Managerial Economics

Dr. Karim KobeissiChapter 4: Concepts of Certainty, Risks and Uncertainty Alternative States of InformationWhile taking a decision, a business executive has to face one of three important situations: certainty, risk and uncertainty. Certainty: a state of knowledge in which the decision makers knows in advance the specific future outcome to which each alternative will consistently leads.Risk: a state of knowledge in which each alternative leads to one of a set of specific outcomes, each occurring with a specific probability that is known to the decision maker. Uncertainty: a state of knowledge in which one or more alternatives result in a set of specific outcomes but where the probabilities of the outcomes are neither known nor meaningful.Difference Between Risk & UncertaintyThe three major difference between risk and uncertainty are:Risk can be quantitatively measured but uncertainty ca not be measured in any form. There are certain risks that can be fully covered by taking insurance policies such as fire, robbery, floodWhile insurance of uncertainty is impossible.Risk is objective while uncertainty is subjective as risk can be measured while uncertainty can only be realized.Decision Making in a Certainty SituationThe Process of Decision Making is very easy in the situation of certainty. There can be no controversy as to what should be the main objective of a business firm. Everyone knows that the main objects of a every firm are to maximize profit, to minimize cost, to provide products of best quality to the society at most reasonable prices However, most economist believe that certainty is only an imaginary situation. In the real life, there can be no field in which a business firm can predict anything with certainty. Expected Monetary ValueExpected Monetary Value (EMV) is the overall value of the alternative determined by multiplying the monetary value of the alternative times the probability of the outcome.Ex: The decision to buy a lottery ticket may be determined by how much the jackpot is worth times the probability of winning.

Decision Making in a Risk SituationIn a situation of RISK we could use Expected Monetary Values (EMV) to take a decision. We choose the alternative that yield the greatest EMV.Where, EMV = SpiVi :pi = probability of the ith outcomeVi = value of the ith outcome (this value is positive for opportunities - positive risks - and negative forthreats -negative risks). Expected Monetary ValuesThe Payoff Table Weather The Possible States of Nature (The possible situations that will be found when the alternative is executed)SunnyCloudyRainingEMV = SpiVi Probability (pi)0.20.40.4Alternative 1

$500$300$100$ 260Alternative 2

$200$250$400$300Expected Monetary ValuesThe Payoff Table The Possible States of Nature (The possible situations that will be found when the alternative is executed)OILDRYEMV = SpiVi Probability (pi)0.250.75Alternative 1(Drill for Oil)$700000 =(Total revenue Cost of drill) = $800000 - 100000$$ - 100000$100000Alternative 2(Sell the Land)$90000$90000$90000Decision Trees A BYesSell (1)$90000OIL (0.25)The same information can be displayed graphically in what is called a Decision Tree.Node (A) is a decision node: represented by a square and indicate that a decision should be taken at that point of the decision process.Node (B) is a chance node: represented by a circle and indicate that a random event occurs at that point of the decision process.

EMV $700000$ - 100000DRY (0.75) $100000 Payoff 10Decision Making Software

Decision Making Software

Limitations of EMVWill you accept a 50/50 bet for $5? Probably YESWill you accept a 50/50 bet for $5m? Probably NOBUT BOTH HAVE AN EMV = SpiVi =0!In some way you care more about losing $5m than winning $5m.Limitations of EMVYour house is worth $200,000 Vi = $200,000 The probability of destruction by fire is equal to 1/10,000 = pi 0.0001Expected Monetary Value of the loss =SpiVi = (0.0001*200,000) = $20So $20 is the most you will pay for insurance? PROBABLY NO. IN SOME WAY YOU CARE MORE ABOUT THE CHANCE OF LOSING YOUR HOUSE.How to Take This Into Account ?Decision-makers have different attitudes to risk:RISK AVERSE - appreciates losses more highly than gains. RISK NEUTRAL appreciates gains and losses equally.RISK LOVER - appreciates gains more highly than losses.N.B. Decision-makers are usually assumed to be risk-averse.Utility (U)Utility refers to want satisfying power of a commodity. It is the satisfaction, actual or expected, derived from the consumption of a commodity. Utility differs from person- to-person, place-to-place and time-to-time. Example: Fadi (likes cheeseburger more than chocolate): Chocolate bar = 2 U; Cheeseburger 5USami (Likes chocolate and Hates cheeseburger): Chocolate bar = 10 U; Cheeseburger -3U

Expected Utility (EU)Expected Utility: a predicted utility value for one of several options, calculated as the sum of the utility of every possible outcome each multiplied by the probability of its occurrence. EU = S UiPi Where:Ui = utility of the ith outcomePi = probability of the ith outcomeIn order to take the decision makers attitude into account, we use the expected utility (EU), instead of using the EMV.Example: Application of Utility Theory

Decision Making in an Uncertainty SituationManagers often must take decisions in environments that are much more fraught with uncertainty. For example: - A manufacturer introducing a new product into the marketplace. What will be the reaction of potential customers?How much should be produced ?Should the product be test marketed in a small region before deciding upon full distribution ?How much advertising is needed to launch the product successfully ?What are the Possible Situations ?We do not know the possible outcomes there is little we can do.We know the possible outcomes, but not their probabilities a number of techniques could be used to take decisions.Maximax CriterionThe maximax criterion involves selecting the best payoff for each alternative and then selecting the best payoff in that set.Risk seekermanagement will usemaximax rule. Maximax Criterion : Implement Alternative 2The Payoff Table (The payoff for each combination of a decision alternative and a state of nature )The Possible States of Nature (The possible situations that will be found when the alternative is executed)ABCAlternatives120401802-401002203607090Maximin CriterionThe maximin criterion involves selecting the worst payoff for each alternative and then selecting the best payoff in that set.Risk aversemanagement will usemaximinrule.Maximin Criterion : Implement Alternative 3The Payoff Table (The payoff for each combination of a decision alternative and a state of nature )The Possible States of Nature (The possible situations that will be found when the alternative is executed)ABCAlternatives120401802-401002203607090Minimax Regret Criterion Regretis the negative emotion experienced when learning that an alternative course of action would have resulted in a more favorable outcome. It is thedifference betweenthe payoff from the best decision and all other decision payoffs (opportunity cost). The minimax regret strategy is the one that minimizes the maximum regret. It involves selecting the worst regret for each alternative, and then selecting the best of that set. Risk neutralmanagement will useminimax regret rule. Minimax Regret Criterion : Implement Alternative 1 The Regret Table (The regret for each combination of a decision alternative and a state of nature )The Possible States of Nature (The possible situations that will be found when the alternative is executed)ABCAlternatives1- 40- 60- 402 - 1000030- 30- 130