Chapter 17: Making Decisions with Uncertainty

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Introduction: Risk . Thinking about riskIdentify the various possible outcomes and the probability of eachEstimate the expected value and compare it to the costEvaluate the risk in light of your portfolioDecide if it is too much risk for you to take based on your level of risk aversion. Expec

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Chapter 17: Making Decisions with Uncertainty

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1. Chapter 17: Making Decisions with Uncertainty

2. Introduction: Risk Thinking about risk Identify the various possible outcomes and the probability of each Estimate the expected value and compare it to the cost Evaluate the risk in light of your portfolio Decide if it is too much risk for you to take based on your level of risk aversion

3. Expected Value – 2 Possible Outcomes If you know the possible outcomes and the probability of each outcomes, you can calculate the expected value (mean) E(X)=px1+(1-p)x2

4. Expected Value – 3 Possible Outcomes If you know the possible outcomes and the probability of each outcomes, you can calculate the expected value (mean) E(X)= p1x1+ p2x2+(1- p1-p2) x3

5. How to Model (Think About) Risk A game wheel, divided into thirds, has payoff values of $100, $75, and $5 The cost to play is $50.00 Should you play the game?

6. How to Think About Risk (cont.) There are three possible outcomes $100 – Probability 1/3 $75 – Probability 1/3 $5 – Probability 1/3 The expected value of playing the game is 1/3 ($100) + 1/3 ($75) + 1/3 ($5) = $60 IF the wheel is biased toward $5 (2/3 chance, 1/6 for $100 and $75), the expected value is 1/6 ($100) + 1/6 ($75) + 2/3 ($5) = $32.50

7. Introductory Anecdote: TeleSwitch A telecom supplier, TeleSwitch, sells its product through distributors (rather than directly to customers) Its largest clients want to deal directly with TeleSwitch rather than through distributors The largest clients threaten to find another supplier if their request (to buy directly) is not accommodated

8. Introductory Anecdote: TeleSwitch TeleSwitch might lose large customers if it doesn’t accommodate the request Probability it would lose large customers = 0.6 Profits from large customers = $30 TeleSwitch might lose distributors (and its small customers) if it accommodates the request Probability TeleSwitch would lose distributors = 0.2 Profits from small customers = $100

11. Remember the Firm’s Entry Decision in Chap. 15? What if the probability the incumbent fights is 0.4?

12. Prob. incumbent fights = 0.4 Expected profit = (.6 * $5) + (.4 * -$5) = $3 - $2 = $1

13. 40% Chance Incumbent Fights

14. Natural Experiments To gather information about the benefits and costs of a decision you can run natural experiments Example: “difference in difference estimator” used by a national restaurant chain to test a special holiday menu Introduce the menu in half the restaurants in one area; the remaining restaurants serve as a “control group” Compare profitability

15. Natural Experiments (Cont.) Difference-in-difference estimator The first difference compares sales before and after the introduction of the menu The second difference is the difference in sales in the experimental and control groups Difference-in-difference ATTEMPTS TO control for unobserved factors that can influence changes (“confounding factors”)

16. Natural Experiments (Cont.) Difference-in-difference estimator Did profitability increase in both the experimental and the control groups? Did profitability increase in just the experimental group? DID SOMETHING ELSE HAPPEN?

17. Natural Experiments (Cont.) Difference-in-difference estimator Change in state minimum wage in New Jersey vs. nearby Pennsylvania Economists called several fast food restaurant chains before and after the change in the minimum wage They found employment at these locations grew with the minimum wage (the opposite of what economic theory predicts) Hmm….what could be confounding this result? (change in consumption patterns; labor turnover)

18. Natural Experiments (Cont.) Difference-in-difference estimator 1990 Americans With Disabilities Act Labor force participation of individuals who are disabled decreased At the same time labor force participation of individuals who are not disabled did not decrease What confounding factors might there have been? (e.g., the generosity of public assistance programs)

19. Minimizing Expected Error Costs Politicians, managers often want to minimize error costs (to save their jobs, to not look bad, etc.) Example: “Should we impose a carbon tax?” Possible error: we impose a tax but global warming is not caused by human activity Cost of this error: Slows economic growth; lower income and significant short-run job loss (recession) Possible error: we fail to impose a tax but global warming is caused by human activity Cost of this error – depends on whether the carbon tax would significantly affect the projected warming

20. Minimizing Expected Error Costs Example: Should the government stop the sale of Toyota cars? Possible error: sales are stopped but accidents were due to human error Cost of this error: job loss at factories and dealerships (loss of income, health insurance, etc.) (1,000’s of workers worldwide) Possible error: sales are not stopped but the brakes were at fault Cost of this error: people are injured and die in accidents (unknown number)

21. Dealing with Uncertainty Uncertainty is unavoidable. So to cope with uncertainty in decision making, gather more or better information Best Buy has used dispersed sets of non-experts to predict future variables, such as a holiday sales rate Google uses internal prediction markets to generate demand and usage forecasting Emphasize flexibility, contingencies, create processes and incentives for individuals to adjust quickly when unforeseen events affect the firm

22. Dealing with Risk and Uncertainty

23. Thinking About a New Investment Identify the various possible outcomes and the probability of each (don’t forget about tax consequences and legal and regulatory issues) Compare the expected value to the cost Consider the incentives of the individuals who are involved (how clearly is responsibility assigned?) Evaluate the risk in light of your existing or planned portfolio Decide if it is too much risk for you to take on based on your level of risk aversion (your taste or distaste for risk)

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