COMPUTER BASED PRESCRIPTIVE DECISION SUPPORT Ari Riabacke Department of Information technology and Media Fibre Science and Communication Network Mid Sweden University R–02–33 ISSN 1650-5387-2002:10 September 2002 Licentiate Thesis Department of Information technology and Media Mid Sweden University R-02-33 ISSN 1650-5387 2002:10 © 2002 Ari Riabacke Printed in Sweden 2002, Tryckeriet, Mid Sweden University I am based on a true story. To my wife Malin, our children Mi and Philippa and to Isak the proud big brother. Abstract The overall aim of this thesis is to study in what type of decision situations (involving risk and uncertainty) managers encounter problems and pitfalls, and to propose formalised methods for handling such situations. Traditionally, at least from an academic perspective, utility theory and the principle of maximising the expected utility has had a great influence on decision-making in such contexts. Even though this principle is often useful when evaluating a decision situation, it is not necessarily, despite what has often been claimed, the definition of rationality. And other approaches are definitely worth considering. The thesis has three main components. It develops a compilation of normative, descriptive and prescriptive theories within the area of risk taking and decision-making. Thereafter follows an empirical study examining some aspects of how managers define risk, how they handle risk, how they make risky decisions and how the organisational context affects the decision- making processes. This part contains an analysis of how managers make their choices from different risky prospects. Taking this into account, the third part brings attention to some of the problematic features of evaluation through utility theory and tries to constructively relax the demand for precise data in situations where only imprecise data are available. i ii Acknowledgements I would like to express my gratitude to: Prof. Love Ekenberg for believing in me, for always supporting me in my academic work, and for valuable guidance in the academic jungle as well as in life in general, i.e. for being an excellent supervisor. Nils Hagen at SCA who has helped me to get in contact with people important for this study. FSCN for considerable financial support. Dr. Marek Makowski, The Institute for Supplied Systems Analysis (IIASA), for patient supervision during Young Scientists Summer Program (YSSP). All fellow YSSPers for an unforgettable summer (2001) in Laxenburg. FORMAS for a generous grant which made that period possible. Dr. Johan Thorbiörnson for many fruitful discussions concerning scientific as well as existential matters. Fiona Wait and Katarina Riabacke, Institute of Information technology and Media (ITM), Mid Sweden University, for proof reading the manuscript. And finally my dear wife Malin for continuously proof reading draft versions of the manuscript and for being a wonderful mother, wife and life partner☺ Philippa and Isak for successfully helping me to divert my thoughts and for helping me focus on the really important things in life. iii iv Contents 1. Introduction..................................................................................................................... 1 2. Risk modelling................................................................................................................. 5 2.1. Definition of Risk ................................................................................................................. 5 2.2 Normative theory .................................................................................................................. 6 2.2.1 Normative rules for choice subject to risk...................................................................................... 6 2.2.2 Mathematical aggregation .............................................................................................................. 9 2.2.3 Aggregating preference judgements ............................................................................................. 11 2.2.4 Criticism against the normative theories ...................................................................................... 14 2.2.4.1 The expected value theory..................................................................................................... 14 2.2.4.2 The expected utility theory .................................................................................................... 15 2.2.4.3 Allais’ paradox ...................................................................................................................... 17 2.2.4.4 Irrelevant contextual effects .................................................................................................. 19 2.3 Descriptive theory............................................................................................................... 22 2.3.1 Descriptive approach to risky choice............................................................................................ 23 2.3.2 Prospect theory - an alternative to the expected utility theory as a descriptive model ................. 27 2.4 Prescriptive theory.............................................................................................................. 32 2.4.1 An example of prescriptive theory in which all three theories are used ....................................... 34 2.5 The decision-making context ............................................................................................. 39 2.5.1 Organisational structure................................................................................................................ 39 2.5.2 Mechanistic and organic organisational structure......................................................................... 40 2.5.3 Organisational culture................................................................................................................... 41 2.5.4 Autocratic and democratic culture, and levels of culture.............................................................. 42 2.6 Discussion ............................................................................................................................ 45 2.6.1 Normative, descriptive and prescriptive theories..........................................................................45 2.6.2 The structure and the culture ........................................................................................................ 47 3. How do managers make risky decisions? .................................................................... 50 3.1 Background ......................................................................................................................... 50 3.2 Attitudes towards risk ........................................................................................................ 52 3.2.1 What is risk?................................................................................................................................. 52 3.2.2 Risky situations ............................................................................................................................ 53 3.2.3 Risk and return – are they related? ............................................................................................... 54 3.2.4 Risk and uncertainty – are they related?....................................................................................... 55 3.3 Dealing with risk ................................................................................................................. 56 3.3.1 Can risk be managed?................................................................................................................... 57 3.3.2 Is it possible to identify risk-prone and risk-averse persons? ....................................................... 58 3.3.3 What do the managers think of themselves - are they risk prone or risk averse? ......................... 60 3.3.4 Do the managers use any computer-based decision aids when working with risk estimations and/or decision problems?.................................................................................................. 60 3.4 The decision-making context ............................................................................................. 61 3.4.1 The organisational structure and the decision-making culture ..................................................... 61 3.5 An analysis of how the managers choose risky prospects ............................................... 65 3.5.1 Certainty effect ............................................................................................................................. 65 3.5.2 The reflection effect...................................................................................................................... 68 3.5.3 The isolation effect ....................................................................................................................... 71 3.6 Discussion ............................................................................................................................ 73 4. Computerised risk modelling........................................................................................ 77 4.1 What problem areas have been identified? ...................................................................................... 77 v 4.2 Modelling risky prospects ..............................................................................................................