Page 594 -

574 CHAPTER 13 DECISION ANALYSIS

Problem 16 asks you to We see that the optimal decision using the expected utility approach is d 3 , do not
use the expected utility invest. The ranking of alternatives according to the president’s utility assignments
approach to determine
the optimal decision. and the associated monetary value is as follows:

Ranking of Expected Expected
Decision Alternatives Utility Monetary Value

Do not invest 7.50 E 0
Investment A 7.35 9 000
Investment B 6.55 1 000

Note that whereas investment A had the highest expected monetary value of
E9000, the analysis indicates that Swofford should decline this investment. The
rationale behind not selecting Investment A is that the 0.2 probability of a
E50 000 loss was considered by Swofford’s president to involve a serious risk.
The seriousness of this risk and its associated impact on the company were not
adequately reflected by the expected monetary value of investment A. It was
necessary to assess the utility for each payoff to adequately take this risk into
account.
The determination of the appropriate utilities is not a trivial task. As we have
seen, measuring utility requires a degree of subjectivity on the part of the decision
maker, and different decision makers will have different utility functions. This aspect
of utility often causes decision makers to feel uncomfortable about using the
expected utility approach. However, if we encounter a decision situation in which
we are convinced monetary value is not the only relevant measure of performance,
utility analysis should be considered.

NOTES AND COMMENTS

1 In the Swofford problem, we used a utility of 10 2 Generally, when the payoffs for a particular
for the largest possible payoff and 0 for the decision-making problem fall into a reasonable
smallest. Had we chosen 1 for the utility of the range – the best is not too good and the worst is
largest payoff and 0 for the utility of the smallest, not too bad – decision makers tend to express
the utility for any monetary value M would have preferences in agreement with the expected
been the value of p at which the decision maker monetary value approach. Thus, as a guideline we
was indifferent between a certain payoff of M and suggest asking the decision maker to consider the
a lottery in which the best payoff is obtained with best and worst possible payoffs for a problem and
probability of p and the worst payoff is obtained assess their reasonableness. If the decision maker
with probability of (1 p). Thus, the utility for any believes they are in the reasonable range, the
monetary value would have been equal to the expected monetary value criterion can be used.
probability of earning the highest payoff. Often, However, if the payoffs appear unreasonably large
this choice is made because of the ease in or unreasonably small and if the decision maker
calculation. We chose not to do so to emphasize feels monetary values do not adequately reflect
the distinction between the utility values and the the true preferences for the payoffs, a utility
indifference probabilities for the lottery. analysis of the problem should be considered.

Copyright 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has
deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.