MANAGERIAL ECONOMICS

02

DECISION MAKING UNDER RISK AND UNCERTAINTY

(13/10/2011)

Prof. Dr. Hasan ALKAS

RISK VS. UNCERTAINTY

Risk
Possible outcomes are known Probailities can be assigned to outcomes Objective vs. Subjective probabilities

Uncertainty
Possible outcomes are (partly) unknown and/or Probabilities cannot be assigned to outcomes

AXIOMS OF PREFERENCE RELATIONS

Axiom 1 Completeness
For any 2 bundles, A and B, either A B, or B A, or A~B.

Axiom 2 Transitivity
Consider any 3 bundles A, B and C. If A B and B C, then A C. Similarly, if A~B and B ~C, then A ~C.

Axioms 1 and 2 imply Rational Preference Relation

ADDITIONAL PROPERTIES OF PREFERENCE RELATIONS

Additional Property 1 More is preferred to less
Non-satiation Higher indifference curve.

Additional Property 2 Diminishing Marginal Rate of Substitutions (MRS)

As more of a good, say apples, is obtained, the rate at which she is willing to substitute, say, apples for bananas, decreases. Convexity
Marginal utility positive but falling as consumption of any good rises

REVEALED PREFERENCES
Paul Samuelson (1938) Addresses question of how to obtain information about preferences. Underlying reasoning:
Individuals reveal their preferences when choosing between alternatives

WEAK AND STRONG AXIOM OF REVEALED PREFERENCES

Requirement: Consistent choices

Weak Axiom of Revealed Preferences

Whenever bundle A is revealed preferred to bundle B, bundle B is never revealed preferred to bundle A.
With more then two bundles we might end up with a circle relationship Circle: A revealed preferred to B, B revealed preferred to C, C revealed preferred to A

Strong Axiom of Revealed Preferences

Given we have bundles B1, B2, , Bn. Suppose B1 is revealed preferred to B2, B2 is revealed preferred to B3, , Bn-1 is revealed preferred to Bn. Then B1 is revealed preferred to Bn.

EXPECTED UTILITY I
Assume:
Individual can choose between a number of risky alternatives (e.g. different lottery tickets) Each risky alternative may result in one of a number of possible outcomes (outcome is not known at the time of decision making) (e.g. possible lottery prizes) Probabilities of outcomes known. (probabilities of prizes of one lottery sum up to one) Preference relation is continuous and satisfies independence axiom.

EXPECTED UTILITY II
: expected utility : risky prospect , i = 1n: n possible outcomes : probability of outcome ( ): utility of outcome (Bernoulli utility function) Discrete case: Assume: = Example Flip coin twice For two heads or two tails you get 5 For one head and one tail you have to pay 2
= =1

= ( ) = ( ) =1

( ) = 2(0.5)2 5 + 2

0.5

2 = 1.5

ATTITUDE TOWARDS RISK I

Risk averse: Preferring a sure amount of X to a risky prospect with an expected value of X. Jensens inequality concave function Risk neutral: [ ]

Indifferent between risky prospect with an expected value of X and a sure amount of X.

Risk loving:

Preferring a risky prospect with an expected value of X to a sure amount of X.

[ ] ( )

[ ] = ( )

ATTITUDE TOWARDS RISK II

RISK AVERSION

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HOW TO MEASURE RISK AVERSION?

Arrow-Pratt Measures Arrow-Pratt Measure of Absolute Risk Aversion (ARA) () = ()

Arrow-Pratt Measure of Relative Risk Aversion (RRA) = =

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ARROW-PRATT MEASURES
Degree of risk aversion is related to the curvature of the utility function Curvature can be represented by second derivative BUT: The second derivative is not invariant to positive linear transformations, but our understanding of utility functions requires that Hence, we need to normalise the second derivative Normalising with respect to the first derivative gives a measure invariant to positive linear transformations

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ARROW-PRATT MEASURES
Decreasing relative risk aversion: A s wealth increases, the individual becomes less risk averse with respect to gambles that are the same in proportion to his wealth level. Decreasing relative risk aversion implies decreasing bsolute risk aversion, i.e. as wealth a increases, the individual becomes less risk averse with respect to gambles that are the same in absolute terms. Finance theory often assumes constant relative risk aversion.

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SYSTEMATIC VS. UNSYSTEMATIC RISK

Risk Systematic Risk (Market Risk)
Risk factors that affect a large number of assets, such as changes in GDP, inflation, interest rates, etc.

Unsystematic (Business Specific)

Risk factors that affect a limited number of assets, such as labor strikes, part shortages, etc.

Portfolio with different assets can eliminate diversifiable risk for the most part. As more and more assets are added to a portfolio, risk measured by decreases, but still some risk remains.

The relevant risk measure is Beta -factor, which measures the riskiness of an individual asset in relation to the market portfolio (see CAPM or SML). = 1.0 : same risk as the market < 1.0 : less risky than the market > 1.0 : more risky than the market

As most investors are Risk Averse they dont like risk and demand a higher return for bearing more risk. The standard deviation of returns is a measure of total risk Total risk = systematic risk + unsystematic risk.

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DECISIONS UNDER UNCERTAINTY

Maximax Criterion
Identify best outcome for each possible decision and choose the decision with the maximum payoff thereof

Maximin Criterion
Identify the worst outcomes for each decision and choose the decision with the maximum payoff thereof

Minimax Regret Criterion

Determine the worst potential regret associated with each decision and choose the decision with the minimum worst potential regret

Equal Probability Criterion

Assume each state of nature is equally likely to occur, compute the average payoff for each equally likely possible state of nature and choose the decision with the highest average payoff

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THE REAL OPTION APPROACH

Uncertainty creates opportunities.

Real Options View

Value

Managerial Options increase Value

Traditional View

Uncertainty Source:
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