Chapter Five

Decision making under risk and uncertainty

Decision making is a managerial process of identifying, developing, analysing

alternative courses of action and selecting the most feasible one to solve a problem.
Decision is the conclusion of a process designed to weigh the relative merits of a set of
available alternatives so that the most preferred course of action can be selected for
implementation.
State of Nature: A possible future condition (consequence or event) resulting from
the choice of a decision alternative depends upon certain factors beyond the control of
the decision-maker. These factors are called states of nature (future).
Payoff: A numerical value resulting from each possible combination of alternatives
and states of nature. Payoff can be revenue or cost.
Decision alternative/Strategy/course of action: - There are a finite
number of decision alternatives available with the decision-maker at
each point in time when a decision is made.
Characteristics of Decision Theory
 Decision Making is problem solving process or a rational process.
If there is no problem, no decision will be made.
 For every problem, there should at least two alternative solutions.
 The alternatives are represented by quantitative pay-off values.
 Pay-off values should be able to be assigned for every alternative.
 The decision to assign pay-off values to each alternative and the
probability of success of every alternative are subject to a set of
environmental factors with influential power beyond the
controlling capacity of the decision maker. These environmental
factors are called states of nature.
 The selection among the identifiable provided alternatives is made
subject to highly dominant environmental variables (state of
nature).
Components of Decision
 State of nature
 Alternatives
 Analysis (Select the best among the alternatives).
Example: -

State of natures (Market demand rates)

Alternatives (Capacity) Low demand Average demand High demand

Small capacity 6 20 24
Medium capacity 10 12 20
Large capacity -2 8 30
Decision Making Environment/conditions
 Decision making under certainty
 Decision making under uncertainty
 Decision making under risk
1. Decision making under certainty
 Decision making under certainty assumes that all relevant
information required to make decision is certain in nature and is
well known. Adequate and reliable information about the past,
present and the future are available.
 In this case the decision-maker has the complete knowledge
(perfect information) of consequence of every decision choice
(course of action or alternative) with certainty.
 To make decision, the manager will have to be quite aware of the
strategies available and their payoffs and each strategy will have
unique payoff resulting in certainty
2.Decision making under uncertainty
 In this case the decision-maker is unable to specify the
probabilities with which the various states of nature (futures) will
occur.
 Thus, decisions under uncertainty are taken with even less
information than decisions under risk.
Characteristics of decision making under uncertainty
 Absence or lack of information about the decision environment
 Lack or absence of adequate or reliable information because the
problem might be unfamiliar.
 Unpredictability of the state of natures
 High degree of environmental volatility
Decision Making Techniques
Decisions are made using the following techniques if the decision maker is under
the condition of uncertainty.
 Maximax
 Maximin
 Minimax regret
 Principle of insufficient reason
i. Maximax

Under the maximax approach, we use maximum of the highest payoff values in each row or identify
the best of the best outcome in order to select the optimal strategy. The strategy/course of action to
be chosen would be the maximum of all row maximum values.

State of nature (i.e. Demand rate)

Alternatives Low demand Average demand High demand Row Maximum
Small facility 6 20 24 24
Medium facility 10 12 20 20
Large facility -2 8 30 30
Decision: building large facility
  II. Maximin
 The maximin approach uses the maximum of the lowest payoff values in each
row.
 To use this approach, first determine the worst possible outcomes in each
alternative (row minimums) and select the best of the worst outcome in order
to select the optimal strategy.
State of nature (i.e. Demand rate)
Alternatives Low demand Average demand High demand Row Minimum
Small facility 6 20 24 6
Medium facility 10 12 20 10
Large facility -2 8 30 -2

Decision: Building medium facility

 III.Minimax Regret
 This approach chooses the minimum of the highest losses to be
faced or the minimum opportunity cost of the specified row would
be selected to reduce the level of regret.
 It requires preparation of the opportunity loss table.
 To find the opportunity loss table (column opportunity loss
matrix), deduct all the elements of a column from the highest
element of that column.
 The obtained table is known as regret matrix.
 While selecting the best strategy, we have to select a strategy
whose opportunity loss is zero or minimum (zero or minimum
regret).
State of nature (i.e. Demand rate)
Alternatives Low demand Average demand High demand
Small facility 6 20 24
Medium facility 10 12 20
Large facility -2 8 30

Column Max. 10 20 30
Opportunity Loss Table
State of Nature (Demand rate)
Alternatives Low demand Average demand High demand Row Max
Small facility 4 0 6 6
Medium facility 0 8 10 10
Large facility 12 12 0 12

Decision: Building small facility

 IV. Principle of Insufficient Reason/Laplace arrangement
 Since the probabilities of states of nature are not known, it is
assumed that all states of nature will occur with equal probability,
i.e. each state of nature is assigned an equal probability.
 This subjective assumption of equal probabilities is known as
Laplace criterion, or criterion of insufficient reason.
 The selection of the best alternative under this approach is made
by computing the expected or average pay of value for each
alternative.
 Hence, the average value of alternatives would be computed by
adding all the payoffs in a row and dividing by the number of
possible states of nature and select the alternative with highest
average value.
State of nature (Demand rate)
Alternatives Low demand Average demand High demand Average Value
Small facility 6 20 24 6+20+24/3=16.67
Medium facility 10 12 20 10+12+20/3 = 14
Large facility -2 8 30 -2+8+30/3 = 12

Decision: Build small facility

1. Decision Making Under Risk

Decision-making under risk describes a situation in which each strategy results in more than one
outcome or payoffs and the manager attaches a probability measure to these payoffs. In this case the
decision-maker has less than completes knowledge with certainty of the consequence of every
decision choice (course of action). This means there is more than one state of nature (future) and for
which he makes an assumption of the probability with which each states of nature will occur
  Decision Making Techniques

i. Expected Monetary Value (EMV)

The expected monetary value (EMV) for a given course of action is the weighted average payoff,
which is the sum of the payoffs for each course of action multiplied by the probabilities associated
with each state of nature. Mathematically EMV is stated as follows:

m
EMV (Course of action, Sj) =  Xij
i 1
Pi

Where m = number of possible states of nature

Pi = probability of occurrence of state of nature i
Xij = Payoff associated with state of nature Ni and course of action, Sj.
Steps in using EMV
a. Construct a payoff table listing all possible courses of action, states of natures, payoff values
and the probabilities of occurrence for each state of nature.
b. Calculate the EMV for each course of action by multiplying the conditional payoff by the
associated probabilities and add these weighted values for each course of action.
Select the course of action that yields the optimal EMV .
State of nature (i.e. Demand rate)
Probabilities 0.2 0.5 0.3
Alternatives Low DD Average DD High DD Expected Monetary Value
Small facility 6 20 24 = 6(0.2) + 20(0.5) +24(0.3 =18.4
Medium facility 10 12 20 =10(0.2) + 12(0.5) + 20(0.3) = 14
Large facility -2 8 30 = -2(0.2) + 8(0.5)+30(0.3) = 12.6
Decision: Build Small facility
Expected Monetary Loss

State of Nature (Demand rate)

Probabilities 0.2 0.5 0.3
Alternatives Low dd Average dd High dd Expected Monetary Loss

Small facility 4 0 6 = 4(0.2) + 0(0.5) + 6(0.3) =2.6

Medium facility 0 8 10 = 0(0.2) +8(0.5) + 10(0.3) =7.0
Large facility 12 12 0 = 12(0.2)+12(0.5)+0(0.3) = 8.4

Decision: Build small facility

 i. Expected Monetary Value With Perfect Information (EMVWPI)
In decision-making under risk each state of nature is associated with the probability of its occurrence.
However, If the decision-maker can acquire perfect (complete and accurate) information about the
occurrence of various states of nature, then he will be able to select a course of action that yields the
desired payoff for whatever state of nature that actually occurs.

State of nature (i.e. Demand rate)

Probabilities 0.2 0.5 0.3
Alternatives Low DD Average DD High DD
Small facility 6 20 24
Medium facility 10 12 20
Large facility -2 8 30
EMVWPI = 10(0.2) + 20(0.5) + 30(0.3) = 21.0
 i. Expected Value of Perfect Information (EVOPI)
Expected value of perfect information (EVPI) represents the maximum amount of money the
decision-maker has to pay to get this additional information about the occurrence of various states of
nature before a decision has to be made.

EVPI = Expected Monetary value with Perfect Information- Expected Value without Perfect
Information

EMVWPI – EMV
= $21.0 – $18.40
= $2.6