Fall 2022 Semester Exam Solution for Dealing with Risk and Uncertainty at the Michigan University

Exam Question: explain the methods used for dealing with risk and uncertainty and elaborate on how firms can apply these methods

Dealing with Risk

Value' of the project, but the probability of each possible outcome. This serves two functions: allowing the probabilities to be challenged and discussed and allowing the decision-taker to decide her attitude to risk itself. She can thus either decide between the projects on the basis (in part) of their riskiness or explore 'risk-aversion' further using the 'certainty equivalence' approach.

Certainty equivalence

One of the features that make firms different is their attitude to risk. As we saw in Chapter 8, when discussing game theory, it is instructive to separate a firm's objectives from the way it takes decisions. Thus, many profit-maximizers firms may also be subject to risk aversion to varying degrees. They intend to make as much profit as possible but may be very wary of projects which appear risky. The extent of risk aversion may be measured by asking decision-takers what certain return they would consider the equivalent of a particular risky return. Put the other way around, we can assign to a risky return its certainty equivalent. This information can then be used to tailor the information about projects to suit the degree of risk aversion of the particular firm or decision-taker.

The Markowitz approach

The final approach to risk that we shall consider is that of Markowitz (1959). He pointed out that it is rational to consider not just the risk (variance of NPV) of the project itself but its effect on the variance of the NPV of the firm as a whole. Thus, more risky projects may be preferred to less risky projects, even if the firm is very risk-averse if they reduce the overall variance of cash flows over time. This is similar to the reasoning behind diversification: a firm that operates in various markets, some of which benefit from recessions and some from recovery and growth, has spread its risks. However, the obvious problem is that reducing the profit fluctuations may reduce their total. While the risk-averse firm may accept this, it may not be to all. Thus we can summarise the managerial economists' approach to risk as displaying as much information as possible about the probabilities involved and attempting to ascertain the degree of risk-aversion of the decision-taker.

Dealing with Uncertainty

Subjective probabilities

Suppose the decision taker is willing to assume certain probabilities for uncertain events. In that case, we can assign these 'subjective probabilities' to the events and use some techniques mentioned in the previous section. One method often used is to use the Bayes criterion (see Chapter 3) and assign equal probabilities to each event. We can then treat the problem as one of risk rather than uncertainty. There is now extensive literature on subjective probabilities, which is useful because decision-takers are often willing to make 'educated guesses' about the probability of future events and thus quantify the normal management procedure of 'taking risks'.

Sensitivity analysis

Analysis of uncertain situations often shows several factors that may be uncertain. For example, the return on an oil refinery may depend on future oil prices, government policy in several countries, and the development of synthetic fuels. Each of these uncertain events could affect the return on the project. We may not be able to predict what will happen to the three factors, but we can predict their effect on the return and thus quantify the sensitivity of a project to you certain events. Thus a particular project might be modified to decrease its sensitivity to, say, competition from synthetic fuels, or one of several projects which was least sensitive to uncertain events might be chosen.

Decision theory

We can go beyond sensitivity analysis and use decision theory in some cases. A simple example will show the principles involved if we can build three different types of aircraft. e of the crucial factors determining their sales is the price of aviation fuel. Sensitivity analysis could tell us the effect of different price levels on sales over ten years. We could then produce a table such as Table 18.2. Using the methods outlined in Chapter 3, the decision-taker" could proceed to decide which project to carry out. As in Chapter 3, we can take the matter further and assign subjective probabilities to the three possibilities to see how that affects the decision. This concludes our brief look at some of the techniques available for dealing with risk and uncertainty, and we now look at how firms try to deal with them in practice.

How Firms Deal with Risk and Uncertainty

Firms deal with risk and uncertainty in a wide variety of ways, and we shall summarise them briefly, although each is worth a study. Firms use the techniques we have outlined to quantify the situations of risk and uncertainty they face. A practical refinement is to use several methods of evaluating a project and try to reconcile them. Large companies commonly ask for several detailed reports on proposed projects, not only dealing with different aspects of the project, such as labour and capital requirements but also evaluating the project using different techniques of investment appraisal. They may even build simulation models of the market, or markets, to explore some of the possibilities.

Another practical refinement is the attempt to gather all possible relevant information. This will include governmental and firm sources and specially commissioned market and cost research studies from consultants. This can be seen as attempting to remove as much uncertainty as possible and turn uncertainties into another obvious tactic to try and reduce the level of risk and uncertainty by actions un- connected with a particular project. We can classify these actions as flexibility, insurance, monopoly, vertical integration, diversification and political action.

Table 18.2 Decision theory and project choice

Taking flexibility first, all firms try to maintain some capacity to respond to unexpected changes in events. The extent to which they do so shows how far they are trying to reduce the effects of risk and uncertainty. Two common types of flexibility are production and finance. It is always possible to buy machinery and plant that is more or less specific to the particular process or product the firm currently uses. Buying less specialized machinery or plant means that if a slightly different product becomes, popular products can be switched relatively easily. Thus, some firms may concentrate on producing long runs of "standard" products, while others may retain the flexibility to quickly adapt to changing consumer fashions and tastes. They are using production flexibility to reduce the risk of being left with unsaleable goods. Financial flexibility consists of maintaining enough liquid assets to take advantage of unexpected opportunities and stave off unexpected problems. The liquid assets may not earn as much as if embodied in plant and machinery, but they allow a flexible response to unpredicted events.

The essence of the insurance approach to risk and uncertainty is the loss of a (relatively) small 'premium' for removing a risk. Thus we can include here insurance proper and other activities of firms of this type. Many of the firm's risks can be insured; in some countries, the risk of customers not paying can be insured. For export orders, the home government is often pre- pared to provide some form of guarantee of payment, either alone or in conjunction with commercial banks. Similarly, accounts may be sold to financial organizations (often called "factoring") at a discount; the firm, in effect, pays the financial organizations to turn its risky accounts receivable" into certain cash. We can also consider holding large stocks as a form of insurance against the risk of production delays and sudden increases in demand. (We saw in Chapter 14 that it was possible to decide on the optimum level of stocks for profitability)

Similarly hotels and motels can give up part of their profits to international booking organizations such as Holiday Inn or Best Western or credit card companies such as American Express to increase the probability of being fully booked. In each case, the insurance process is taking place; a small premium/ discount/service charge is lost for the gain of more certainty. Our last example of insurance concerns only some firms but can be very important to them. This removes uncertainty about input prices by using the futures markets for commodities. This enables a firm heavily dependent on input, say copper in its electric cables, to fix prices for a few months ahead with certainty. The firm has a small additional cost and forgoes the possibility of a large gain if prices were to fall but gains certainty of the future price. (Texts on commodity markets will explain the detailed process.)

Monopoly can also be considered a way of reducing risk, as it reduces the opportunity for customers to go elsewhere. It is always easier to forecast the demand for a product as a whole rather than the demand for one firm. Thus control over the whole market makes planning easier. Under a monopoly, we have not only one firm dominating a market but also agreements between firms and monopolistic practices that reduce customers' freedom to change suppliers. Standard economics texts explain in detail the advantages of monopoly to firms and government restrictions on monopoly in different countries.

Vertical integration involves a firm acquiring suppliers and customers to establish greater security for planning purposes. Many farmers feel that their prices and profits fluctuate far more than those of wholesalers, merchants and retailers; thus, they have often been interested in becoming involved in cooperative ventures such as Marketing Boards (in the UK) for milk and eggs and Sunkist Growers marketing oranges from California. Similarly, farmers have set up joint organizations to supply their farms with feeds, fertilizers and oil products, particularly in the UK. Consumer (retail) cooperatives in the UK have also practised vertical integration by buying up dairy farms, tea plantations, and banking and insurance operations. There are some obvious dangers in vertical integration, which are neatly illustrated by the tyre companies buying up rubber plantations just before the successful use of synthetic rubber. Tying the firm to one input source can be just as bad for its profits as not having the security of supply. Control of retail outlets seems to be much more rewarding; thus, we find brewers controlling 'public houses in the UK and oil companies controlling filling stations worldwide. Here the customer definitely has to make an effort to change suppliers, which gives the firm time to adjust to changing tastes.

Diversification is a common response to the problems of risk and uncertainty because spreading risk reduces risk. Thus we find oil companies diversifying into coal, natural gas, chemicals, solar power and computers, and tobacco firms moving into cosmetics, frozen foods, chickens and publishing. More restricted examples occur when the firm stays within a particular group of products and produces products that respond differently to conditions of prosperity and recession. For example, in Europe, Unilever produces frozen foods which do well when incomes are growing, and pork products, which do well when incomes are not growing, thus reducing the overall fluctuation in profit for the group. The obvious problem with diversification is that it has to be carried out on a very large scale to be successful; thus, we often find diversified firms selling off some of their smaller, less successful attempts, as British Oxygen did in 1980. The group's management may feel uneasy about a firm that produces diverse products. Still, some of the 'conglomerates' of the 1960s and 1970s are doing as well as more 'coherent' companies.

Political action may sometimes be, like patriotism, 'the last resort of a scoundrel', but it is also effective in removing risk and uncertainty. Governments, whether national or local, can often guarantee markets for products. Thus we find firms entering into relations with foreign and home governments which guarantee access to particular markets. Sometimes the government prevents other firms from competing by establishing a 'buy American' or 'buy British' policy; in other cases, there is a direct contract to supply some branch of the state. Political pressure can be used to win contracts, keep out foreign competition, obtain subsidies and loans and obtain cheap inputs. This pressure can be applied openly or through political contributions, lobbying, bribery, and corruption. In each case, what is being sought is an ability to plan the future; firms seek advantages but also seek to reduce the future to a pattern that can be planned for. They often see the political system as creating uncertainty and, thus, a source of danger. Political action may be morally or morally bad, but it is in many firms' interests to engage in it if they wish to reduce risk and uncertainty.