Plekhanov Russian University of Economics

ABSTRACT
Making Decisions under Uncertainty and Risk

Done by Bastanova Aigul

Group 1390
Management Faculty
Supervisor:
Smirnova E.I

Moscow 2016
Content
Introduction.................................................................................................................................................2
1. Decision making process.........................................................................................................................2
2. Risk and uncertainty................................................................................................................................2
3. Decision making models and criteria.......................................................................................................2
Conclusion...................................................................................................................................................2
References...................................................................................................................................................2

Introduction
Decision making is certainly the most important task of a manager and it is often a very difficult
one. The domain of decision analysis models falls between two extreme cases. This depends upon the
degree of knowledge we have about the outcome of our actions. One pole on this scale is deterministic.
The opposite pole is pure uncertainty. Between these two extremes are problems under risk. The main
idea here is that for any given problem, the degree of certainty varies among managers depending upon
how much knowledge each one has about the same problem. This reflects the recommendation of a
different solution by each person. Probability is an instrument used to measure the likelihood of
occurrence for an event.
Business decision making is almost always accompanied by conditions of uncertainty. Clearly,
the more information the decision maker has, the better the decision will be. In this paper making
decisions under conditions of uncertainty and risk will be analysed.

1. Decision making process

Decision making is a multidimensional process and it is not simply to make one choice. Decision
taking as an integral part of management is one of determining characteristics of leadership. Managers
make decisions affecting the organization daily and communicate those decisions to other organizational
members. Some decisions affect a large number of organization members, cost a great deal of money to
carry out, or have a long term effect on the organization. Such significant decisions can have a major
impact, not only on the management systems itself, but on the career of the manager who makes them.
Other decisions are fairly insignificant, affecting only a small member of organization members,
costing little to carry out, and producing only a short term effect on the organization.
According to Richard L. Daft, Decision represents the process of problem identification and the
process of solving it. John R. Shcermeron defines decision as the process of selection of best possible
action, from the entirety of alternatives. Decision taking is the process of problem introduction,
formulation of alternatives, analyses of alternatives and selection of best alternative, than continues with
the implementation of alternative and its control.
The decision making process is consists of eight steps:
1. Identification of problem. This process starts with existence of problem and the difference
between existing and desired state.
2. Identification of criteria for decision making. After identification of problem the criteria for
solution of problem should be identified.
3. Distribution of importance / weight of criteria. The decision maker should weight the
importance of criteria and classify them by giving priority according to its importance.
4. Development of alternatives. Decision maker in cooperation with team should list the
alternatives based on which certain problem could be solved.
5. Analyses of alternatives. Investigation of information and additional material will be carried
out in order to identify the priorities and weaknesses for each alternative.
6. Selection of alternative. After applying the weight to listed alternatives, the best alternative is
chosen. It generates the highest amount calculated at previous step.
7. Execution of decision. Decision is transferred into action. People who execute decision
participate in the process and support the implementation of decision.
8. Evaluation of effectiveness of decision. It is evaluation of the result where we can conclude if
the problem is solved. In the cases where the problem still exists the manager has to see what was done
wrong and return to previous steps.
The decision making process involves evaluating a scenario from different angles, or
perspectives, in order to identify solutions that will lead to the desired outcome.
Three main perspectives on decision making are rationality, limited rationality and intuition.
Rational decision making means managers make sustainable solution that maximizes value under the
conditions of specific limitations. When managers take rational decisions but are limited in their ability to
process information, this presents rational limited decision making. Whereas intuitive decision making is
when the decisions are taken based on experience, feeling and accumulated judgment.
Depending on the nature of problem, the manager may take different types of decisions. When we
have to deal with structural problems, the decision making is programmed while when we have to deal
with unstructured problems it is not. Managers try to take good and weighted decisions because they will

be judged based on the results of those decisions.

2. Risk and uncertainty
Researches tried to study the role of risk in their field of interest. According to researches P.Slivic
(2000) and P.More (1983), people percept risk in different ways depending on the sphere of work. One
valuable definition for risk in the decision making field was introduced by authors H. Raiffa and R.D
Luce, who make the distinction between three conditions that managers are faced with while taking
decisions:
1. Security -accurate decision making because results of each alternative are known, therefore
managers may take secure decisions.
2. Risk each action leads to one of specific results, where results of alternatives cannot be
evaluated. The ability of determining probability may be the result of previous experience or of secondary
information.
3. Insecurity -actions may lead to a group of consequences, but where the probability of result is
completely unknown. For decision maker the security and justification for settling an alternative is
missing.
When managers make choices or decisions under risk or uncertainty, they must somehow
incorporate this risk into their decision-making process.
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.

In gambling for example, if you are taking a risk on a particular number in a

game of roulette, you know that the probability of that number finally appearing is
1/29 or the number being present in the game, while uncertainty is reflected when
you are not sure of the outcome as in the case of putting money on a horse in a
horse race.
Risk and uncertainty are concepts that talk about expectations in future, but
whereas you can minimize risk by taking health policies to face an uncertain
future, you cannot remove uncertainty from life altogether.

Characteristics of risk as a probability distribution

We can define risk as a probability distribution of outcomes of an action.
To measure the risk associated with a decision, the manager can examine several characteristics of the
probability distribution.

The various rules for making decisions under risk require information about such characteristics
of the probability distribution of outcomes as:
1) the expected value (or mean) of the distribution,
2) the variance and
standard deviation,
3) the coefficient of variation.
While there is no single decision rule that managers can follow to guarantee that profits are actually
maximized, we discuss a number of decision rules that managers can use to help them make decisions
under risk:
1) the expected value rule
2) the meanvariance rules
3) the coefficient of variation rule.
These rules can only guide managers in their analysis of risky decision making.
Attitudes towards Risk
The actual decisions made by a manager will depend greatly on the manager's willingness to take
on risk. We can group people's attitudes towards risk into 3 distinct categories, based on the form of their
respective Bernoulli utility functions.
Let's illustrate this with a simple gamble based on a coin toss, which pays $10 if the coin lands
heads, and $20 if the coin lands tails.
The expected value of this gamble is, of course: (0.5*10) + (0.5*20) = $15.
1. Risk-neutral. If a person's utility of the expected value of a gamble is exactly equal to their expected
utility from the gamble itself, they are said to be risk-neutral.
In practice, most financial institutions behave in a risk-neutral manner while investing.
Risk-neutral behavior is captured by a linear Bernoulli function. For the above gamble, a risk-neutral
person whose Bernoulli utility function took the form u(w) = 2w
would have an expected utility over the gamble of: (0.5*2* 10) +
(0.5*2* 20) = 30, while their utility of the expected value of the
gamble is 2*15 = 30.

A risk-neutral subject decides with regard only to the

expectancy value .
Spread/dispersion of a probability distribution therefore is
irrelevant.

Accordingly, the respective decision model is the Expectancy value

(expectation value, expected value) decision model.
2. Risk-Averse. If a person's utility of the expected value of a gamble is greater than their expected utility
from the gamble itself, they are said to be risk-averse. This is a more precise definition of Bernoulli's
idea. Risk-averse behavior is captured by a concave Bernoulli utility function, like a logarithmic function.
For the above gamble, a risk-averse person whose Bernoulli utility function took the form u(w) = log(w),

where

was

the

outcome,

would

have

an

expected

utility

over

the

gamble

of:

0.5*log(10)+0.5*log(20)=1.15,
while their utility of the expected value of the gamble is log(15) = 1.176.
3. Risk-loving. If a person's utility of the expected value of a
gamble is less than their expected utility from the gamble itself,
they are said to be risk-loving. Note, however, that this does no
capture normal gambling behavior of the kind observed in casinos
the world over. By this definition, a truly risk-loving person ought
to be willing to stake all of their assets, everything they own, on
a single roll of dice.
A convex Bernoulli utility function captures risk-loving
behavior; for example, an exponential function. For the above
gamble, a risk-loving person whose Bernoulli utility function
took the form u(w) = w2 would have an expected utility over the
gamble of: 0.5 * 102+ 0.5 * 202= 250, while their utility of the
expected value of the gamble is 152 = 225.
3. Decision making models and criteria
How can we now express risk aversion and risk sympathy?
In addition to the expectancy value take into account the spread/dispersion of the probability
distributions.
And that leads us to the My/Sigma Decision Model or (/)-Model.
The (/-)-model takes into account the spread/dispersion of a probability distribution by a
weight let us call it g of the standard deviation ,

g being thus a coefficient

expressing the decision-makers attitude towards risk.

So the alternatives/actions are ranked each according to the following characteristic: + g*.
And g itself has two aspects:

sign (+, -), expressing a certain attitude towards risk;

absolute value, abs(x) or |x|, expressing to what extent this certain attitude is there.
As a general rule can serve the following one:

If the characteristic + g* is better (in the decision makers view) in comparison to , then the sign
of g expresses risk-sympathy.
If the characteristic + g* is worse (in the decision makers view) in comparison to , then the sign
of g expresses risk-aversion.
Note: If g = 0, we return to the expectancy value decision model:
+ g* = + 0* = And this expresses as we already know risk neutrality.
So the expectancy value decision model is a special case of the (/)-model.

A number of decision making criteria exist which take into account the risk preferences of the
decision maker. These are summarized in the following table.
Decision makers attitude towards risk
Risk-seeking
Risk-averse
Risk-neutral

Decision making criterion used

Maximax
Maximin

Maximising expected values

Having identified all possible actions and all possible outcomes, we must rank the actions in light
of the criterion selected by the manager. We look at the maximin criterion (sometimes called the
pessimists criterion) and the maximax criterion (sometimes called the optimists criterion).
The maximin criterion

The action taken is that which maximises the smallest possible payoff for each action.
The manager who employs this criterion is assuming that whatever action he takes, the worst will
happen (pessimist) a very risk-averting approach.

The maximax criterion

The action taken is that which has the highest maximum possible payoff.
The manager who employs this criterion is assuming that, whatever action he takes, the best will
happen (optimist).

Decision Tree Approach

A decision tree is a chronological representation of the decision process. It utilizes a network of
two types of nodes: decision (choice) nodes (represented by square shapes), and states of nature (chance)
nodes (represented by circles).

Here is a step-by-step description of how to build a decision tree:

1.
2.
3.
4.

Draw the decision tree using squares to represent decisions and circles to represent uncertainty,
Evaluate the decision tree to make sure all possible outcomes are included,
Calculate the tree values working from the right side back to the left,
Calculate the values of uncertain outcome nodes by multiplying the value of the outcomes by
their probability (i.e., expected values).

Conclusion

Virtually all decisions are made in an environment of at least some

uncertainty. However, the degree will vary from relative certainty to great
uncertainty. There are certain risks involved in making decisions.
In a situation involving certainty, people are reasonably sure about what will
happen when they make a decision. The information is available and is considered
to be reliable, and the cause and effect relationships are known.
In a situation of uncertainty, on the other hand, people have only a meager data
base, they do not know whether or not the data are reliable, and they are very
unsure about whether or not situation may change. Moreover, they cannot evaluate
the interactions of the different variables.
To improve decision making, one may estimate the objective probabilities of
an outcome by using, for example, mathematical models. On the other hand,
subjective probability, based on judgment and experience, may be used.
Fortunately, there are a number of tools available that helps make more effective
decisions such analysing risk as a probability distribution of outcome of an action
or modern approaches like decision tree approach.

References

1. Biswas, T. 1997. Decision Making Under Uncertainty. New York: St. Martin's Press.
2. Eiser, J. 1988. Attitudes and Decisions. Routledge.
3. Erwin Eszler, Risk Management and Insurance, Vienna University of Economics and Business
2014.
4. Golub, A. 1997. Decision Analysis: An Integrated Approach. New York: Wiley.
5. Goodwin P., and Wright, G. 1998. Decision Analysis for Management Judgment.
6. John R. Shermerhon jr. Management and Organization Behaviour, Yew York, John Wiley and
Sons, 1996
7. Joseph G. Johnson1 and Jerome R. Busemeyer Decision making under risk and uncertainty
8. New York: Wiley.
9. Richard L. Daft Organization Theory and Design, Fourth edition, USA, West Publishing
Company, 1992
10. Stephen P. Robins, Mary Coulter, Management, 9-th edition, New Jersey, Prentice Hall, 2006
11. http://highered.mheducation.com/sites/0073402818/student_view0/chapter15/index.html
12. http://www. decision-making-confidence.com