Managerial Economics Chapter-5: Decision Making Under Risk and Uncertainty

CHAPTER FIVE

DECISION MAKING UNDER RISK AND UNCERTAINTY

5.1. The Nature of Decision Making

It was assumed that the decisions of both consumers and producers were based on complete and
accurate knowledge of consumer, firm, and market conditions. In fact, however, most economic
decisions are made with something less than perfect information, and the consequences of these
decisions cannot, therefore, be known beforehand with any degree of precision. A manager
cannot know, for example, whether the introduction of a new product will be profitable because
of the uncertainty of macroeconomic conditions, consumer tastes, and reactions by competitors,
resource availability, input prices, labor unrest, political instability, and so forth. In addition to
the uncertainty associated with decisions made at any point in time, the uncertainty of outcomes
associated with those decisions tends to increase the further we project into the future.

The ability to make good decisions is the key to successful managerial performance. All
decision-making shares several common elements. Once the source/s of the problem are
identified, the manager can move to an examination of potential solutions. The choice between
these alternatives depends on an analysis of the relative costs and benefits, as well as other
organizational and societal constraints that may make one alternative preferable to another.

The final step in the decision-making process, after all alternatives have been evaluated, is to
analyze the best available alternative under a variety of changes in the assumptions before
making a recommendation. This crucial final step is referred to as a sensitivity analysis.
Knowing the limitations of the planned course of action as the decision environment changes, the
manager can then proceed to an implementation of the decision, monitoring carefully any
unintended consequences or unanticipated changes in the market. This six-step decision-making
process is illustrated in Figure 5.1.

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Managerial Economics Chapter-5: Decision Making Under Risk and Uncertainty

Figure 5.1: The decision-making process

5.2. Meaning and Measurement of Risk

Risk implies a chance for some unfavorable outcome to occur—for example, the possibility that
actual cash flows will be less than the expected outcome. Risk implies a degree of uncertainty
and an inability to fully control the outcomes or consequences of such an action. Risk or the
elimination of risk is an effort that managers employ.

When a range of potential outcomes is associated with a decision and the decision maker can
assign probabilities to each of these possible outcomes, the risk is said to exist. A decision is said
to be risk-free if the cash flow outcomes are known with certainty. A good example of a risk-free
investment is U.S. Treasury securities. There is virtually no chance that the Treasury will fail to
redeem these securities at maturity or that the Treasury will default on any interest payments
owed. In contrast, US Airways bonds constitute a risky investment because it is possible that US
Airways will default on one or more interest payments and will lack sufficient funds at maturity
to redeem the bonds at face value. In summary, risk refers to the potential variability of
outcomes from a decision. The more variable these outcomes are the greater the risk.

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Managerial Economics Chapter-5: Decision Making Under Risk and Uncertainty

5.3. Approaches of Incorporating Risk into Decision Making Process

As there are different kinds of decisions, there are also different conditions in which decisions
must be made. The manager must be aware of the environment in which s/he makes decisions.
Decision making like other management functions doesn’t take place in a vacuum. There are
factors in the environment that affect the process & the decision-maker. In some situations, one
manager can have perfect knowledge/ understanding of what to do & what the consequence of
the action will be; whereas in others has no such knowledge or have few clues.

Decisions are made under the conditions of certainty, risk & uncertainty. These different
decision-making environments/ circumstances require different responses from a manager.

Decision making conditions/ environments

Certainty Risk Uncertainty

Level of ambiguity & chance of making bad

decision

Lower moderate higher

Fig 5.2: The decision-making condition

1) Decision-making under conditions of certainty

The term certainty refers to accurate knowledge of the outcome of each alternative. All relevant
data are available for making decisions. Under complete certainty conditions, all relevant
information about the decision variables and outcomes is known or assumed to be known.

For example, a company wants to transport goods from five warehouses to several customers. It
is possible to obtain the relevant facts for the problem like the type of transport available, and the
cost of transporting a unit from each warehouse to each customer. With this, it is possible to
design the least cost distribution pattern.

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Managerial Economics Chapter-5: Decision Making Under Risk and Uncertainty

2) Decision-making under conditions of uncertainty

Uncertainty is said to exist when the decision maker does not know the probabilities associated
with the possible outcomes, though s/he has been able to identify the possible outcomes and their
related pay-offs. Since the probabilities are not known, the decision maker cannot use the
criterion of maximizing the payoff.

This is the most difficult situation for managers. It is like being a pioneer/ breaking new ground.
The manager may be dealing with too many variables, or perhaps there are too many unknown
facts. The management is unable to accurately predict the probable results of choosing any one
of the alternatives. Reliance on experience, judgment & other people’s experience can assist the
manager in assessing the value of the alternatives. In this case, no information is available on
how likely the various states of nature are under those conditions.

The Four possible decision criteria are Maximin, Maximax, Laplace, and Minimax regret.
i) Maximin: Determine the worst possible pay-off for each alternative, and choose the
alternative that has the “best worst.” The Maximin approach is essentially a pessimistic
one because it takes into account only the worst possible outcome for each alternative.
The actual outcome may not be as bad as that, but this approach establishes a “guaranteed
minimum.”
ii) Maximax: Determine the best possible pay-off, and choose the alternative with best pay-
off. The Maximax approach is an optimistic, “go for it” strategy; it does not take into
account any pay-off other than the best.
iii) Laplace: Determine the average pay-off for each alternative, and choose the alternative
with the best average. The Laplace approach treats the states of nature as equally likely.
iv) Minimax regret: Determine the worst regret for each alternative, and choose the
alternative with the “best worst.” This approach seeks to minimize the difference between
the pay-off that is realized and the best pay-off for each state of nature.

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Managerial Economics Chapter-5: Decision Making Under Risk and Uncertainty

Example:
Referring to the pay-off table, determine which alternative would be chosen under each of these
strategies: (a) Maximin, (b) Maximax, and (c) Laplace

Possible future demand

Alternatives
Low Medium High
Small Facility 10 10 10
Medium Facility 7 12 12
Large Facility (4) 2 16

SOLUTION:
(a) Using Maximin, the worst pay-offs for the alternatives are:
Small facility: $10 million
Medium facility: $7 million
Large facility: $–4 million
Hence, since $10 million is the best, choose to build the small facility using the maximum
strategy.
(b) Using Maximax, the best pay-offs are:
Small facility: $10 million
Medium facility: $12 million
Large facility: $16 million
The best overall pay-off is the $16 million in the third row. Hence, the Maximax criterion
leads to building a large facility.
(c) For the Laplace criterion, first find the row totals, and then divide each of those amounts by
the number of states of nature (three in this case). Thus, we have:
Raw
Alternatives Raw total
Average
Small Facility 30 10
Medium Facility 31 10.33
Large Facility 14 4.6

Because the medium facility has the highest average, it would be chosen under the Laplace criterion

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Managerial Economics Chapter-5: Decision Making Under Risk and Uncertainty

D) To determine which alternative would be chosen using a Minimax regret approach: The first
step in this approach is to prepare a table of opportunity losses, or regrets.
To do this, subtract every pay-off in each column from the best pay-off in that column. For
instance, in the first column, the best pay-off is 10, so each of the three numbers in that column
must be subtracted from 10. Going down the column, the regrets will be 10 – 10 = 0, 10 – 7 = 3,
and 10 – (– 4) = 14. In the second column, the best pay-off is 12. Subtracting each pay-off from
12 yields 2, 0, and 10. In the third column, 16 is the best pay-off. The regrets are 6, 4, and 0.
These results are summarized in a regret table:
Possible future demand
Alternatives Worst
Low Medium High
Small Facility 0 2 6 6
Medium Facility 3 0 4 4
Large Facility 14 10 0 14

The second step is to identify the worst regret for each alternative. For the first alternative, the
worst is 6; for the second, the worst is 4; and for the third, the worst is 14. The best of these
worst regrets would be chosen using Minimax regret. The lowest regret is 4, which is for a
medium facility. Hence, this alternative would be chosen.
3) Decision-making under conditions of risk
This situation provides a more difficult decision-making environment than the certainty situation.
In this situation, the manager knows what the problem is; what the alternative are; but doesn’t
know how each alternative will work out even though s/he knows the odds (probabilities) of
possible outcomes. The manager is faced with dilemma of choosing the best alternative
available. Between the two extremes of certainty and uncertainty lies the case of risk: The
probability of occurrence for each state of nature is known. (Note that because the states are
mutually exclusive and collectively exhaustive, these probabilities must add to 1.00.) A widely
used approach under such circumstances is the expected monetary value criterion.

The expected value is computed for each alternative, and the one with the highest expected value
is selected. The expected value is the sum of the pay-offs for an alternative where each pay-off is
weighted by the probability for the relevant state of nature.

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Managerial Economics Chapter-5: Decision Making Under Risk and Uncertainty

Example:
Determine the expected pay-off of each alternative, and choose the alternative that has the best-
expected pay-off. Using the expected monetary value criterion, identify the best alternative for
the previous pay-off table for these probabilities: low = 0.30, moderate = 0.50, and high = 0.20.
Using the above example

SOLUTION:
For each state of nature by the pay-off for that state of nature and summing them:
EV small facility = 0.30 ($10) + 0.50 ($10) + 0.20 ($10) = $10
EV medium facility = 0.30 ($7) + 0.50 ($12) + 0.20 ($12) = $10.5
EV large facility = 0.30 ($–4) + 0.50 ($2) + 0.20 ($16) = $3
Hence, choose the medium facility because it has the highest expected value

 There are four ways to manage the risk and uncertainty:

 Insurance (Business risks are transferred through Insurance Policies)
 Hedging is a mechanism whereby the expected loss is to be offset by an expected profit
from another contract.
 Diversification is a method of managing the risk where the risk is spread to various
investments and thus the risk is minimized to each investment.
 Adjusting risk is the mechanism whereby the provision is made to offset the expected
loss.

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Managerial Economics Chapter-5: Decision Making Under Risk and Uncertainty

Self-test Exercises

Dear student, please attempt the following question to further understand the concept of the
chapters.

T. Bone Pucket, a corporate raider, has acquired a textile company and is contemplating the
future of one of its major plants, located in South Carolina. Three alternatives decisions are being
considered:

1. Expand the plant and produce lightweight, durable materials for possible sales to military,
a market with little foreign competition;
2. Maintain the status quo at the plant, continuing production of textile goods that are
subject to heavy foreign competition; or
3. Sell the plant now.

If one of the first two alternatives is chosen, the plant will still be sold at the end of a year. The
amount of profit that could be earned by selling the plant in a year depends on foreign market
conditions, including the status of trade embargo bull in Congress. The following payoff table
describes this decision situation:

Determine the best decision by using the following decision criteria:

(a) Maximax

(b) Maximin

(c) Minimax regret

(d) Equal likelihood

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