53 preference theory most formal analyses of business

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Unformatted text preview: the prescriptive decision analysis literature to outline first the mathematics underlying preference theory and then proceeds to evaluate critically its contribution to investment decision-making particularly in the upstream. 5.3 PREFERENCE THEORY Most formal analyses of business decisions involving risk and uncertainty, for example the EMV concept described above, assume that every individual or company has, or ought to have, a consistent attitude toward risk and uncertainty. The underlying assumption is that a decision-maker will want to choose the selected course of action by “playing the averages” on all options, regardless of the potential negative consequences that might result, to choose the course of action that has the highest expected value of profit. However as Hammond (1967) and Swalm (1966) observed, few executives adopt such an attitude toward risk and uncertainty when 86 making important investment decisions. Rather, decision-makers have specific attitudes and feelings about money, which depend on the amounts of money, their personal risk preferences, and any immediate and/or longer-term objectives they may have. As Bailey et al. (in press) argue: “In the case of industries like oil where risk plays such an important part in the thinking of executives, individual (or group) attitudes to risk and risk taking can be important.” Such attitudes and feelings about money may change from day to day and can even be influenced by such factors as business surroundings and the overall business climate at a given time (Newendorp, 1996 p138). Similar observations led Hammond (1967) and others (for example, Goodwin and Wright, 1991; Swalm, 1966) to argue that since the EMV concept does not include, in any quantitative form, the consideration of the particular attitudes and feelings the decision-maker associates with money, it may not provide the most representative decision criterion. These writers perceive preference theory as offering a useful tool to incorporate these attitudes and feelings regarding money into a quantitative parameter. The concepts of preference theory are based on some very fundamental, solid ideas about decision-making that are accepted by virtually everyone who has studied the theory (Newendorp, 1996). However, the real world application of preference theory is still very controversial and, some academics, and many business executives, question its value in the investment decision-making context. In the many articles and books on investment decision-making, preference theory is some times referred to as utility theory or utility curves. While the latter is used more frequently in the decision analysis literature, it is also used to describe another subject in economics. Hence, the term “preference theory” will be used here (Newendorp, 1996 p137). This section will discuss first the principles of preference theory before reviewing its applicability to investment decision-making in the upstream. In 1738 the mathematician Daniel Bernoulli published an ess...
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