DECISION MAKING WITH RISK AND UNCERTAINTY

 Uncertainty – occurs when there is insufficient

information about what will happen ,or what will
probably happen in future.
 Risk – occurs when the future outcome from a

decision could be any of several different

possibilities.
Reducing uncertainty
 It can be reduced by obtaining more
information on which some reliance can be
placed.
 It is uncertainty of volume of sales demand for
a product:
 For established products estimates of future
sales can be, by taking historical sales figures
and making adjustment for sales growth or
decline and planned changes in the sales price.
 New products –estimate of sales demand is
difficult as no benchmark exist on which to
base.
 Uncertainty about future sales demand can be
reduced through market research.

 Using probabilities :expected values

 Expected values
 These can be used to analyse information
where risk can be assessed in terms of
probabilities of different outcomes.
 Worth of a decision can be the expected value
or weighted average of these outcomes.
 Expected values(EV) =weighted average of
possible outcomes.
 Weighted average is calculated by applying
probability of each possible outcome to
expected value of the outcome.
 EV=SUMMATION PX
 Where p=the probability of each outcome
 x= the value of each outcome.
 An expected value is a measurement of weighted
average value.
 A decision is based on selecting the course of action
that offers the highest of EV of profit or the lowest EV
of cost.
 That is the decision rule is to select the course of action
with the highest EV of profit or the lowest EV of cost.
 The main advantage is that it takes into account
uncertainty by considering the probability of each
possible outcome and using this information to
calculate an expected value. Also the information is
reduced to a single number resulting in easier
decisions.
 Example 1
 JB ltd has to decide which of the three projects
to select for investment. The three projects are
mutually exclusive and only one of them can
be selected. The projects do not involve any
initial capital expenditures. The expected
annual profit from investing in each of the
projects will depend on the state of the market.
The following estimates of annual profits
(operational cash flows) have been prepared.
 State of market declining static expanding
 Probability 0.4 0.3 0.3
 $ $ $
 Project 1 100 200 800
 2 0 400 600
 3 180 190 200

Required:
Identify which project would be selected if the
decision is to choose the project with the highest
expected value of annual profit.
 Expected value should be reliable for decision
making when:
 Probabilities can be estimated with reasonable
accuracy.
 The outcome from the decision will happen many
times and will not be a “one off” event.
 Example 2
 E and E Investments manufactures product pipe.
At the moment, when customers complain that
there is one or more defects in the product they
have bought, the company repairs the product, at
its own cost. Management is now considering a
new policy , whereby the company will accept no
liability at all for any defects in the product , but
will reduce the sales price by $6.00 per unit.
 The estimates of defects in each product, and cost
of repairs each defect, have been estimated from
historical records as follows:
 Number of defects probability cost probability
 per product of repairs
 $
 0 0.99 20 .20
 1 0.007 30 .50
 2 0.002 40 . 30
 3 0.001 - -
 The company makes and sells 10000units of
product pipe each month.
 Would it be cheaper to continue repairing faulty
products ,or would it be more profitable to reduce
the sales price by $6.00 per unit for all units of
the product?.
DECISION MAKING-MAXIMAX-MAXIMIN-MINIMAX

 A pay off table—profit table

 A profit table (payoff-table) can be a useful
way to represent and analyse a senario where
there is a range of possible outcomes and a
variety of possible responses.
 A payoff table simply illustrates all possible
profits/losses and as such is often used in
decision making under uncertanity.
EXAMPLE
 Getrude runs a kitchen that provides food for
various canteens throughout a large organisation.
A particular salad is sold to the canteen for
$10.00 and costs $8.00 to prepare, therefore, the
contribution per salad is $2.00
 Based upon past demands, it is expected that
during the 250 day working year, the canteen will
require the following daily quantities:
 On 25days of the year 40salads
 On 50 days of the year 50 salads
 On 100days of the year 60 salads
 On 75days of the year 70 salads

 The kitchen must prepare the salads in batches of

10 meals in advance. The manager has asked you
to help decide how many salads the kitchen
should supply for each of the forth coming year.
MAXIMAX
 The maximax rule involves selecting the
alternative that maximises pay off available.
 This approach would be suitable for an optimist
or risk seeking investor who seeks to achieve the
best results if the best happens.
 The manager who employs the maximax criterion
is assuming that whatever action is taken, the best
will happen: he or she is a risk taker.
 So how many salads should Getrude decide to
supply.
 Use profit table.

 MAXIMIN
 The maximin rule involves selecting that
alternative that maximises the minimum pay-
off achievable.
 The investor would at the worst possible
outcome at each supply level, then selects
 The highest one of these.
 The decision maker therefore chooses the
outcome which is guaranteed to minimise his
losses.
 In the process, he loses out on the opportunity of
making his profits.
 This approach would be appropriate for a
pessimist who seeks to achieve the best results if
the worst happens.
MIMIMAX REGRET
 Is one that minimises the maximum regret.
 The minimax regret criterion focuses on avoiding
the worst possible consequences that could result
when making a decision.
 It views actual losses and missed opportunities
as equally comparable.
 It is useful for a risk neutral decision maker.
 An ice cream seller, when deciding how much ice
cream to order (a small, medium, or large order), takes
into consideration the weather forecast (cold, warm, or
hot). There are nine possible combinations of order
size and weather, and the payoffs for each are shown in
BELOW:
 Decide the order size under the following:
 maxi maxi
 Maxi min
 Minimax regret
DECISION TABLE
ORDER/ COLD WARM HOT
WEATHER

SMALL 250 200 150

MEDIUM 200 500 300

LARGE 100 300 750

 1. Maximin
This criteria is based upon a risk-averse (cautious)
approach and bases the order decision upon
maximising the minimum payoff. The ice cream
seller will therefore decide upon a medium order,
as the lowest payoff is $200, whereas the lowest
payoffs for the small and large orders are $150
and $100 respectively.
 Maximax
This criteria is based upon a risk-seeking
(optimistic) approach and bases the order
decision upon maximising the maximum payoff.
The ice cream seller will therefore decide upon a
large order, as the highest payoff is $750,
whereas the highest payoffs for the small and
medium orders are $250 and $500 respectively.
 3. Minimax regret
This approach attempts to minimise the regret from
making the wrong decision and is based upon first
identifying the optimal decision for each of the
weather outcomes. If the weather is cold, then the
small order yields the highest payoff, and the regret
from the medium and large orders is $50 and $150
respectively. The same calculations are then
performed for warm and hot weather and a table of
regrets constructed below:
ORDER/ COLD WARM HOT
WEATHER

SMALL 0 300 600

MEDIUM 50 0 450

LARGE 150 200 0

 The decision is then made on the basis of the
lowest regret, which in this case is the large order
with the maximum regret of $200, as opposed to
$600 and $450 for the small and medium orders