MARY ANN M. REYES ALVIN LUCIANO A.

UBASA, DBA
DM 315 RISK MANAGEMENT PROFESSOR

THE CONCEPTS OF UNCERTAINTY AND DECISION-MAKING

UNCERTAINTY

The existence of uncertainty is an inescapable element of human existence. People

cannot know now what they will discover in the future. Yet future discoveries may co-
determine the pay-off/consequences of today’s decisions and shape future events relevant to
today’s decisions. There is only one certainty that people have with respect to the future. That
is that they may be surprised. Uncertainty is an inherent property of the future. It cannot be
reduced.

The existence of uncertainty leads to the role of confidence in people’s own

calculations, expectations, et cetera, in making their decisions. Confidence can fluctuate and
thereby impact our decisions and their consequences. Confidence is subjective. It cannot be
grounded in knowledge about the future, only about that of the past and present.

Broadly speaking, uncertainty refers to an epistemic state at the limits of knowledge. It

concerns what is known or believed without certainty. It also concerns what is not known. If
being certain means having clarity with regard to the truth, then being uncertain means having
an obscured view of the truth. The problem of uncertainty points not only to the limits of what
any individual might know, but also to the ultimate limits of what is knowable.

Within disciplines, uncertainty is rarely considered on its own. In business and

economics, it is often paired and compared with the term risk.

Risk and uncertainty

Taking two quick stops at the dictionary, we find the following:
1. risk: “possibility of loss or injury; peril”
2. uncertainty: “indefinite, indeterminate” and “not known beyond a doubt.”

In economics, the definitions of risk and uncertainty are different, and the distinction
between the two is clearer. Frank H. Knight established the economic definition of the terms in
his landmark book, Risk, Uncertainty, and Profit (1921):
1. risk is present when future events occur with measurable probability
2. uncertainty is present when the likelihood of future events is indefinite or incalculable
 Aside from Knight, the concept of (fundamental) uncertainty was also introduced in
economics by John Meynard Keynes. They felt a distinction should be made between risk and
uncertainty.

Difference between Risk and Uncertainty

Risk Uncertainty
Distinction in nature A measurable uncertainty An unknown risk
Probability of quantitative Can be quantitatively Cannot be measured in any
measurement measured by any form form
Insurance and insurability Certain risks can be fully Insurance is not possible
covered by taking insurance
policies such as fire, flood,
draught, theft, robbery etc
Transferability Can be transferred into Cannot be transferred
another risk
Elements of cost Cost of production includes Not included in the cost of
the cost of risk bearing also. production; the reality is that
Entrepreneur does not get the profit is the reward of the
any profit for risk bearing entrepreneur for bearing
uncertainty
Subjective and Objective Objective and measurable Subjective and can only be
realized
Knowledge of alternatives All the possible alternatives Such previous knowledge is
of a problem are known to not possible
the economists in advance
Nature of decisions Decisions taken under the
conditions of uncertainty are
more important than the Risk
decisions taken under the
conditions of Risk because
measurement of alternatives
is not possible in case of
uncertainty

So in common usage, the distinction between the two is that risk denotes a positive
probability of something bad happening, while uncertainty does not necessarily imply a value
judgment or ranking of the possible outcomes. Fundamentally, though, in common usage both
terms refer to a similar situation, in which some aspect of the future cannot be foreseen.

In case of risk all possible future events or consequences of an action or decision are
known. However, the events that will actually materialize are unknown beforehand. In case of
risk the probability calculus is applicable and provides a sound basis for risk management,
cost/benefit analysis, budget planning, etc.
 Both Keynes and Knight argued that often in human decisions not all possible outcomes
of an action or decision can be known. These are cases of (fundamental) uncertainty. There are
things people simply do not know in advance. In situations of uncertainty the probability
calculus has no sound foundation. There is no objective basis for risk management, cost/benefit
analysis and other control techniques.

Knight stresses that risk provides a basis for insurance. Uncertainty cannot be insured

against. Knight argued that entrepreneurs who dare to act in the presence of the unknown
future, emerged as a major response to fundamental uncertainty. Profits are their reward.
Without uncertainty no profits would exist.

In Keynes’ view uncertainty gave money, liquidity and finance in general a central role in
the economy. The existence of uncertainty of the future is the root cause for economies not
automatically tending to full employment. If people are not confident about their own
expectations, they do not want to commit themselves to irreversible investments. They would
like to remain liquid instead. Money in a way is a hedge against uncertainty. It allows its holder
to respond quickly and flexibly to any, at present unknown, future event when it occurs.

By holding money, you do not commit yourself. But the supply of money can be
increased without almost using any labor. A higher demand for money at the expense of
demand for goods and services creates unemployment. If confidence is low, an economy can be
locked into below full employment.

Sources of Uncertainty
Demand Structure
 customer preferences
 market size
 price responsiveness
 segmentation
Externalities
 industry structure
 government regulation
 influence of non-governmental organizations
 social norms
Supply Structure
 new products
 new processes
 new technology
Competitors
 nature of competitors
 strategies of competitors
 behavior of competitors
Internal Forces
 alignment of ownership
 behavior of management
 behavior of employees
 Time
 the rapidity of a phenomenon

Levels of Uncertainty

Clear Trends
These are factors that are plain and can be investigated without problems, and their
details are knowable, while the activities can be predictable on probing deeper therein. For
example: assumptions about upward trend in the society, market and economic bloc.

Unknowns that are Known

This second level of uncertainty is characterized by factors which when subjected to
proper analysis, their probability of outcome can be known. For example: demand trends and
consumer preferences.

Residual Uncertainty
This is the topmost level of uncertainty and its distinctive features are complexity and
futility in every attempt of people to conduct analysis for predicting occurrence. Therefore,
residual uncertainty normally causes fear, stress and discomfort to decision makers.
Nevertheless, movement from one position of time to another, may be able to downgrade it to
a lower level of uncertainty. For example: the effect of consumer choice on the future of
financial services.

Ways to Prepare for Uncertainty in Business

 There's just no way to completely prepare for the future of your business. All you can do
is stay up to date on current trends, forge quality relationships, and, above all, never assume.

If you've been in business for decades, you understand that circumstances change and
unforeseeable events occur. While you can't read the future, you can make smart choices to
prepare well for it. Not only will this provide you peace of mind, but you're more likely to
respond quickly and effectively when trouble strikes.
What Causes Uncertainty?
As much as we desire control and predictability, uncertainty is a permanent fixture in
business. While conditions may seem unfair at times, it's important to remember that most
people are exposed to the same effects. A brief look at various facets of business shows that at
least three uncontrollable factors can have a profound effect on your operations:
 Economic conditions. If the recessions in history taught us anything, it's that small
mistakes compounded over time and across the nation can have drastic consequences.
When an entire nation's economy hits a rough patch, this may require companies to cut
back on resources, hiring, and expenditures. Have a plan in place.
 Illness. Whether it's a flu bug traveling through the office or a more serious pandemic
issue like the present COVID-19 virus, illness is something you can't plan for but it
can lead to serious consequences.
 Shifts in consumer behavior. One reason many businesses eventually have to close up
shop is that consumers demand change. A product that satisfies a need or addresses a
pain point in the present may not do the same in six months, a year, or five years.

Preparing for Uncertainty: Practical Tips

By nature, not all future events can be fully prepared for, but you can equip your
company with the tools necessary to fend off potential threats by developing specific plans for
certain situations. Here are some practical tips designed to help your company prepare for the
unknown:
1.) Stay in the now. It's easy to get caught up in your own little world or bubble, but that's
an important trap to avoid. One of the best ways to combat financial uncertainty is
to stay abreast of economic indicators. By educating yourself on the general state of the
economy, what decisions are being made at the national level, and how economic
forecasts might affect your industry, you can put yourself a step ahead of others.
2.) Prepare for multiple outcomes. It's wise to stop assuming the most likely outcome will
turn up at the conclusion of every situation. A successful company prepares for multiple
outcomes regardless of what's expected. Foresight enables you to respond effectively in
all circumstances. The best way to prepare is to include all departments and employees
in the planning process. You'll get fresh, unique perspectives that are more likely to
result in critical and innovative thinking.
 3.) Consistently review. A forward-thinking company understands the value of analysis. Are
you consistently reviewing your business plan to ensure it is current? This is a
particularly helpful way to combat changes in consumer demands. If your business plan
is still addressing the needs of customers as they were five years ago, the odds are it's
out of date and in danger of extinction.
4.) Build relationships. In times of real trouble, is a computer going to help you regain solid
footing? It's possible, but unlikely. What you really need is support from peers and
partners. The best investment you can make for future stability is relationship building.
Whether it's tough times in a struggling economy, a lack of resources, or changes in
demand, healthy business relationships can help you weather the rough patches.
We’ve heard it said many times: the only certainty in life is change. This is particularly
true in business, where unpredictably has been at an all-time high in the past decade. Are you
properly prepared for the uncertainty into which your company is surely headed?

DECISION-MAKING
Decision making is the process of making choices by identifying a decision, gathering
information, and assessing alternative resolutions. Using a step-by-step decision-making
process can help you make more deliberate, thoughtful decisions by organizing relevant
information and defining alternatives. This approach increases the chances that you will choose
the most satisfying alternative possible.

Defining the business decision-making process

The business decision-making process is a step-by-step process allowing professionals to

solve problems by weighing evidence, examining alternatives, and choosing a path from there.
This defined process also provides an opportunity, at the end, to review whether the decision
was the right one.

Seven (7) decision-making process steps

 Though there are many slight variations of the decision-making framework floating
around on the Internet, in business textbooks, and in leadership presentations, professionals
most commonly use these seven steps.

1. Identify the decision

To make a decision, you must first identify the problem you need to solve or the
question you need to answer. Clearly define your decision. If you misidentify the problem
to solve, or if the problem you’ve chosen is too broad, you’ll knock the decision train off
the track before it even leaves the station.

If you need to achieve a specific goal from your decision, make it measurable and
timely so you know for certain that you met the goal at the end of the process.

2. Gather relevant information

Once you have identified your decision, it’s time to gather the information
relevant to that choice. Do an internal assessment, seeing where your organization has
succeeded and failed in areas related to your decision. Also, seek information from
 external sources, including studies, market research, and, in some cases, evaluation
from paid consultants.

Beware: you can easily become bogged down by too much information—facts and
statistics that seem applicable to your situation might only complicate the process.

3. Identify the alternatives

With relevant information now at your fingertips, identify possible solutions to
your problem. There is usually more than one option to consider when trying to meet a
goal—for example, if your company is trying to gain more engagement on social media,
your alternatives could include paid social advertisements, a change in your organic
social media strategy, or a combination of the two.

4. Weigh the evidence

Once you have identified multiple alternatives, weigh the evidence for or against
said alternatives. See what companies have done in the past to succeed in these areas,
and take a good hard look at your own organization’s wins and losses. Identify potential
pitfalls for each of your alternatives, and weigh those against the possible rewards.

5. Choose among alternatives

Here is the part of the decision-making process where you, you know, make the
decision. Hopefully, you’ve identified and clarified what decision needs to be made,
gathered all relevant information, and developed and considered the potential paths to
take. You are perfectly prepared to choose.

6. Take action
Once you’ve made your decision, act on it! Develop a plan to make your decision
tangible and achievable. Develop a project plan related to your decision, and then set
the team loose on their tasks once the plan is in place.

7. Review your decision

After a predetermined amount of time—which you defined in step one of the
decision-making process—take an honest look back at your decision. Did you solve the
problem? Did you answer the question? Did you meet your goals? If so, take note of
what worked for future reference. If not, learn from your mistakes as you begin the
decision-making process again.
Three (3) Decision Making Conditions

Decision making faces three (30 particular conditions: (1) uncertainty, (2) certainty, and
(3) risk. These conditions determine the probability of an error in decision making.

1. Certainty

Under conditions of certainty, the manager has enough information to know the
outcome of the decision before it is made.

For example, the managing director of a company has just put aside a fund of
$100,000 to cover the renovation of all executive offices. This money is kept in a savings
account at a local bank that pays 7.5% interest. Half of the money will be drawn out next
month and the rest when the job is completed in 90 days. Can the managing director
determine today how much interest will be earned on the money over the next 90 days?

Given the fact that the managing director knows how much is being invested,
the length of investment time, and the interest rate, the answer is yes. Investment of
the funds in a local bank branch is a decision made under conditions of certainty. The
outcome in terms of interest is known today. In this condition, the decision-maker
knows with reasonable certainty what the alternatives are, what conditions are
associated with each alternative.

When the decision-maker knows with reasonable certainty what the alternatives
are and what conditions are associated with each alternative, a state of certainty exists.
The information is available and considered to be reliable, and the cause and effect
relationship is known. So under this condition, the manager has enough information to
known the outcome of the decision before it is made.
2. Risk

Most managerial decisions are made under conditions of risk. Risks exist when
the individual has some information regarding the outcome of the decision but does not
know everything when making decisions under conditions of risk, the manager may find
it helpful to use probabilities.

To the degree that the probability assignment is accurate; he or she can make a
good decision.

Let us consider the case of a company that has four contract proposals it is
interested in bidding on. If the firm obtains any one of these contracts, it will make a
profit on the undertaking. However, because only a limited number of personnel can
devote their time to putting bids together, the firm has decided to bid on one proposal
only—one that offers the best combination of profit and probability that the bid will be
successful. This combination is known as the expected value.

The profit associated with each of these four contract proposals, as presented in
Table 1, varies from $100,000 to $400,000. Notice that the contract offering $400,000 is
the least likely to be awarded to the company, but it offers the smallest profit of the
four.

On which of the proposals should the firm bid?

As the table shows, the answer is number three. It offers the greatest expected
value.

Computation of Expected Values

Contract Profit ($) The probability of Expected Value ($)

Proposal
1 100,000
2 200,000
3 300,000
4 400,000
getting the contract
6 60,000
5 100,000
4 120,000
2 80,000
 This example illustrates the importance of probability assignment when
decisions are made at a risk. If we reversed the probabilities so that proposal no.1 had a
20% success factor and proposal no. 4 had a 60% success factor, the manager would opt
for the latter proposal.

The effective manager must investigate each alternative to be as accurate as

possible in making probability assignments. In a situation with risks, most managerial
decisions are made under conditions of risk. Under a state of risk, the availability of each
alternative and its potential payoffs and costs are all associated with probability
estimates.

Risks exist when the individual has some information regarding the outcome of
the decision but does not know everything when making decisions. Under conditions of
risk, the manager may find it helpful to use probabilities. Factual information may exist,
but it may be incomplete.

To improve decision making, one may estimate the objective probability of an

outcome by using different models. On the other hand, subjective probability, based on
judgment and experience, may be used.

3. Uncertainty

Uncertainty exists when the probabilities of the various results are not known.
The manager feels unable to assign estimates to any of the alternatives.

While the situation may seem hopeless, mathematical techniques have been
developed to help decision-makers deal with uncertainty. Some of these are heavily
quantitative and are outside the scope of our present consideration. Some non-
mathematical approaches have been developed to supplement these techniques,
however, and they do warrant brief discussion.

One is simply to avoid situations of uncertainty. A second is to assume that the

future will be like the past and assign probabilities based on previous experiences. A
third is to gather as much information as possible on each of the alternatives, assuming
the fact that the decision-making condition is one of risk, and assign probabilities
accordingly.

Using these approaches requires side-stepping the uncertainty factor. It is

assumed not to exist, and this can be a wise philosophy. After all, by definition,
uncertainty throws a monkey wrench into decision-making.

The manager’s best approach is to withdraw from this condition either by

gathering data on the alternatives or by making assumptions that allow the decision to
be made under the condition of risk.
 Although many managers are perfectly comfortable in making decisions under
conditions of risk or uncertainty, they should always try to reduce the uncertainty
surrounding their decisions. They can do so by conducting comprehensive and
systematic research.

The research can tell them more about their alternatives, give them a firmer
basis for estimating possible outcomes arid help them look at the best and worst
alternatives.

Think of a manager who is considering whether to finance a new building by

taking a fixed interest rate loan of 10% or a variable rate of the loan that begins at 9%
but could increase by 4%. He might consider that for the variable rate loan the best case
rate is 9%. The worst-case rate is 13%. By taking this approach, he can at least reduce
some uncertainty and get firmer support for his decision.

In this condition, the decision-maker does not know all the alternatives, the risk
associated with each, or the consequence of each alternative is likely to have.

Here, people have an insufficient database, they do not know whether or not the
data are reliable, and they are very unconfident about whether or not the situation may
change. Moreover, they cannot evaluate the interactions of the different variables.

In all three situations, managers have to take different decisions. To make decisions in
these circumstances, managers must acquire as much relevant information as possible and
approach the situation from a logical and rational perspective.

Decision-making under Uncertainty

Most significant decisions made in today’s complex environment are formulated under a
state of uncertainty. Conditions of uncertainty exist when the future environment is
unpredictable and everything is in a state of flux. The decision-maker is not aware of all
available alternatives, the risks associated with each, and the consequences of each alternative
or their probabilities.

The manager does not possess complete information about the alternatives and
whatever information is available, may not be completely reliable. In the face of such
uncertainty, managers need to make certain assumptions about the situation in order to
provide a reasonable framework for decision-making. They have to depend upon their
judgment and experience for making decisions.
Modern Approaches to Decision-making under Uncertainty

There are several modern techniques to improve the quality of decision-making under
conditions of uncertainty.

The most important among these are:

(1) Risk analysis,
(2) Decision trees and
(3) Preference theory.

Risk Analysis
Managers who follow this approach analyze the size and nature of the risk involved in
choosing a particular course of action.

For instance, while launching a new product, a manager has to carefully analyze each of
the following variables the cost of launching the product, its production cost, the capital
investment required, the price that can be set for the product, the potential market size and
what percent of the total market it will represent.

Risk analysis involves quantitative and qualitative risk assessment, risk management and
risk communication and provides managers with a better understanding of the risk and the
benefits associated with a proposed course of action. The decision represents a trade-off
between the risks and the benefits associated with a particular course of action under
conditions of uncertainty.

Decision Trees
These are considered to be one of the best ways to analyze a decision. A decision-tree
approach involves a graphic representation of alternative courses of action and the possible
outcomes and risks associated with each action.

By means of a “tree” diagram depicting the decision points, chance events and

probabilities involved in various courses of action, this technique of decision-making allows the
decision-maker to trace the optimum path or course of action.

Preference or Utility Theory

This is another approach to decision-making under conditions of uncertainty. This
approach is based on the notion that individual attitudes towards risk vary. Some individuals
are willing to take only smaller risks (“risk averters”), while others are willing to take greater
risks (“gamblers”). Statistical probabilities associated with the various courses of action are
based on the assumption that decision-makers will follow them.

For instance, if there were a 60% chance of a decision being right, it might seem
reasonable that a person would take the risk. This may not be necessarily true as the individual
might not wish to take the risk, since the chances of the decision being wrong are 40%. The
attitudes towards risk vary with events, with people and positions.

Top-level managers usually take the largest amount of risk. However, the same
managers who make a decision that risks millions of funds of the company in a given program
with a 75% chance of success are not likely to do the same with their own money.

Moreover, a manager willing to take a 75% risk in one situation may not be willing to do
so in another. Similarly, a top executive might launch an advertising campaign having a 70%
chance of success but might decide against investing in plant and machinery unless it involves a
higher probability of success.

Though personal attitudes towards risk vary, two things are certain. Firstly, attitudes
towards risk vary with situations, i.e. some people are risk averters in some situations and
gamblers in others. Secondly, some people have a high aversion to risk, while others have a low
aversion.

Most managers prefer to be risk averters to a certain extent, and may thus also forego
opportunities. When the stakes are high, most managers tend to be risk averters; when the
stakes are small, they tend to be gamblers.