Uncertainty and Expected Value

People face uncertain situations. 

For example, Nicole’s manager informs her that she will receive a higher bonus if the company performs well and a lower bonus if its performance is average.

Outcomes are the possible results in uncertain situations. For Nicole, these are higher or lower bonuses depending on the company’s performance.

Payoffs represent the value associated with each outcome. For Nicole, the payoffs are $10,000 for a higher bonus and $5,000 for a lower bonus.

Probability is a measure of the likelihood that a particular outcome will occur in a situation of uncertainty. For example, the probability of the company performing well or on average is assumed to be 0.5 each.

The expected value is calculated by multiplying each payoff by its probability of occurring and then summing the weighted payoffs.

Here, the expected value is the product of a $10,000 payoff, and its 0.5 probability added to the product of a $5,000 payoff and its 0.5 probability, resulting in $7,500.