By Julian Gough
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Extra resources for Fundamentals of Managerial Economics
Suppose we run a factory worth £100,000 and there is one chance in a thousand of it being burned down in a year. 001 (= £100). If an insurance company offered fire insurance for £110 the use of expected loss would lead us to disregard the insurance, as the expected loss of insuring is greater than the expected loss of not insuring. But if we felt that the loss of £100,000 was greater than we could stand, we would disregard expected loss and purchase insurance. To emphasise the point, suppose someone offered you, for just £1, a lottery ticket with a 50/50 chance of winning £10.
Consequently with the given utility function we would not invest, as the expected utility of not investing is higher than that of investing. Obviously in order to formulate decision problems in this utility form we need some sort of assessment of utility functions. ) and the variance of this return (a 2 ). Theoretically we can find indifference curves6 between expected return and variance (Fig. ). The shape of the curve (Fig. 4) then indicates the attitude of the investor towards risk. The indifference curve of the risk-averse investor would have a steep positive slope, showing that as variance increases expected return must increase steeply if the investor is to remain indifferent.
Consequently historical data may be a record of earlier mistakes. Finally, decision implies a choice among alternatives. At any given moment the decision-maker is faced with an infinite number of alternative actions, some of which he cannot be aware of. Therefore information even about the present is incomplete. In recent years techniques of decision-making have been developed which attempt to provide a systematic framework for analysing decisions under uncertainty. e. uncertainty can never be completely eliminated.