋) =
1
(300 + 𝑋)2 ) . State all salient assumptions and show all essential calculations.
Answer
The utility function has the form:
1
𝑈($𝑋) = (𝑎 + 𝑋)𝑏
Since utility is an ordinal number, we can assign utility values to the highest and lowest outcomes as follows:
𝑈(Highest outcome in the decision problem) = 𝑈($9,700) = 100
𝑈(Lowest outcome in the decision problem) = 𝑈(−$300) = 0
Now:
1
𝑈($𝑋) = (𝑎 + 𝑋)𝑏
1
𝑈(−$300) = (𝑎 − 300)𝑏 = 0 ⇒ 𝑎 = 300
Next:
1
𝑈($9,700) = (300 + 9,700)𝑏 = 100
⇒ 10,000 = 100𝑏
⇒ ln 10,000 = 𝑏 ln 100
ln 10,000
⇒𝑏= = 2 (after all, 1002 = 10,000)
ln 100
Thus:
1
𝑈($𝑋) = (300 + 𝑋)2
87
(b) True or false: -$200 is the certainty equivalence to the hypothetical “gamble”:
{Highest outcome in the decision making problem, Lowest outcome in the decision making problem; 0.1, 0.9}?
State all salient assumptions and show all essential calculations.
Answer
1
From the utility function 𝑈($𝑋) = (300 + 𝑋)2 we see that:
1
𝑈(−$200) = (300 − 200)2 = 10
Now, consider the following hypothetical gamble:
{Highest outcome in the decision making problem, Lowest outcome in the decision making problem; 0.1, 0.9}
The 𝐸𝑈 of this hypothetical gamble is:
𝐸𝑈 = 0.1 𝑈(Highest outcome in the decision making problem)

+ 0.9 𝑈(Lowest outcome in the decision making problem)
𝐸𝑈 = 0.1 ∗ 100 + 0.9 ∗ 0 = 10
Since 𝑈(−$200) = 𝐸𝑈 we see that −$200 is in fact the 𝐶𝐸 to the hypothetical “gamble”:
{Highest outcome in the decision making problem, Lowest outcome in the decision making problem; 0.1, 0.9}
Thus, true.
88
(c) Graph the decision tree below and solve the decision making under uncertainty problem to show that Project A is the
1
optimal choice. State all salient assumptions and show all essential calculations. Hint: Remember that 𝑈($𝑋) = (300 + 𝑋)2
Answer
The risk averse agent must decide whether to invest in “Project A” or in “Project B” where:
Project 𝐴 = {$7,800, −$300; 0.6, 0.4}
Project 𝐵 = {$9,700, −$200; 0.3, 0.7}
The decision tree is (oval nodes represent uncertainty):
Since the agent is risk averse, she will choose the project with the highest expected utility. To do this, we need to compute the
utilities of all outcomes. We already know that:
𝑈($9,700) = 100
𝑈(−$300) = 0
1
From 𝑈($𝑋) = (300 + 𝑋) we have: 2
1
𝑈($7,800) = (300 + 7,800)2 = 90
1
𝑈(−$200) = (300 − 200)2 = 10
Thus:
89
𝐸𝑈(𝑃𝑟𝑜𝑗𝑒𝑐𝑡 𝐴) = 0.6𝑈($7,800) + 0.4𝑈(−$300) = 0.6 ∗ 90 + 0.4 ∗ 0 = 54
𝐸𝑈(𝑃𝑟𝑜𝑗𝑒𝑐𝑡 𝐵) = 0.3𝑈($9,700) + 0.7𝑈(−$200) = 0.3 ∗ 100 + 0.7 ∗ 10 = 37
The agent will choose Project A over Project B (following tree is not required in the answer):
(d) Calculate and interpret the “discount due to risk” of Project 𝐴 = {$7,800, −$300; 0.6, 0.4}. State all salient assumptions
1
and show all essential calculations. Hint: Remember that 𝑈($𝑋) = (300 + 𝑋)2
Answer
The discount due to risk is equal to 𝐸𝑉 − 𝐶𝐸.
First, consider Project 𝐴 = {$7,800, −$300; 0.6, 0.4}.
𝐸𝑉(𝑃𝑟𝑜𝑗𝑒𝑐𝑡 𝐴) = 0.6 ∗ 7,800 + 0.4 ∗ (−300) = $4,560
𝐸𝑈(𝑃𝑟𝑜𝑗𝑒𝑐𝑡 𝐴) = 0.6𝑈($7,800) + 0.4𝑈(−$300) = 54
The 𝐶𝐸 of Project A is:

1
𝑈(𝐶𝐸) = (300 + 𝐶𝐸)2 = 𝐸𝑈(𝑃𝑟𝑜𝑗𝑒𝑐𝑡 𝐴) = 54
𝐶𝐸 = 542 − 300 = $2,616
90
(You should confirm that 𝑈(𝐶𝐸) = 𝐸𝑈)
The discount due to risk for project A is:
Project 𝐴 discount due to risk = 𝐸𝑉 − 𝐶𝐸 = $4,560 − $2,616 = $1,944
Here’s the interpretation of the discount due to risk. Project A’s 𝐸𝑉 is $4,560. Now, if the agent invests in project A, her
𝐸𝑈 will be 54. Now, would this agent prefer the 𝐸𝑉 for sure over facing the uncertain situation? Yes, because (as you can show)
the 𝑈(𝐸𝑉) > 𝐸𝑈. What about $4,559: will the agent prefer this or the uncertain situation? As you can show, she will prefer
$4,559 over the uncertain situation even though it is $1 less than the 𝐸𝑉 of the project. That is, she is willing to “sacrifice” some of the
𝐸𝑉 to avoid uncertainty and gain peace of mind. What’s the maximum amount she’ll “sacrifice”? That is, of course, the 𝐶𝐸 (at
which point the utility of the 𝐶𝐸 is the same as 𝐸𝑈). Thus, the maximum discount due to risk is 𝐸𝑉 − 𝐶𝐸.
91

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University of Toronto, Department of Economics (STG). ECO 204, S. Ajaz Hussain. Do not distribute.

Department of Economics (STG), ECO 204, Sayed Ajaz Hussain

DECISION MAKING UNDER UNCERTAINTY1

1 Thanks: Matthew Oh. Feedback welcome: please e-mail eco.204@utoronto.ca.

Enter Chinese market and earn uncertain profits?

2. Decision Making Under Uncertainty Without Option of Prior Testing

Expected Value = 𝐸𝑉 = 0.6($600𝑚) + 0.4(−$200𝑚) = $280𝑚

𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑈𝑡𝑖𝑙𝑖𝑡𝑦 = 𝐸𝑈 = 0.6 𝑈($600𝑚) + 0.4 𝑈(−$200𝑚)

The expected utility represents the “utility of facing an uncertain situation”.

Now, the agent’s “utility” from not investing is:

𝑈(𝑁𝑜𝑡 𝐼𝑛𝑣𝑒𝑠𝑡𝑖𝑛𝑔) = 𝑈($0𝑚) = √200 + 0 = 14.14

𝐸𝑈 = 0.6𝑈($600𝑚) + 0.4𝑈(−$200𝑚) = 0.6 √200 + 600 + 0.4 √200 − 200 = 16.97

This particular agent will invest so long as:

𝐸𝑈(Invest) ≥ 𝑈(Not Invest)

𝑝𝑈(600) + (1 − 𝑝)𝑈(−200) ≥ 𝑈(0)

𝑝√200 + 600 + (1 − 𝑝)√200 − 200 ≥ √200 + 0

This agent will invest so long as:

𝐸𝑈(Invest) ≥ 𝑈(Not Invest)

0.6𝑈(𝑋) + 0.4𝑈(−200) ≥ 𝑈(0)

0.6√200 + 𝑋 + 0.4√200 − 200 ≥ √200 + 0

𝐸𝑉 = 0.6($600) + 0.4(−$200) = $280

We can plot the outcomes and the 𝐸𝑉 on the numbers line:

 The distance between -$200 and $600 is $800

3. Decision Making Under Uncertainty: Characterizing “Attitude Towards Risk”

“Attitudes Towards Risk” in a Particular Decision Making Under Uncertainty Problem:

Combing these examples, we see that:

Thus, we conclude that:

4. Decision Making Under Uncertainty for Risk Neutral Agents

𝐸𝑈(Situation 𝑋) 𝑣𝑠. 𝐸𝑈(Situation 𝑌)

But notice this is tantamount to comparing:

𝐸𝑉(Situation 𝑋) 𝑣𝑠. 𝐸𝑉(Situation 𝑌)

𝐸𝑈(Situation 𝑋) 𝑣𝑠. 𝐸𝑈(Situation 𝑌)

5. Certainty Equivalence (𝑪𝑬) of an Uncertain Situation

𝑈(𝐶𝐸) = 𝐸𝑈 = 0.6 𝑈($600𝑚) + 0.4 𝑈(−$200𝑚)

√200 + 𝐶𝐸 = 0.6 √200 + 600 + 0.4 √200 − 200

𝐶𝐸 ≈ $88𝑚 (𝑏𝑒𝑙𝑜𝑤, 𝑓𝑜𝑟 𝑐𝑜𝑛𝑣𝑒𝑛𝑖𝑒𝑛𝑐𝑒, 𝑠𝑒𝑡 𝐶𝐸 = $88𝑚)

Your certainty equivalence of playing the uncertain game is:

𝐸[𝐹𝐶𝐹1 ] 𝐸[𝐹𝐶𝐹2 ] 𝐸[𝐹𝐶𝐹𝑇 ]

𝐶𝐸[𝐹𝐶𝐹1 ] 𝐶𝐸[𝐹𝐶𝐹2 ] 𝐶𝐸[𝐹𝐶𝐹𝑇 ]

𝑫𝑪𝑭 Approach to Valuing an Asset with uncertain free cash flows:

𝑟 = Risk adjusted discount rate

𝐸[𝐹𝐶𝐹𝑡 ] = Expected Free cash flow in period 𝑡.

𝑟𝑓 = Risk free rate

𝐶𝐸(𝐹𝐶𝐹𝑡 ) = Certainty Equivalence of Free cash flow in period 𝑡

6. How to Derive “Utility Values” for Decision Making Under Uncertainty

𝑈(Highest outcome in decision tree) = 100

𝑈(Lowest outcome in decision tree) = 0

𝑈($𝑋) = 𝑝𝑈(ℎ𝑖𝑔ℎ𝑒𝑠𝑡 𝑜𝑢𝑡𝑐𝑜𝑚𝑒) + (1 − 𝑝)𝑈(𝑙𝑜𝑤𝑒𝑠𝑡 𝑜𝑢𝑡𝑐𝑜𝑚𝑒) = 𝑝100 + (1 − 𝑝)0 = 100𝑝

𝑈($600m = Highest outcome in decision tree) = 100

𝑈(−$200m = Lowest outcome in decision tree) = 0

𝐸𝑉[Decision with Test] − 𝐸𝑉[Decision without Test] ≥ Cost of the Test

Invest and earn uncertain profits?

This meta-decision is depicted below:

𝑃(+), 𝑃(−), 𝑃(𝑆|+), 𝑃(𝐹|+); 𝑃(𝑆|−), 𝑃(𝐹|−)

Testing Agency’s Track Record of Previous Tests

From these we have:

Notice that 𝑃(𝑆|+) + 𝑃(𝐹|+) = 1. Similarly:

Notice that 𝑃(𝑆|−) + 𝑃(𝐹|−) = 1.