managerial economics

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managerial economics chapter five decision making under risk and uncertainty by: teklebirhan a. (asst. prof) e-mail: tbalemnew@gmail.com 1 aau , 2024 2 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 objectives 3 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. 5.1. the nature of decision making 4 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 …

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n 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. 5.2. meaning and measurement of risk 8 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.  cont….. 9 as there are different kinds of decisions, there are also different conditions …

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er complete certainty conditions, all relevant information about the decision variables and outcomes is known or assumed to be known. cont….. 13 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….. 14 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 …

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e 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….. 18 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 cont….. alternatives possible future demand low medium high small facility 10 10 10 medium facility 7 12 12 large facility (4) 2 16 19 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….. 20 b) using maximax, the best pay-offs are:  small facility: $10 million  medium facility: $12 million  large facility: $16 million  the best …

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….. 24 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….. 25 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….. 26 example: determine the expected pay-off of each alternative, and choose the alternative that has the best-expected pay-off. using …

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managerial economics chapter five decision making under risk and uncertainty by: teklebirhan a. (asst. prof) e-mail: tbalemnew@gmail.com 1 aau , 2024 2 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 objectives 3 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 decision...

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