9781118041581

2. The decision tree should accurately depict the chronology of the decision
   setting, that is, the sequence of decision nodes and chance nodes.


3. The expected-value criterion values a risky prospect by taking a weighted
   average of the possible monetary outcomes, the weight for each outcome
   being its probability:

The expected-value criterion is appropriate for a risk-neutral decision

maker, one who is willing to play the averages.

4. More generally, the principle of expected-utility maximization provides a
   consistent guide to decisions. In applying this principle, the manager
   constructs a utility graph that portrays his or her attitude toward risk. If the
   manager is risk neutral, this graph will be linear; if risk averse, it will be
   concave.


5. Whatever his or her attitude toward risk, the manager “solves” the decision
   tree by a process of “averaging and eliminating”—starting from the right
   and moving left. The expected utility (profit) at any chance node is found
   by averaging—that is, by multiplying branch utilities (or profits) by
   probabilities. At any decision node, the decision maker selects the
   alternative having the greatest expected utility (profit). All inferior decision
   branches are eliminated. The movement from right to left means that the
   last uncertainties are averaged first and the last decisions are evaluated first.

Questions and Problems

1. a. Average back the decision tree below, supplying expected monetary
   values for points A through E.
   b. One of your fellow managers is worried that there are no probabilities
   given for the branches leading from point D. In order to solve the

E(v)p 1 v 1 p 2 v 2  Ápnvn

532 Chapter 12 Decision Making under Uncertainty

.7

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$20

$5

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B

E

A

.2

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$50

$37

C D

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