Zerbe and Bellas, Chapter 10

Risk and Uncertainty

Definitions and Concepts

1. States of the world (e.g., wet, dry)
2. Uncertainty - the ultimate state of the world is not known
3. Risk - probabilities attached to states of the world
4. Expected value: EV = p1*v1 + p2*v2; p1 + p2 = 1
5. Risk preferences

Sources of Uncertainty

1. Predicting the future
2. Measurement of benefits and costs

Sensitivity Analysis: variable by variable approach

1. List all uncertain and important variables
2. Identify the likely values in each state of the world
3. Calculate the NPV, BCR using each value of the variable
   a. Best case
   b. Most likely
   c. Worst case