Expected Profit B


The results in Table 14.3 are shown as a bar chart in Figure 14.1. The height of each bar signifies the probability that a given outcome will occur. The probable outcomes for project A range from $4,000 to $6,000, with an average, or expected, value of $5,000. For project B, the expected value is $5,400, and the range of possible outcomes is from $0 to $12,000.

For simplicity, this example assumes that only three states of nature can exist in the economy: recession, normal, and boom. Actual states of the economy range from deep depression, as in the early 1930s, to tremendous booms, such as in the mid- to late 1990s, with an unlimited number of possibilities in between. Suppose sufficient information exists to assign a probability to each possible state of the economy and a monetary outcome in each circumstance for every project. A table similar to Table 14.3 could then be compiled that would include many more entries for columns 1, 2, and 3. This table could be used to calculate expected values as shown, and the probabilities and outcomes could be approximated by the continuous curves in Figure 14.2.

Figure 14.2 is a graph of the probability distribution of returns for projects A and B. In general, the tighter the probability distribution, the more likely it is that actual outcomes will be close to expected values. The more loose the probability distribution, the less likely it is that actual outcomes will be close to expected values. Because project A has a relatively tight

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