Risk Analysis: Managerial Economics

MANAGERIAL ECONOMICS:
THEORY, APPLICATIONS, AND CASES

W. Bruce Allen | Neil A. Doherty | Keith Weigelt | Edwin Mansfield
Chapter 14
RISK ANALYSIS
OBJECTIVES
• Explain how managers should make

strategic decisions when faced with
incomplete or imperfect information
MANAGEMENT TOOLS
• Expected value
• Decision trees
• Techniques to reduce uncertainty
• Expected utility
RISK AND PROBABILITY
• Risk: Hazard or chance of loss

• Probability: Likelihood or chance that
something will happen
RISK AND PROBABILITY
• Frequency definition of probability: Event’s limit

of frequency in a large number of trials
• Probability of event A = P(A) = r/R
• R = Large number of trials
• r = Number of times event A occurs
PROBABILITY DISTRIBUTIONS AND
EXPECTED VALUES
• Subjective definition of probability: Degree of a

manager's confidence or belief that the event will
occur
• Rules of probability
• Probabilities may not be less than zero nor greater
than one.
• Given a list of mutually exclusive, collectively
exhaustive list of the events that can occur in a
given situation, the sum of the probabilities of the
events must be equal to one.
PROBABILITY DISTRIBUTIONS AND
EXPECTED VALUES
• Subjective definition of probability (cont’d)

• Probability distribution: A table that lists all possible
outcomes and assigns the probability of occurrence to
each outcome
• i = Profit associated with the outcome i

• Pi = Probability of outcome i
COMPARISONS OF EXPECTED PROFIT
• Example: Jones Corporation is considering a

decision involving pricing and advertising. The
expected value if they raise price is
Profit Probability (Probability)(Profit )
$800,000 0.50 $400,000
-600,000 0.50 -300,000
Expected Profit = $100,000
• The payoff from not increasing price is

$200,000, so that is the optimal strategy.
ROAD MAP TO DECISIONS
• Decision tree: Diagram that helps managers

visualize their strategic future
• Figure 14.1: Decision Tree, Jones Corporation
DECISION TREE, JONES CORPORATION
Managerial Economics, 8e
Copyright @ W.W. & Company 2013
DECISION TREE, GENCO EXPLORATION
THE EXPECTED VALUE OF PERFECT
INFORMATION
• Expected Value of Perfect Information (EVPI)

• Increase in expected profit from completely accurate
information concerning future outcomes
• Jones Example (Figure 14.1)
• Given perfect information, the company will increase price if
the campaign will be successful and will not increase price if
the campaign will not be successful.
• Expected profit = $500,000, so EVPI = $500,000 – $200,000
= $300,000
MEASURING ATTITUDES TOWARD RISK:
THE UTILITY APPROACH
• Example
• A small business is offered the following choice:
1. A certain profit of $2,000,000
2. A gamble with a 50–50 change of $4,100,000 profit or a
$60,000 loss. The expected value of the gamble is
$2,020,000.
• If the business is risk averse, it is likely to take the
certain profit.
• Utility function: Function used to identify the
optimal strategy for managers conditional on
their attitude toward risk
• Constructing a Utility Function

• Expected utility: The sum of the utility of each
outcome times the probability of the
outcome’s occurrence
• Constructing a Utility Function (cont’d)

• Procedure
1. Arbitrarily assign utility levels to two payoffs with the higher payoff
set to a higher level of utility certain profit of $2,000,000. For the
Genco Exploration example, set U(–90) = 0 and U(500) = 50.
2. Next, ask the decision maker what value of P (probability) would
make them indifferent between a certain amount (say 100) and the
following gamble: P(50) + (1 – P)(0).
3. Suppose the decision maker sets P = 0.4, then U(100) = (0.4)(50)
+ (0.6)(0) = 20.
4. Continuing with this method will allow the derivation of utility for
any possible payoff.
UTILITY FUNCTION
ATTITUDES TOWARD RISK: THREE TYPES
• Risk averters: When managers prefer a choice

with a more certain outcome to one with a less
certain outcome when confronted with gambles
offering equal expected wealth
• Utility function has diminishing marginal utility.
ATTITUDES TOWARD RISK: THREE TYPES
• Risk lovers: When managers prefer a gamble

with a less certain outcome to one with a more
certain outcome, when confronted with gambles
offering equal expected wealth
• Utility function has increasing marginal utility.
• Risk neutral: When a manager maximizes expected
wealth, regardless of risk
• Utility function is linear and marginal utility is constant.
THREE TYPES OF UTILITY FUNCTIONS
THE STANDARD DEVIATION AND COEFFICIENT OF
VARIATION: MEASURES OF RISK
• Standard deviation: The most frequently used

metric for dispersion in a probability distribution
• 
• Coefficient of variation: V = /E()

• Figure 14.4: Probability Distribution of the Profit
from an Investment in a New Plant
PROBABILITY DISTRIBUTION OF THE PROFI T FROM
AN INVESTMENT IN A NEW PLANT
ADJUSTING THE VALUATION MODEL FOR
RISK
• Certainty equivalent approach: When a

manager is indifferent between a certain
payoff and a gamble, the certainty
equivalent (rather than the expected profit)
can identify whether the manager is risk
averse, risk loving, or risk neutral.
RISK
• Certainty equivalent approach (cont’d)

• If the certainty equivalent is less than the expected
value, then the decision maker is risk averse.
• If the certainty equivalent is equal to the expected
value, then the decision maker is risk neutral.
• If the certainty equivalent is greater than the expected
value, then the decision maker is risk loving.
RISK
• The present value of future profits, which

managers seek to maximize, can be
adjusted for risk by using the certainty
equivalent profit in place of the expected
profit.
RISK
• Indifference curves
• Figure 14.5: Manager's Indifference Curve between
Expected Profit and Risk
• With expected value on the horizontal axis, the
horizontal intercept of an indifference curve is the
certainty equivalent of the risky payoffs represented
by the curve.
• If a decision maker is risk neutral, indifference curves
will be vertical.
MANAGER’S INDIFFERENCE CURVE
BETWEEN EXPECTED PROFIT AND RISK
CERTAINTY EQUIVALENCE AND THE
MARKET FOR INSURANCE
• Example
• Managers hold $900 million in debt.
• There is a 25% chance that the value of the bonds
will fall to $400 million.
• There is a 75% chance that the value of the bonds
will remain constant.
• Expected value = $775 million
• Example (cont’d)
• Managers use the following utility function defined on
wealth (W): U = W0.5
• Expected utility = 27.5
• Certainty equivalent = W* = U2 = (27.5)2 = $756.25 million
• The certainty equivalent should be the manager’s reservation
price for selling the bonds at a discount.
• Example
• LBI Insurance Company provides full coverage of loss
and is risk neutral.
• LBI’s expected payout is $125 million, so that is the minimum
price for the policy.
• The most that the policy is worth to the buyer is the
difference between $900 million and the certainty equivalent
of $756.25 million, or $143.75 million.
• The risk premium is the difference between LBI’s reservation
price for the policy and the maximum amount the buyer
would pay: $143.75 – $125 = $18.75 million.
MANAGER’S INDIFFERENCE CURVE
BETWEEN EXPECTED RATE OF RETURN
AND RISK
This concludes the Lecture
PowerPoint Presentation for
Chapter 14: RISK ANALYSIS
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MANAGERIAL ECONOMICS:

THEORY, APPLICATIONS, AND CASES

• Explain how managers should make

• Risk: Hazard or chance of loss

• Frequency definition of probability: Event’s limit

• Subjective definition of probability: Degree of a

• Subjective definition of probability (cont’d)

• i = Profit associated with the outcome i

• Example: Jones Corporation is considering a

• The payoff from not increasing price is

• Decision tree: Diagram that helps managers

• Expected Value of Perfect Information (EVPI)

• Constructing a Utility Function

• Constructing a Utility Function (cont’d)

• Risk averters: When managers prefer a choice

• Risk lovers: When managers prefer a gamble

• Standard deviation: The most frequently used

• Coefficient of variation: V = /E()

• Certainty equivalent approach: When a

• Certainty equivalent approach (cont’d)

• The present value of future profits, which

Visit the StudySpace at:

W. W. Norton & Company

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