Managerial decision-making under uncertainty

In this piece, SBE Associate Professor Wilko Letterie looks at three ways in which uncertainty affects the managerial decision-making process.

Uncertainty is an important driver of decisions. This is also true at the firm level. First, uncertainty tends to make firms cautious and find it more profitable to wait for more information. Second, rather than passively waiting for information, firms may also actively decide to search for learning opportunities. Finally, uncertainty implies that environments may change and that as a result firms have to respond.

These themes have inspired my recent and current research in micro level factor demand decisions and my research in the formation of alliances by firms.

Below I will shortly elaborate on these three issues.

Uncertainty induces cautious behaviour

There can be various sources of uncertainty. At the moment for instance, stock markets are very volatile. This indicates that the economic environment we now face is very uncertain. Of course the Euro crisis plays an important role to explain the current situation.

With high uncertainty, firms become reluctant to make major resource commitments. They postpone investing in capital and hiring new employees until better economic prospects.

It seems that firms face many costs they cannot recoup once they have made expenditures to expand their business.

Such irreversible expenditures may be due to imperfections at second hand markets for machines, which make it hard for firms to sell equipment at a good price to other firms when at some point they need to sell their machines.

As a consequence, firms have a preference for deferring the purchase of expensive machinery until they are more confident that their expenses are profitable.

This partly explains the current economic downturn, given the high level of uncertainty at the moment. An important policy implication in line with this argument is that governments may enhance economic outcomes by limiting the amount of uncertainty, since it is also the cautious behaviour of firms and other participants in the economy induced by lack of confidence that is impacting the current economic situation.

The benefits of an extended learning horizon

Firms are facing uncertainty not only with respect to economic conditions affecting the immediate returns to investment. Especially in high tech industries, companies are subject to uncertainty with respect to the technologies that will be important in the future.

To cope with such uncertainty, firms can engage in partnerships with other firms in order to learn from them. Information about future technologies is dispersed across firms. Firms tend to specialise in the knowledge they already possess and produce in, for instance, biotech and computer industries.

Hence, a strategic selection of partner firms to conduct joint R&D projects is required to enhance learning and reduce uncertainty. Limiting redundancy among partners is important to reduce duplication of knowledge acquisition and production.

A strategic move towards distant partners, in terms of geography, technology or along other dimensions, is important to get access to new insights and avoid becoming over-embedded and being trapped into current networks which can make a firm blind to new and promising developments occurring elsewhere.

Also, partners may be chosen to triangulate and confirm information provided by previous partners.

Firms may not only learn from their direct partners, i.e. the firms with which they have formed a partnership, but also from the ties of their partners, i.e. their indirect ties.

By enhancing the learning horizon across the network, i.e. improving information transmission and acquisition from indirect partners, firms may improve learning and reduce the residual technological uncertainty that remains after forming partnerships.

An additional benefit of an extended learning horizon is that it reduces vulnerability to structural changes in the environment.

Thus, perhaps in contradiction to intuition, a firm’s number of learning alliances will be more stable – in other words, less sensitive to changes – if a firm has the ability to learn both from direct and indirect partners.

This can be understood as follows. Let’s assume that technological uncertainty increases. This produces an incentive for a firm to increase its number of learning alliances. Crucially, the partners of the focal firm will have a similar incentive as well so that in case of a distant learning horizon the firm’s increased learning requirement will be satisfied in part by its partners’ alliance formation.

Partnership Sculpture, Reykjavik

The need to adjust to changing environments

A logical implication of uncertainty is that environmental or technological change may occur sooner or later.

Changing environments require firms to adjust at some point in time to the new situation. One issue arising from this is how and when firms adjust their capital resources.

It appears that oftentimes firms concentrate investment within short episodes, especially so when firms plan to expand their business.

Replacements or retooling efforts can be lumpy as well but tend to be distributed more smoothly over time.

Investments are triggered by for instance better economic conditions, availability of internal financial resources, higher productivity, lower uncertainty but also by differences between local business conditions in comparison with those abroad.

For instance firms may invest and focus production in countries offering better wage conditions.

Major investment episodes (expansions and replacements) are likely to have serious consequences for the organisation of the company.

During such instances, a firm does not only adjust its stock of physical resources. Often major investments tend to be synchronised with hiring efforts.

Evidence so far hints at benefits of simultaneous adjustment of capital and labour. Hence, such events usually represent radical organisational upheaval rather than incremental changes.

 A fruitful research area

It is important to understand to which shocks firms react, how they react, how they prepare themselves to these changes, and which strategies can help firms to cope with uncertainty in the most profitable manner.

The topic of uncertainty has been on the research agenda for quite some time both in the fields of economics and business strategy.

Technological, legislative and economic developments all over the world, however, are fostering new possibilities for firms to enhance flexibility and to learn. As a consequence the topic is likely to remain a fruitful research area.

Dr. Wilko Letterie studied econometrics at the Erasmus University of Rotterdam, where he also received a PhD in economics. In 1997 he began at the School of Business and Economics at Maastricht University. He is Associate Professor at the Organization and Strategy department since 2002. His current work revolves around the capital and labour adjustment process of the firm. He is also interested in alliance formation.

Photos by Alf Melin and Rob Young via Flickr, some rights reserved)

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