9781118041581

Risk Aversion 519

decision makers that if untoward risks developed, they could be managed and

controlled. Though there were numerous instances in which workers, engi-

neers, and middle managers raised safety concerns, top managers, in the thrall

of Group Think, could downplay these concerns and maintain an unshakeable

consensus in favor of the company’s aggressive strategic plan.

Finally, BP could have drawn strong lessons from a decade of experience—

a series of disasters stemming from the company’s aggressive risk-taking attitude.

In March 2005, BP’s Texas City plant exploded killing 15 people and injuring

170 others, making it the worst industrial accident in a generation. Later that

year, a series of cost-cutting decisions, shoddy operations, and mistakes nearly

sank one of BP’s $1 billion rigs in another part of the Gulf. In 2006, BP suffered

a nearly 300,000 gallon oil leak in its pipeline in Prudhoe Bay, Alaska. Though

BP changed its top leadership in 2007 and pledged to recommit itself to improv-

ing safety, the company’s core culture did not significantly change.

RISK AVERSION

Thus far, we have used the concept of expected monetary value as a guide to

making decisions under uncertainty. A decision maker who follows the

expected-profit criterion is said to be risk neutral.This standard is appropriate

for a manager who is willing to play the averages. The evidence suggests, how-

ever, that individuals and firms are not neutral toward risks that are large rela-

tive to their financial resources. When it comes to significant risks, individuals

and institutions adopt an attitude that is conservative toward losses. Thus, the

use of the expected-profit criterion must be qualified.

A COIN GAMBLE You are offered the following choice: You can receive $60

for certain (the money is yours to keep), or you can accept the following gam-

ble. A fair coin is tossed. If heads come up, you win $400; if tails come up, you

lose $200. Would you choose the sure $60 or accept the gamble on the coin

toss? In answering, imagine that real money (your own) is at stake.

When given this choice, the majority of individuals prefer the sure $60 to

the gamble. This is not surprising given the magnitude of the risk associated

with the coin toss. Notice, however, that choosing $60 is at odds with maxi-

mizing expected profit. The expected profit of the coin toss is (.5)(400) 

(.5)(200) $100. Thus, a risk-neutral decision maker would prefer the gam-

ble to the sure $60. Refusing the bet shows that you are not risk neutral when

it comes to profits and losses of this magnitude.

A precise way to express one’s evaluation of the coin toss (or any risky

prospect) is to name a certainty equivalent. The certainty equivalent (CE)is the

amount of money for certain that makes the individual exactly indifferent to

the risky prospect. Suppose that, after some thought, you determine you would

be indifferent to the options of receiving $25 for certain or facing the risk of the

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