Business today is filled with risk and uncertainty. There’s no guarantee of the outcome of the decisions taken by a manager. There are numerous risks involved, ranging from the line of business to the type of product to be produced, the price of the product and what will be the demand for the product? So, there is a whole list of risks and uncertainties that the owner or the manager has to take care of.
From where does Risk arise? Risk arises out of uncertainty. What is uncertainty? Uncertainty is not having the knowledge of the outcome, whether the outcome will be favorable or unfavorable. Now, in business sense, the unfavorable situations are facing loss of investment. When a company is investing in a business, the investment from the shareholders and other creditors, the line business must ensure that there is some return on the investment. So, these are the basic risks that a firm or a company faces. So, the managers have to balance between the high risk high return and low risk low return type businesses.
In Economics, there are certain tools and techniques by which the managers gauge the risks involved in a business and go ahead and take some decisions. The tools and techniques are probability distributions & expected values; standard deviations and coefficient of variation; utility function; decision tree model; simulation techniques, etc. These are some of the tools that manager use to evaluate the risk involved in a certain lines of business.
Probability distribution is one of the basic methods to know the percentage of the outcome. If the percentage is high then the manager can proceed and take the risk, but, if the percentage is mid or low, then the manager cannot jeopardize the investment.
Risk is often measured by the standard deviation and coefficient of variation.
A Decision tree is a graphical representation of a decision problem as a series of choices, each of which is depicted by a decision fork or a chance fork. It is used to map the course of action with the highest expected risk. This Is much like the flow chart diagrams that are drawn by Computer Science students.
To construct a Utility function, we begin by setting the utility attached to two monetary values arbitrarily. Then we present the data to the decision-maker with a choice between the certainty of one of the other monetary values and a gamble in which possible outcomes are the two monetary values whose utilities we set arbitrarily. Repeating this process over and over, we can construct he decision maker’s utility function.
Simulation techniques are used by managers very frequently. These techniques involve in experimenting or testing with models. Just as wind tunnel testing is used in the aviation industry to know the flaws in a flight. In the same way, these simulation techniques use computer models to process the outcome in different situations and will know the average outcomes. This will help in understanding whether the risk is worth taking or not.
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