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Unformatted text preview: University of Toronto, Department of Economics, ECO 204 2009 2010 S. Ajaz Hussain ECO 204 2009 2010 S. Ajaz Hussain (Draft) Chapter 7.1: Decision Making Under Uncertainty Please help improve the course by sending me an e mail about typos or suggestions for improvements Introduction Almost every decision in business, as in life, involves uncertainty. As such, it is critical to have an understanding of the various models, techniques, and methods for dealing with uncertainty. This chapter is an introduction to decision making under uncertainty: we show how a decision maker should choose between discrete, uncertain, choices with pecuniary outcomes; characterize attitudes towards risk; construct utility functions, and do simple applications 1 . Lets start by showing how to depict decision making under uncertainty 2 . 1. Decision Trees In ECO 204 we assume a decision maker must choose from a set of discrete choices where some of the choices involve uncertainty. For example: An investor must decide whether to invest or not invest in a risky project. An oil company must decide whether to drill or not drill for oil with no guarantee of finding oil. An investor must decide whether to invest today, invest later, or not invest in a risky project. A company must decide whether to settle a lawsuit out of court or go to trial. A movie studio must decide whether to hire a director who is notorious for cost over runs. In each of the examples above the decision maker must choose one of several discrete choices where at least one of the choices involves uncertainty. A useful way to represent decision making under uncertainty is through a decision tree. For example, suppose an investor must decide between 3 : 1 Note that we have examined uncertainty before: in chapter 5.3 we examined output and pricing in response to ex post uncertainty (for example, if demand is lower than expected). 2 Note to self: For summer 2010 version insert a section on probabilities. Also discuss how stochastic models do away with determinism, a controversial proposition in science (see for example Fellers early work) . 3 Please note: this is a slightly different example from the lectures. 1 ECO 204 (Draft) Chapter 7.1 University of Toronto, Department of Economics, ECO 204 2009 2010 S. Ajaz Hussain Investing $200m in a project which can be a success with probability 0.6, generating $800m in revenues and therefore $800m $200m = $600m in net profits, or a failure with probability 0.4, generating $0m in revenues and therefore $0m $200m = $200m in net profits. Not investing in the project and earning $0m (assumes the $200m sits under the mattress)....
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