9781118041581

problem starts with a point of decision, by convention represented by a square,

from which emanate two branches: the decisions to drill or not to drill. If the

choice is not to drill, the story ends there. The final profit outcome is $0, as

indicated at the tip of the branch. If the choice is to drill, a chance event, rep-

resented by a circle, occurs. The chance event summarizes the risk associated

with drilling. The two possible outcomes, a strike or a dry well, are shown on

the branches emanating from the circular chance node. The respective mon-

etary outcomes, $600,000 and $200,000, are listed next to the branch tips.

We need one final piece of information to complete the description of the

decision problem. This is the probability, in the wildcatter’s best judgment, that

the site will have oil. Suppose this probability is .4 (or a 40 percent chance). This

is listed on the chance branch corresponding to “wet.” Obviously, the probabil-

ity of dry must be .6, because wet and dry sites are the only two outcomes. For the

moment, let us suppose the wildcatter’s probability assessment is based on a com-

pleted geological survey of the site, his judgment of how this site compares with

other sites (with and without oil) that he has drilled in the past, and any other

pertinent information. (In Chapter 13, we will say much more about interpret-

ing, estimating, and revising probability projections of uncertain outcomes.)

All that remains is to specify a criterion by which the decision maker can

choose a course of action under uncertainty. The criterion we employ at the

outset of this chapter is expected value.

The expected-value criterioninstructs the manager to choose the course of action

that generates the greatest expected profit.

Let’s apply the expected-value criterion to determine the wildcatter’s best

course of action. The “do not drill” option results in a certain outcome of $0.

The expected profit from the “drill” option is

(.4)(600,000)(.6)(200,000)$120,000.

504 Chapter 12 Decision Making under Uncertainty

120

120

Do not drill

Drill

Wet

Dry

$0

$600

–$200

.4

.6

FIGURE 12.1

The Wildcatter’s

Drilling Problem

By drilling, the

wildcatter earns an

expected profit of

$120,000.

c12DecisionMakingunderUncertainty.qxd 9/29/11 1:34 PM Page 504