MANAGERIAL

ECONOMICS
ANALYSIS AND STRATEGY
Evan J. Douglas
CHAPTER 2

DECISION MAKING UNDER

RISK AND UNCERTAINTY
Executive Summary
This chapter combine present-value (PV) analysis and expected-value (EV) analysis as
expected-present-value (EPV) analysis, for cases where the decision to be made has future
cash flows and is made in an uncertain environment. To facilitate multiperiod EPV analysis we
introduce decision trees, which display the cost and revenue consequences of each decision
like the branches of a tree, so all scenarios are accounted for and the EPV of the decision can
be properly calculated.
We then consider the risk involved in each decision alternative, the measurement of this
risk, and the incorporation of risk analysis into the decision-making process. Most business
decision makers are risk averse, but they will bear risk if adequately compensated for so doing.
Recognition of risk requires modifications to the decision criteria introduced in Chapter 1.
Managers who are risk averters will want to incorporate some measure of risk into their decision
rule, as well as considering the expected profitability. Thus, we introduce several decision
criteria that incorporate risk. We also consider some noneconomic factors which may enter the
decision-making process.
Next, we note that the problem of incomplete information can be at least partly
rectified by information-search activity. Information-search costs should be incurred only if the
decision maker expects that the value of the information acquired will exceed the search costs.
If the information is expected to cost more than it is worth, the firm should proceed without
seeking further information.
Finally, we ask the question “How do I know if I have just made a good decision?” We
shall see that decisions should be evaluated as good or bad on the basis of whether or not
sufficient search activity was undertaken, whether or not the information was fully and properly
utilized, whether or not the appropriate decision criterion was applied, and whether or not the
decision is highly sensitive to the validity of the assumptions on which it is based.
 Expected-present-value (EPV) analysis is
required whenever there are cost and revenue
implications of the decision that fall in both the
present period and at least one future period.
The Decision Tree for the Printing Machine Decision
Risk Analysis of Decision
Alternatives
 The Degree of Risk and Uncertainty
The risk associated with a particular decision is defined as the dispersion
of the possible outcomes that might occur
 The Standard Deviation of a Probability Distribution
The standard deviation of a probability distribution shows the average
absolute deviation of all possible outcomes from the expected value of
that probability distribution

where
δ = standard deviation
Xi = the ith possible outcome
Pi = the probability of that outcome
EPV = the expected present value of the probability distribution
Risk Aversion
 Risk aversion is defined as the psychic dissatisfaction
(or disutility) caused by uncertainty. Risk averters will
take on risk (and disutility) only if they, at the same time,
expect to gain a sufficiently large amount of profit (and
utility) associated with the proposed investment project.

Indifference Curves for a Risk Averter in Risk-Return

Space
Differing Degrees of Risk Aversion

 Different people will have different degrees of risk aversion, because they
have different marginal rates of substitution between risk and return.

Indifferent Curves for Different Degrees of Risk Aversion

Risk Preference and Risk Neutrality
 Risk preference means that risk is viewed as a utility-producing good, and
so the individual’s indifference curves are negatively sloping.
 Risk neutrality means that the individual is indifferent to risk, receiving
neither utility nor disutility from risk regardless of the amount of risk
involved.

Indifferent Curves for Risk Preference and Risk Neutrality

Adjustment For Risk In Decision Making
 The Maximin Criterion
Maximin is the term given to the largest (the maximum) of the
smallest outcomes (the minimums) associated with each decision
alternative.
 The Coefficient-of-Variation Criterion
The coefficient of variation is defined as the ratio of the standard
deviation (σ) to the expected present value (EPV).
 The EPV Criterion Using Different Discount Rates
The opportunity discount rate (ODR) is defined as the best rate of
interest that could be earned elsewhere at the same degree of
risk.
 The Certainty-Equivalent Criterion
The certainty equivalent of a decision alternative is the sum of
money, available with certainty, that would make the manager
indifferent between taking that decision and accepting the certain
sum of money.