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Decision Making Under Risk Analysis

The document discusses decision-making under risk, where probabilities are assigned to various states of nature based on past records or subjective judgment. It outlines three decision criteria: Expected Monetary Value (EMV), Expected Opportunity Loss (EOL), and Expected Value of Perfect Information (EVPI), providing calculations and recommendations for investment decisions in real estate. The analysis concludes that investing in an office building is optimal based on both EMV and EOL criteria, with an EVPI of N1,000 indicating the maximum amount to pay for additional information.

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alaminusman002
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18 views4 pages

Decision Making Under Risk Analysis

The document discusses decision-making under risk, where probabilities are assigned to various states of nature based on past records or subjective judgment. It outlines three decision criteria: Expected Monetary Value (EMV), Expected Opportunity Loss (EOL), and Expected Value of Perfect Information (EVPI), providing calculations and recommendations for investment decisions in real estate. The analysis concludes that investing in an office building is optimal based on both EMV and EOL criteria, with an EVPI of N1,000 indicating the maximum amount to pay for additional information.

Uploaded by

alaminusman002
Copyright
© All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as DOCX, PDF, TXT or read online on Scribd

DECISION MAKING UNDER CONDITIONS OF RISK

Under the risk situation, the decision maker has sufficient information to allow him
assign probabilities to the various states of nature. In other words, although the
decision maker does not know with certainty the exact state of nature that will
occur, he knows the probability of occurrence of each state of nature. Here also,
more than one state of nature exists. Most Business decisions are made under this
condition. The probabilities assigned to each state of nature are obtained from past
records or simply from the subjective judgement of the decision maker. A few
decision criteria are available to the decision maker. These include.

i. Expected monetary value criterion (EMV).


ii. Expected Opportunity Loss Criterion (EOL).
iii. Expected Value of Perfect Information (EVPI)

EXPECTED MONETARY VALUE (EMV) CRITERION


To apply the concept of expected value as a decision making criterion, the decision
maker must first estimate the probability of occurrence of each state of nature.
Once the estimations have been made, the expected value of each decision
alternative can be computed. The expected monetary value is computed by
multiplying each outcome (of a decision) by the corresponding probability of its
occurrence and then summing the products. The expected value of a random
variable is written symbolically as E(x), is computed as follows.

A businessman has constructed the payoff matrix below. Using the EMV criterion,
analyse the situation and advise the businessman on the kind of property to invest
on.

Investment Good Poor Turbulent


Economy Economy Economy
Apartment Building (d1) 50,000 30,000 15,000
Office Building (d2) 100,000 40,000 10,000
Warehouse (d3) 30,000 10,000 -20,000
Probabilities 0.5 0.3 0.2

SOLUTION
EVd1 = 50,000 (0.5) + 30,000 (0.3) + 15,000 (0.2)
25,000 + 9,000 + 3,000
N 37,000

EVd2 = 100,000 (0.5) + 40,000 (0.3) + 10,000 (0.2)


N50,000 +12,000 + 2000
N64,000

EVd3 = 30,000 (0.5) + 10,000 (0.3) + (-20,000(0.2)


15,000 + 3000 - 4000
N14,000

Recommendation: Using the EMV criterion, the businessman should select


alternative d2 and invest in office building worth N64,000.
EXPECTED OPPORTUNITY LESS (EOL)
The Expected Opportunity Loss EOL criterion is a regret criterion. It is used mostly in
minimization problems. The minimization problem involves the decision maker
either trying to minimize loss or minimize costs. It is like the Minimax Regret
Criterion earlier discussed under decision making under uncertainty. The difference,
however, is that EOL has probabilities attached to each state of nature or
occurrence. The difference in computation between the EMV and EOL methods is
that, unlike the EMV methods, a regret matrix must be constructed from the original
matrix before the EOL can be determined.

A businessman has constructed the payoff matrix below. Using the EMV criterion,
analyse the situation and advise the businessman on the kind of property to invest
on.
Investment Good Poor Turbulent
Economy Economy Economy
Apartment Building (d1) 50,000 30,000 15,000
Office Building (d2) 100,000 40,000 10,000
Warehouse (d3) 30,000 10,000 -20,000
Probabilities 0.5 0.3 0.2

We shall determine the best alternative EOL using the contingency matrix above.
First, we construct a regret matrix from contingency the matrix above. Remember
how the Regret matrix table is constructed. To construct a regret matrix, determine
the highest value in each state of nature and subtract every payoff in the same
state of nature from it. Your will observe that most of the payoff will become
negative values and zero.

Regret Matrix
Investment Good Poor Turbulent
Economy Economy Economy
Apartment Building (d1) (100,000 – (40,000 - (15,000 - 15,000)
50,000) 30,000) 0
50,000 10,000
Office Building (d2) (100,000- (40,000 - (15,000 - 10,000)
100,000) 40,000) 5,000
0 0
Warehouse (d3) (100,000 - (40,000 - (15,000 – (-20,000)
30,000) 10,000) 35,000
70,000 30,000
Probabilities 0.5 0.3 0.2

EOLd1 = (50,000)(0.5) + (10,000)(0.3) + (0)(0.2)


25,000 + 3,000 + 0
N28,000

EOLd2 = (0)(0.5) + (0)(0.3) + (5,000)(0.2)


0 + 0 + 1000
N1,000

EOLd3 = (70,000)(.05) + (30,000)(0.3) + (35,000)(0.2)


35.000 + 9,000 + 7,000
N51,000
Recommendation: Using the EOL criterion, the decision maker should select
alternative d2 and invest in office building worth N1,000. The Optimum investment
option is the one which minimizes expected opportunity losses, the action calls for
investment in office building at which point the minimum expected loss will be
N1,000.

EXPECTED VALUE OF PERFECT INFORMATION (EVPI).


It is often possible to purchase additional information regarding future events and
thus make better decisions. For instance, a farmer could hire a weather forecaster
to analyse the weather conditions more accurately to determine which weather
condition will prevail during the next farming season. However, it would not be wise
for the farmer to pay more for this information than he stands to gain in extra yield
from having this information. That is, the information has some maximum yield
value that represents the limit of what the decision maker would be willing to spend.
This value of information can be computed as an expected value – hence its name,
expected value of perfect information (EVPI).

The expected value of perfect information therefore is the maximum amount a


decision maker would pay for additional information. The value of perfect
information is the amount by which the profit will be increased with additional
information. It is the difference between expected value of optimum quantity under
risk and the expected value under certainty. Using the EOL criterion, the value of
expected loss will be the value of the perfect information. Expected value of perfect
information can be computed as follows

EVPI = EVwPI – EMVmax

Where
EVPI = Expected value of perfect information.
EVwPI = Expected value with perfect information.
EMVmax = Maximum expected monetary valueor Expected value without perfect
information (Or minimum EOL for a minimization problem)

EVwPI = Pj x Best out of each state of nature (sj)

The expected value with perfect information can be obtained by multiplying the
best outcome in each state of nature by the corresponding probabilities and
summing the results.

We can obtain the EVwPI from the table above as follows.

EVwP1 = (100,000)(0.5) + (40,000)(0.3) + (15,000)(0.2)


50,000 + 12,000 + 3,000
N65,000
Recall that our optimum strategy as calculated earlier was
N64,000.

EVP1 = EVwP1 – EMVmax


N65000 - 64,000
N 1,000

The expected value of perfect information (EVPI) isN1000.

This implies that the maximum amount the investor can pay for extra information is
N1000. Because it is difficult to obtain perfect information, and most times
unobtainable, the decision maker would be willing to pay some amount less than
N1000 depending on how accurate the decision maker believes the information is.
Notice that the expected value of perfect information (N1000) equals our expected
opportunity loss (EOL) of N1000 as calculated earlier.

Common questions

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The EVPI represents the potential gain from perfect information, while the minimum EOL reflects the least regret possible with current knowledge, both addressing the value of information and opportunity cost. They equate because EVPI equals the difference between expected outcomes with perfect information and current optimal outcomes, while minimum EOL highlights the lowest potential opportunity loss achievable. Hence, the equivalency indicates the highest justifiable expense for attaining such perfect foresight .

The EMV method helps determine investment choices by calculating the expected monetary gains for each alternative, factoring in the likelihood of different economic conditions. For the businessman, this method identifies the office building as the optimal investment choice with the highest EMV of N64,000. This insight supports informed financial decisions in contexts of uncertainty and varying economic scenarios .

The EOL method differs from the EMV in focusing on minimizing losses rather than maximizing gains. It involves constructing a regret matrix by subtracting each outcome from the maximum possible outcome in each state of nature. Using the EOL method, the recommended investment changes to the office building (d2) with an expected opportunity loss of N1,000, the lowest among the alternatives .

The EMV criterion involves estimating the probability of each state of nature and calculating the expected value for each decision alternative by multiplying outcomes by their respective probabilities and summing the results. Using the EMV criterion, the investment recommended is the office building (d2) as it provides the highest expected monetary value of N64,000 .

A regret matrix is crucial for the EOL criterion because it shifts focus from profit maximization to minimizing potential regret or opportunity loss. By comparing each investment outcome against the best possible outcomes in each state of nature, decision makers can better analyze the cost of not choosing the optimal alternative. This approach helps to identify the strategy that minimizes potential regrets, guiding decisions effectively in uncertain environments .

The EVPI is the maximum value a decision maker should be willing to pay for perfect information. It is the difference between the expected value with perfect information (EVwPI) and the maximum EMV. This metric is significant as it helps assess the value of additional information, guiding decisions on whether to invest in obtaining such information. In the given scenario, the EVPI is N1,000, indicating the maximum amount the investor should pay for extra information .

The EMV for each investment is calculated by multiplying each potential outcome by its probability of occurrence and summing these values. For the apartment building, EVd1 = N37,000; for the office building, EVd2 = N64,000; and for the warehouse, EVd3 = N14,000. This reveals that decision-making relies on probabilistic analysis to predict potential earnings, helping to prioritize investments with higher expected returns under risk .

A decision-maker might prefer EOL over EMV when the focus is on minimizing potential regret rather than maximizing gains. EOL is crucial in risk-averse contexts where decision-makers aim to avoid the worst-case scenarios over maximizing returns. It provides insights into risks through the construction of a regret matrix, facilitating strategic planning in environments with uncertain variables .

Regret in the EOL method acts as the metric for measuring missed opportunities and negative feelings from suboptimal decisions. By constructing a regret matrix, decision-makers quantify potential losses relative to the best possible scenarios, allowing them to minimize regret. This metric shifts focus from outcomes to the emotional and economic costs of decisions, emphasizing foresight in risk management .

Subjective judgement is utilized when assigning probabilities to states of nature in risk decision-making. Beyond relying on historical data, decision-makers often apply personal experience and insight to estimate probabilities, recognizing the inherently uncertain nature of these assessments. This emphasizes the combination of empirical data and individual expertise in informed decision-making .

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