- Listing the outcomes that can possibly occur (these will depend on
chance events as well as on his or her own actions). - Evaluating the chances that any uncertain outcome will occur.
- Deciding how well he or she likes each possible outcome.
As this list indicates, decision making under certainty and uncertainty share
a number of features. Whatever the setting, the manager should be aware of all
available actions, determine the consequences of each action, and formulate
a criterion for assessing each outcome. The introduction of uncertainty, how-
ever, requires additional analysis and judgment. First, the manager must be
aware of these uncertain events and how they will affect the outcome of any
action he or she chooses. Moreover, after accounting for these uncertainties,
the manager must assess or estimate the likelihood of alternative outcomes.
Second, in decisions under risk, the manager has a course of action that is miss-
ing in decisions under certainty: the option to acquire additional information
about the risks before making the main decision. Third, the manager must
carefully assess the firm’s attitude toward risk, that is, formulate a criterion that
determines which risks are acceptable. This criterion then can serve as a guide
for choosing among risky alternatives.
In this chapter, we begin our study of decision making under uncertainty.
First, we review the fundamentals of uncertainty, probability, and expected
value. Then we examine the use of decision trees as a guide for managerial
choices, especially in sequential decisions. Finally, we explore the effect of risk
aversion on managerial decisions: how a manager can assess attitudes toward
risk and apply the expected-utility criterion as a decision guide.
UNCERTAINTY, PROBABILITY,
AND EXPECTED VALUE
Uncertainty lies at the heart of many important decisions. Managers are often
uncertain about outcomes that have a direct bearing on the firm’s profit. For
example, introducing a new product entails a multitude of risks, including the
cost and timetable of development, the volume of sales in the product’s first
and subsequent years, and competitors’ possible reactions. The example that
opens this chapter suggests that uncertainty concerning the future course of
the macroeconomy—consumer and business spending, price inflation, inter-
est rate movements—is an important factor for many industries and firms.
Uncertainty(or risk) is present when there is more than one possible out-
come for a decision.^1 Roughly speaking, the greater the dispersion of possible
outcomes, the higher the degree of uncertainty. The key to sound decision
making under uncertainty is to recognize the range of possible outcomes and500 Chapter 12 Decision Making under Uncertainty(^1) Throughout the discussion, we use the terms riskand uncertaintyinterchangeably.
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