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Analysis of Decisions and Risks

Decision ElementsDecision and Risk Analysis IntuitionExpected Value Decision MakingConflicts of Interest and IncentivesExpected Utility Decision Making

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A Decision Frame Sets Analytic Range

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Decisions Require a Balanced Basis

Decision Basis has 3 parts:

1. Alternatives (Options)

2. Information (Analyses)

3. Preferences (Preferences)Also need a Decision Rule,

such as MACDADI, Decision Analysis, voting, bargaining, …

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Analysis of Decisions and Risks

Decision ElementsDecision and Risk Analysis IntuitionExpected Value Decision MakingConflicts of Interest and IncentivesExpected Utility Decision Making

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Intuition for Decision Analysis

Decision Analysis (DA)is applied Decision Theory; a Structured Conversation leading to Clarity of Action

“DA” is appropriate only if a conversation is possible and clarity is needed

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Uncertainty Makes Decisions ComplexHow Much Tornado-Proofing Makes Sense?

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Intuition for Risk Analysis

Often Important: Soil Conditions, Weather, Earthquakes, Defects, Real Estate Market …Rarely Important: Nuclear War (can’t act on the risk), labor rates (don’t change much)…

Magnitude of a risk = eventprobability times consequence

Probability

Con

sequ

ence

High Magnitude Risks

Low Magnitude Risks

Importance of risk for a decision =Effect on risk magnitude

Ear

thqu

ake

(she

ar w

alls

)E

arth

quak

e(s

hear

wal

ls)

Nuc

lear

War

(no

deci

sion

)N

ucle

ar W

ar(n

o de

cisi

on)

Price Escalation(minimize steel)Price Escalation(minimize steel)

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Analysis of Decisions and Risks

Decision ElementsDecision and Risk Analysis IntuitionExpected Value Decision MakingConflicts of Interest and IncentivesExpected Utility Decision Making

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Formal Method 1:Maximize Expected Value (Average Result)= Sum (probabilities times outcomes)

Ex: Structural Decision Using Expected Value

EV(Profit | Steel) =$30M x 0.50 + $0M x 0.50 = $15M

EV(Profit | Concrete) = $10M x 1.00 = $10M

ReinforcedConcrete

$10Mprofit

$10Mprofit

100%

Steel Steel is Cheap

50% (Heads)

Steel is Expensive50%(Tails)

$30Mprofit

$30Mprofit

$0Mprofit

$0Mprofit

How can a large, profit-seeking company choose between these structural design options?

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Analysis of Decisions and Risks

Decision ElementsDecision and Risk Analysis IntuitionExpected Value Decision MakingConflicts of Interest and IncentivesExpected Utility Decision Making

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Getting the Team to Decide Well is Complex

How can the company ensure employees make the best choices (e.g., Steel)?

Managers have differing payoffs from the company, “conflicts of interest” (e.g, politics, self-aggrandizement, personal aesthetic views)

This classic challenge is known as a “Principal Agent” problem.

A common solution: try to “align incentives” to share the benefits of success

What if your incentive for the structural decision was 10% of profit?

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What if your incentive for the structural decision was 10% of profit?

Best Decision Depends on Individual

$3M

$0M

100%$1M$1M

EV(Income | Steel) =$3M x 0.50 + $0M x 0.50 = $1.5M

EV(Income | Concrete) = $1M x 1.00 = $1M

What if you were a billionaire?

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Analysis of Decisions and Risks

Decision ElementsDecision and Risk Analysis IntuitionExpected Value Decision MakingConflicts of Interest and IncentivesExpected Utility Decision Making

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Ex: Structural Decision Using Expected Utility

To formally analyze decisions with “high risk,” assess each outcome’s utility (usefulness)

Formal Method 2:Maximize Expected Utility (Avg. Satisfaction)= Sum (probabilities times outcome utilities)

Good Market 50% (Heads)

Bad Market 50%(Tails)

$3M$3M

$0M$0M$1M$1M 100%

Example: assume that$3M is 1.5x as useful as $1M

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Intuition: Risk Attitude is PersonalRisk AverseIf each dollar is less useful than the last, it’s generally better to avoid big gambles

Risk Seeking (less common)If each dollar is more useful than the last, it’s generally better to take big gambles

Risk NeutralIf each dollar is about as useful as the last, decisions can use expected value

Rule of thumb: If range of outcomes is < 1/8 total wealth, use Risk Neutrality as an approximatione.g., Insure catastrophes onlyMACDADI uses risk neutrality, but can be changed

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Analysis of Decisions and Risks

Decision ElementsDecision and Risk Analysis IntuitionExpected Value Decision MakingConflicts of Interest and IncentivesExpected Utility Decision Making

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Questions and Comments