Chapter 5.

Decision Making Under Risk and Uncertainty

5.1 The nature of Decision making

Decision making is the process of choosing the best among possible alternatives to maximize the value of
the firm.

Steps in Decision making Process involve the following:

1. Identify the problem

2. Specify objectives and criteria for a solution
3. Develop suitable alternatives
4. Analyze and compare alternatives
5. Select the best alternative
6. Implement the solution
7. Monitor to see that the desired result is achieved

5.2 Types of Decision Making Environments

The types of decisions people make depend on how much knowledge or information they have about the
situation. There are three decision-making environments:

1. Decision making under certainty- In the environment of decision making under certainty,
decision makers know with certainty the consequence of every alternative or decision choice.
Naturally, they will choose the alternative that will maximize their well-being or will result in the
best outcome. In the decision rules discussed so far an assumption of certainty has been developed
in which the manager is certain about the marginal benefits and marginal costs associated with the
decision he/she has taken.
2. Decision making under risk- Indecision making under risk, there are several possible outcomes
for each alternative, and the decision maker knows the probability of occurrence of each outcome.
3. Decision making under uncertainty- In decision making under uncertainty, there are several
possible outcomes for each alternative, and the decision maker does not know the probabilities of
the various outcomes. Decisions are sometimes made under complete uncertainty: No information
is available on how likely the various states of nature are.

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5.3 Managerial Decisions under Risk and Uncertainty

5.3.1 Decision Making Under Risk

Meaning of risk

Risk is a decision making condition under which a manager can list all outcomes and assign probabilities
to each outcome. Or it refers to a situation in which possible future events can be defined and
probabilities assigned.

Rules for decision under Risk

I. Probability distribution: Probability is an expression of the chance that a particular event will
occur. The probabilities of all possible events sum to 1. So, Probability distribution: describes, in
percentage terms, the chances of all possible occurrences. The concept of probability distributions
is essential in evaluating and comparing investment projects.
II. Expected value: A widely applied measure is expected monetary value (EMV). The EMV for an
alternative is just the sum of possible payoffs of the alternative, each weighted by the probability
of that payoff occurring. Determine the expected payoff of each alternative, and choose the
alternative that has the best expected payoff. The average of all possible outcomes weighted by
their respective probabilities is calculated as
n
R̄=∑ Ri p i
i=1

R̄ = Expected value pi = probability in case i

n = number of possible outcomes Ri = value in case

III. Standard deviation: The standard deviation reflects the variation of possible outcomes from the
average. It measure the degree of dispersion of a probability distribution by the standard
deviation, which is indicated by the symbol δ , Thus, the standard deviation (δ) measures the
dispersion of possible outcomes from the expected value. The smaller the value of δ, the less
dispersed is the distribution, and the lower the risk involves.
IV. Coefficient of variation: the expected value rule only focuses on a decision which gives
maximum expected value regardless of the level of risk associated with the decision but this rule
considers both the expected value and the coefficient of variation for risk which directly related

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 with the level risk. Thus, according to this rule the decision to be chosen should be the one with
the higher expected value, smallest coefficient of variation, and low level of risk.

5.3.1.1 Approaches of incorporating Risk into Decision Making

Expected Utility Theory

It describes the managers’ attitude towards risk in relation to the marginal utility of profit they
assumed. Utility function measures utility associated with a particular level of profit. The level
that managers’ assume to drive utility from earning profit determines the risk level they want to
assume. Hence, Marginal utility (slope of utility curve) determines attitude toward risk
• Risk averse-If faced with two risky decisions with equal expected profits, the less risky
decision is chosen. Thus, managers have Diminishing MUprofit

• Risk loving-Expected profits are equal & the more risky decision is chosen. Thus,
managers have Increasing MUprofit

• Risk neutral-Indifferent between risky decisions that have equal expected profit. Thus
managers have constant MUprofit

5.3.2 Decision Making Under Uncertainty

Meaning of Uncertainty

Uncertainty is a decision making condition under which a manager cannot list all possible outcomes
and/or cannot assign probabilities to the various outcomes. Or it refers to situations in which there is no
viable method of assigning probabilities to future random events.

Rules of Decision under Uncertainty

Maximum rule: In using the optimistic criterion, the best (maximum) payoff for each alternative is
considered and the alternative with the best (maximum) of these is selected. Hence, the optimistic
criterion is sometimes called the maximax criterion.

Maximin rule: In using the pessimistic criterion, the worst (minimum) payoff for each alternative is
considered and the alternative with the best (maximum) of these is selected. Hence, the pessimistic

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criterion is sometimes called the maximin criterion. This criterion guarantees the payoff will be at least
the maximin value (the best of the worst values).

Minimax regret rule: Choose the alternative that has the least of the worst regrets. Determine worst
potential regret associated with each decision, where potential regret with any decision & state of nature
is the improvement in payoff the manager could have received had the decision been the best one when
the state of nature actually occurred. Manager chooses decision with minimum worst potential regret.

Equal probability (Laplace) rule: Assume each state of nature is equally likely to occur & compute
average payoff for each. Choose decision with highest average payoff.

Illustration Example 1.In the following payoff table the present value (in millions) for each alternative
under each state of nature is expressed. A decision is to be made concerning which size facility should be
constructed.

Required I- Using maximum rule

1st Identify the best payoff for each alternative

 Small facility: $10 million
 Medium facility $12 million
 Large facility $16 million
nd
2 choose the alternative with best payoff

Decision: construct a large facility

II. Using Maximin rule

1st Indentify the worst payoff for each alternative

 Small facility: $10 million
 Medium facility $7 million
 Large facility -$4 million
2nd Choose the alternative with maximum payoff

Decision: construct a small facility

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 III. Using Minimax regret rule

1st Construct a regret (or opportunity loss) table

• The difference between a given payoff and the best payoff for a state of nature

2nd Identify the worst regret for each alternative

• Small facility $6 million
• Medium facility $4 million
• Large facility $14 million
3rd Select the alternative with the minimum of the maximum(worst) regrets

Decision: Build a medium facility

V. Using laplace rule

1st The average payoff for each alternative is

 Small facility: (10+10+10)/3 = $10 million
 Medium facility (7+12+12)/3 = $10.33 million
 Large facility (-4+2+16)/3 = $4.67 million
2nd Choose the alternative with the best average payoff

Decision: construct a medium facility