Introduction to Management Science (10th Edition)

All the decision-making criteria presented so far in this chapter have been based on monetary value. In other words, decisions have been based on the potential dollar payoffs of the alternatives. However, there are certain decision situations in which individuals do not make decisions based on the expected dollar gain or loss.

For example, consider an individual who purchases automobile insurance. The decisions are to purchase and to not purchase, and the states of nature are an accident and no accident . The payoff table for this decision situation, including probabilities, is shown in Table 12.13.

Table 12.13. Payoff table for auto insurance example

The dollar outcomes in Table 12.13 are the costs associated with each outcome. The insurance costs $500 whether there is an accident or no accident. If the insurance is not purchased and there is no accident, then there is no cost at all. However, if an accident does occur, the individual will incur a cost of $10,000.

The expected cost ( EC ) for each decision is

Because the lower expected cost is $80, the decision should be not to purchase insurance. However, people almost always purchase insurance (even when they are not legally required to do so). This is true of all types of insurance, such as accident, life, or fire.

Why do people shun the greater expected dollar outcome in this type of situation? The answer is that people want to avoid a ruinous or painful situation. When faced with a relatively small dollar cost versus a disaster, people typically pay the small cost to avert the disaster. People who display this characteristic are referred to as risk averters because they avoid risky situations.

People who forgo a high expected value to avoid a disaster with a low probability are risk averters .

Alternatively, people who go to the track to wager on horse races, travel to Atlantic City to play roulette, or speculate in the commodities market decide to take risks even though the greatest expected value would occur if they simply held on to the money. These people shun the greater expected value accruing from a sure thing (keeping their money) in order to take a chance on receiving a "bonanza." Such people are referred to as risk takers .

People who take a chance on a bonanza with a very low probability of occurrence in lieu of a sure thing are risk takers .

For both risk averters and risk takers (as well as those who are indifferent to risk), the decision criterion is something other than the expected dollar outcome. This alternative criterion is known as utility . Utility is a measure of the satisfaction derived from money. In our examples of risk averters and risk takers presented earlier, the utility derived from their decisions exceeded the expected dollar value. For example, the utility to the average decision maker of having insurance is much greater than the utility of not having insurance.

Utility is a measure of personal satisfaction derived from money .

As another example, consider two people, each of whom is offered $100,000 to perform some particularly difficult and strenuous task. One individual has an annual income of $10,000; the other individual is a multimillionaire. It is reasonable to assume that the average person with an annual income of only $10,000 would leap at the opportunity to earn $100,000, whereas the multimillionaire would reject the offer. Obviously, $100,000 has more utility (i.e., value) for one individual than for the other.

In general, the same incremental amount of money does not have the same intrinsic value to every person. For individuals with a great deal of wealth, more money does not usually have as much intrinsic value as it does for individuals who have little money. In other words, although the dollar value is the same, the value as measured by utility is different, depending on how much wealth a person has. Thus, utility in this case is a measure of the pleasure or satisfaction an individual would receive from an incremental increase in wealth.

In some decision situations, decision makers attempt to assign a subjective value to utility. This value is typically measured in terms of units called utiles . For example, the $100,000 offered to the two individuals may have a utility value of 100 utiles to the person with a low income and 0 utiles to the multimillionaire.

Utiles are units of subjective measures of utility .

In our automobile insurance example, the expected utility of purchasing insurance could be 1,000 utiles, and the expected utility of not purchasing insurance only 1 utile. These utility values are completely reversed from the expected monetary values computed from Table 12.13, which explains the decision to purchase insurance.

As might be expected, it is usually very difficult to measure utility and the number of utiles derived from a decision outcome. The process is a very subjective one in which the decision maker's psychological preferences must be determined. Thus, although the concept of utility is realistic and often portrays actual decision-making criteria more accurately than does expected monetary value, its application is difficult and, as such, somewhat limited.