MANAGERIAL ECONOMICS

CHAPTER FIVE
DECISION MAKING UNDER RISK AND UNCERTAINTY

By: Teklebirhan A. (Asst. Prof)

E-mail: tbalemnew@gmail.com

1 AAU , 2024
Objectives
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Describe decision making in different situations

Know the application risk and probability distribution in
investment evaluation
Evaluate investment in risk environment
Understand how to make investment decisions in uncertainty
 5.1. The Nature of Decision Making
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Most economic decisions are made with something less than

perfect information.
For example: A manager cannot know, 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.

The ability to make good decisions is the key to successful

managerial performance.
 Cont…..
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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.
 Cont…..
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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 (fluctuation) 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.
 Figure 5.1: The decision-making process
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 5.2. Meaning and Measurement of Risk
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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 is able to assign probabilities to each of
these possible outcomes, risk is said to exist.
 Cont…..
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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.
In contrast, US Airways bonds constitute a risky investment
In summary, risk refers to the potential variability of outcomes
from a decision.
 The more variable these outcomes are, the greater the risk.

5.3. Approaches of Incorporating Risk into
Decision Making Process
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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 vacuum.
There are factors in the environment that affect the process &
the decision maker.
 Cont…..
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In some situations, one manager can have perfect knowledge/

understanding of what to do & what the consequence of the action
will be; where as 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.
 Cont…..
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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

 Cont…..
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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 decision.
Under complete certainty conditions, all relevant information
about the decision variables and outcomes is known or assumed to
be known.
 Cont…..
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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 pay off.
This is the most difficult situation for managers.
 Cont…..
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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 anyone of the alternatives.
Reliance on experience, judgment & other people’s experience can
assist the manager in assessing the value of the alternatives.
No information is available on how likely the various states of
nature are under those conditions.
 Cont…..
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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.”
 It 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.”
 Cont…..
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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.
 Cont…..
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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.
 Cont…..
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ILLUSTRATION 1:
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
 Cont…..
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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 worst, choose to build the
small facility using the maximum strategy.
 Cont…..
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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.
 Cont…..
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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
 Cont…..
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d) 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.

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
 Cont…..
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The second step is to identify the worst regret for each alternative.
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.
 Cont…..
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3) Decision-making under conditions of risk

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 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.
 Cont…..
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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.
 Cont…..
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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
 Cont…..
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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 (EV)
 Cont…..
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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.
 Cont…..
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