Decision Analysis for Management Judgment, 6th Edition

6Decision-making under risk

Introduction

In many decisions, the consequences of the alternative courses of action cannot be predicted with certainty. A company which is considering the launch of a new product will be uncertain about how successful the product will be, while an investor in the stock market will generally be unsure about the returns which will be generated if a particular investment is chosen. In this chapter, we will show how the ideas about probability, which we introduced in Chapter 5, can be applied to problems where a decision has to be made under conditions where there are risks.

We will first outline a method which assumes that the decision-maker is unable, or unwilling, to estimate probabilities for the outcomes of the decision, but which makes extremely pessimistic assumptions about these outcomes. Then, assuming that probabilities can be assessed, we will consider an approach based on the expected value concept that we met in Chapter 5. Because an expected value can be regarded as an average outcome if a process is repeated a large number of times, this approach is arguably most relevant to situations where a decision is made repeatedly over a long period. A daily decision by a retailer on how many items to have available for sale might be an example of this sort of decision problem. In many situations, however, the decision is not made repeatedly, and the decision-maker may only have one opportunity to choose the best course of action. If things ...