Decision Analysis for Management Judgment, 6th Edition

5Introduction to probability

Introduction

In Chapter 4, we discussed the analysis of decisions where risk was not considered a major factor. However, in many problems, the decision-maker is not sure what will happen if a particular course of action is chosen. A company considering the purchase of an expensive new machine is unlikely to be certain about the machine’s reliability, life span, and resale value. Similarly, an individual deciding whether or not to purchase household insurance has to consider risks such as burglary, flooding, or fire damage. In the next chapter, we will be looking at how to analyze decisions like these, but before this, we need to consider how the concept of probability can be used to provide a measure of the likelihood of different events occurring.

Numbers offer a precise way of measuring how likely it is that an event will occur, and most people will be familiar with the use of odds. While many decision-makers may be happy to use expressions such as ‘100-to-1 against’ or ‘evens,’ odds have the disadvantage that they are awkward to handle arithmetically when, for example, we want to determine the chances that a number of different outcomes will occur.

Because of this, we will be using the concept of probability in our decision models. Probabilities are measured on a scale from 0 (impossible) to 1 (certain). Note that that odds can be converted to probabilities. For example, odds of 50 to 1 against imply that there are 50 ‘chances’ that the ...