The expected monetary value method
The expected pay off as profit associated with a described combination of act and event is acquired by multiplying the pay off for that act and event combination by the probability of occurrence of the described event. The expected monetary value or EMV of an act is the sum of all expected conditional profits associated along with that act
Illustration
A manager has a choice among
i. A risky contract promising of shs 7 million along with probability 0.6 and shs 4 million along with probability 0.4 and
ii. A diversified portfolio consisting of two contracts along with independent outcomes each promising Shs 3.5 million along with probability 0.6 and shs 2 million along with probability 0.4
Could you arrive at the decision by using EMV method?
Solution
The conditional payoff table for the problem may be constructed as given below:
(Shillings in millions)
|
Event Ei
|
Probability (Ei)
|
Conditional pay offs decision
|
Expected pay off decision
|
|
|
(i)
|
Contract (ii)
|
Portfolio(iii)
|
Contract (i) x (ii)
|
Portfolio (i) x (iii)
|
|
Ei
|
0.6
|
7
|
3.5
|
4.2
|
2.1
|
|
E2
|
0.4
|
4
|
2
|
1.6
|
0.8
|
|
|
|
|
EMV
|
5.8
|
2.9
|
By using the EMV method the manager must go in for the risky contract that will yield him a higher expected monetary value of shs 5.8 million