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Decisions Under Risk and Uncertainty


When managers make choices or decisions under risk or uncertainty, they must somehow incorporate this risk into their decision-making process. This chapter presented some basic rules for managers to help them make decisions under conditions of risk and uncertainty. Conditions of risk occur when a manager must make a decision for which the outcome is not known with certainty. Under conditions of risk, the manager can make a list of all possible outcomes and assign probabilities to the various outcomes. Uncertainty exists when a decision maker cannot list all possible outcomes and/or cannot assign probabilities to the various outcomes. To measure the risk associated with a decision, the manager can examine several characteristics of the probability distribution of outcomes for the decision. The various rules for making decisions under risk require information about several different characteristics of the probability distribution of outcomes: (1) the expected value (or mean) of the distribution, (2) the variance and standard deviation, and (3) the coefficient of variation.

While there is no single decision rule that managers can follow to guarantee that profits are actually maximized, we discussed a number of decision rules that managers can use to help them make decisions under risk: (1) the expected value rule, (2) the mean–variance rules, and (3) the coefficient of variation rule. These rules can only guide managers in their analysis of risky decision making. The actual decisions made by a manager will depend in large measure on the manager's willingness to take on risk. Managers' propensity to take on risk can be classified in one of three categories: risk averse, risk loving, or risk neutral.

Expected utility theory explains how managers can make decisions in risky situations. The theory postulates that managers make risky decisions with the objective of maximizing the expected utility of profit. The manager's attitude for risk is captured by the shape of the utility function for profit. If a manager experiences diminishing (increasing) marginal utility for profit, the manager is risk averse (risk loving). If marginal utility for profit is constant, the manager is risk neutral.

If a manager maximizes expected utility for profit, the decisions can differ from decisions reached using the three decision rules discussed for making risky decisions. However, in the case of a risk-neutral manager, the decisions are the same under maximization of expected profit and maximization of expected utility of profit. Consequently, a risk-neutral decision maker can follow the simple rule of maximizing the expected value of profit and simultaneously also be maximizing utility of profit.

In the case of uncertainty, decision science can provide very little guidance to managers beyond offering them some simple decision rules to aid them in their analysis of uncertain situations. We discussed four basic rules for decision making under uncertainty in this chapter: (1) the maximax rule, (2) the maximin rule, (3) the minimax regret rule, and (4) the equal probability rule.











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