Risk Taking and Decision Making

MANG 6134

Time allowed: 2 hours plus 15 minutes reading time (During the 15 minutes reading time
you will be permitted to make rough notes)

Answer any THREE questions.

Each question carries equal marks.
Unless otherwise stated, please answer ALL parts of a question you choose to answer.

Calculator permitted (University model only).

A foreign language translation dictionary is permitted provided it contains no notes, additions or

annotations.
Electronic dictionaries are NOT permitted.

Graph paper is available if required.

June 2012
Answer any THREE questions. Each question carries equal marks.

1. The Management School of Harvampton University (MSHU) are trying to decide which
new MSc programmes to offer in the following year.

(a) Describe the types of information that MSHU will require in order to develop a payoff
matrix to aid their decision making and discuss the potential sources of this information.
(30 marks)

(b) Discuss at what stage of the decision analysis process MSHU should form the payoff
matrix and the role the payoff matrix should play in the decision analysis process. (40
marks)

(c) Outline some of the difficulties of applying the payoff matrix approach, other than the
availability of appropriate data, and discuss how these difficulties might be overcome. (30
marks)

2. Summermute is attempting to secure the services of a new programmer, Fu, for their
organisation. They are now entering into negotiations with Fu, regarding the salary he will
be paid.

(a) Describe the conditions which need to exist to enable Summermute to model the
problem of which strategy to choose in these negotiations, as a zero sum game. (15 marks)

Summermute (S) are also purchasing some new computer equipment from Pear plc (P) and
both parties believe they each have three potential strategies they can adopt in these
negotiations, S1, S2, and S3 and P1, P2 and P3, respectively. They both expect that the
amount (£00,000) which S will be charged for the computer equipment will depend upon
the negotiation strategies adopted by both P and S, as follows:

S’s strategies

S1 S2 S3

P’s P1 4 5 5

strategies P2 2 4 7

P3 4 9 6

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(b) (i) Identify the two potential saddle points to these negotiations. (10 marks)

(ii) Explain your method for identifying these potential saddle points. (10 marks)

(iii) Discuss whether either of these potential saddle points represents a stable outcome to
the negotiations. (10 marks)

S is informed by a senior member of their purchasing team that they agree with the
estimated costs of purchasing in the gain matrix shown above if S adopts S2 or S3.
However, they believe the costs of purchasing the equipment if S employed strategy S1 will
be double those shown in the gain matrix above (i.e., will be 6, 4 and 8 if P adopts
strategies P1, P2 and P3, respectively).

(c) If the member of the purchasing team is correct what would be P’s optimal negotiation
strategy/ies and how much would S pay for the computer equipment? (20 marks)

S later determines that the costs that the senior member of their purchasing team suggests
are correct. In addition, S develops a new negotiating strategy S4, which results in S paying
(£00,000): 1, 8 and 1 if P adopts strategies P1, P2 and P3, respectively. What proportion of
the time should S consider adopting this new strategy in the negotiations? (25 marks)

(d) Explain why it may be more appropriate to treat the negotiations between S and P as a
non-zero sum game. (10 marks)

3. (a) Discuss under what conditions a decision maker, when choosing between a number of
competing strategies, might choose the strategy which was associated with the maximum
expected monetary value. (20 marks)

A decision maker, Victor Chandler (VC) is seeking to make carbon emissions savings
(CES) for his business, measured in (‘000) tons. A consultant asks VC a series of questions.
For each of these questions VC must choose between receiving a fixed amount of CES or
selecting a ball at random from an opaque jar which contains 100 balls, ‘B’ of which are
blue and ‘100-B’ of which are red. If VC chooses the uncertain alternative and pulls out a
blue ball they will be given CES (‘000) of 50 and if they pull out a red ball they will gain
no CES. The fixed CES and the number of blue balls in the opaque jar are varied in order to
discern the point at which VC is indifferent between receiving the fixed amount of money
and selecting at random a ball from the opaque jar. The number of blue balls in the opaque
jar and the fixed amounts of CES (‘000) for which VC is indifferent were as follows:

Fixed amount of carbon emission Number of blue balls

savings (CES, ‘000 tons)) in the jar (B)

5 10

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 18 30

22 50

40 80

(b) (i) Draw the VC’s utility curve for carbon emission savings (CES) for CES(‘000)
between 0 and 40, assuming that the VC’s attitude to risk(averse/neutral or preferring) for
all CES (‘000) less than 5 is similar to his risk attitude for 5, his risk attitude for CES > 5
but ≤ 18 is similar to his risk attitude for 18, his risk attitude for CES > 18 but ≤ 22 is
similar to his risk attitude for 22, and his risk attitude for CES> 22 but ≤ 40 is the same as
his risk attitude for 40. (20 marks)

(ii) Identify VC’s risk attitude for different amounts of CES and explain how you reached
this conclusion. (20 marks)

VC must decide which of three strategies he should adopt to maximise the carbon emission
savings of his business over the next three years, A, B or C. The amount of carbon emission
savings by his business over the next three years, measured in tons (‘000), after applying
these strategies is expected to depend upon the level of demand in the economy over that
period (high or low). Consequently, if A is adopted, carbon savings are expected to be 5
and 40 if demand is high and low, respectively. If B is adopted, carbon savings are
expected to be 22 whether demand is high or low. If C is adopted, carbon savings are
expected to be 40 and 5 if demand is high and low, respectively.

(c) What must the VC’s subjective probability of a high level of demand in the economy be
in order for him to select strategy B? (30 marks)

(d) Outline two difficulties of applying utility analysis to aid decision making. (10 marks)

4. (a) Outline the elements of an effective system for developing subjective probability
estimates and discuss the value of each stage of the process. (30 marks)

(b) Explain why most methods employed for helping decision-makers to ‘visualise’ the
chances of an event when eliciting their subjective probability are not appropriate for rare
events. (15 marks)

(c) Outline two approaches that can be employed to develop accurate subjective
probabilities for rare events. (30 marks)

(d) Discuss the advantages of employing these ‘rare event’ techniques and why they are
usually both employed for assessing the same subjective probability. (25 marks)

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5. A financial market spread-trading company Universalspreads (U) is in the process of
expanding the products it offers in the Far East. U is trying to decide which of three new
products it should launch in the coming year and estimates that the profit (£M) they will
make from these products over the next three years will depend upon whether the economic
growth in Asia during this period is high, medium or low, as follows:

Economic
Growth in
Asia

H M L

Launch A 10 5 7

Product: B 15 2 5

C 5 10 12

U’s economist predicts that the chances of high, medium and low growth rates being
experienced in Asia over the next three years are 0.7, 0.2 and 0.1, respectively.

(a) Describe how decisions are arrived at using Markowitz’s risk return model and discuss
how risk is accounted for in this model. (15 marks)

(b) Identify under what circumstances product B would be selected if the Markowitz’s risk
return model were employed by U to help determine which product to launch. (20 marks)

(c) Draw the risk/return diagram for U’s decision and discuss why these diagrams are a
useful aid to decision making, especially where the decision maker has a large number of
potential strategies to choose from. (20 marks)

In addressing the Board, the Managing Director of U, says that he does not trust the
probability estimates of the economist.

(d) Discuss how you might go about dealing with the potential unreliability of the
economist’s estimates, without abandoning the estimates completely. No calculation
required. (15 marks)

Assuming, now, that the Managing Director wanted to ignore the economist’s estimates
altogether.

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(e) Explain why product C would be selected if adopting the insufficient reason criterion
and discuss what assumptions are likely to have been made if product A was selected on the
basis of the regret criteria. (15 marks)

(f) Discuss the relative strengths of the regret and coefficient of optimism criteria. (15
marks)

6. (a) Describe the ‘anchoring and adjustment’ heuristic and the ‘representativeness’
heuristic, discuss in what ways they can impact the over- and under-estimation of
probability estimates involved in risk analysis and how these biases might be minimised.
(50 marks)

(a) Describe in what manner Prospect Theory suggests that decisions are reached in
practice and discuss to what extent this captures the important heuristics which have been
observed to affect decision making. (50 marks)