Decision-Making Under Risk and Uncertainty

Decision-Making Environment:-
1. Concept of Decision-Making Environment
2. Decision-Making Environment under Uncertainty
3. Risk Analysis
1. Concept of Decision-Making Environment:
 The starting point of decision theory is the distinction among three
different states of nature or decision environments:
 Certainty
 risk
 uncertainty.
 The distinction is drawn on the basis of the degree of knowledge or
information possessed by the decision-maker.
 Certainty can be characterized as a state in which the decision-maker
possesses complete and perfect knowledge regarding the impact of all of
the available alternatives.
 In our day-to day conversation, we use the two terms ‘risk’ and
‘uncertainty’ synonymously. Both imply ‘a lack of certainty’. But there is
a difference between the two concepts.
 Risk can be characterized as a state in which the decision-maker has
only imperfect knowledge and incomplete information but is still able to
assign probability estimates to the possible outcomes of a decision.
 These estimates may be subjective judgments, or they may be derived
mathematically from a probability distribution.
 Uncertainty is a state in which the decision-maker does not have even
the information to make subjective probability assessments.
 It was Frank Knight who first drew a distinction between risk and
uncertainty.
 Risk is objective but uncertainty is subjective; risk can be measured or
quantified but uncertainty cannot be. Modern decision theory is based on
this distinction.
 In general, two approaches are used to estimate the probabilities of
decision outcomes.
 The first one is deductive and it goes by the name a priori measurement;
the second one is based on statistical analysis of data and is called a
posteriori.
 With the priori method, the decision-maker is able to derive probability
estimates without carrying out any real world experiment or analysis.
 For example, we know that if we toss an unbiased coin, one of two equally
likely outcomes (i.e., either head or tail) occur, and the probability of each
outcome is predetermined.
 The a posteriori measurement of probability is based on the assumption
that past is a true representative (guide to) of the future.
 For example, insurance companies often examine historical data in order
to determine the probability that a typical twenty-five year-old male will
die, have an automobile accident, or incur a fire loss.
 Thus the implication is that even though they cannot predict the
probability that a particular individual will have an accident, they can
predict how many individuals in a particular age group are likely to have
an accident and then fix their premium levels accordingly.
 By contrast, uncertainty implies that the probabilities of various outcomes
are unknown and cannot be estimated.
 It is largely because of these two characteristics that the decision-making
in an uncertain environment involves more subjective judgment.
 Uncertainty does not seem to suggest that the decision-maker does not
have any knowledge.
 Instead it implies that there is no logical or consistent approach to
assignment of probabilities to the possible outcomes.
Some Characteristics of a Decision Problem:
 All business decision problems have certain common characteristics.
 These not only constitute a formal description of the problem but also
provide the structure necessary for a solution:
1. A decision-maker
2. Alternative courses of action (strategies)
3. Events or outcomes
4. Consequences or payoffs.
 In order to illustrate these common characteristics of a decision problem,
we may start with a simple real life example.
 Suppose you are the inventory manager of Calcutta’s New York, which is
selling men’s dresses. Your company is not a dress manufacturer. It is just
a retail store selling readymade garments. You have to decide how many
men’s T-shirts to order for the summer season.
The manufacturer of these has imposed a condition on you: You have to
order in batches of 100. If only 100 T-shirts are ordered, the cost is Rs. 10
per shirt, if 200 or more are ordered, the cost is Rs. 9 per shirt; and if 300
or more shirts are ordered the cost is Rs. 8.50.

The results of market survey provide you with information that the selling
price will be Rs. 12 and that the possible sales levels are 100, 150, or 200
units. But you cannot assign any probability estimate to the alternative
levels of demand or sales.

If any T- shirt remains unsold during summer, it can be disposed off at half
the price in winter. The marketing manager also feels that there is a
 goodwill loss of 50 paise for each T-shirt that consumers want to purchase
from your shop but cannot because of inadequate supplies.

It is not possible for you to wait for some time to study the nature (or
determine the level) of demand, nor can you place more than one order.
Thus, a situation of complete uncertainty prevails.

 In our example, the decision-maker is the inventory manager, who must

decide how many T- shirts to order in the face of uncertain demand. The
three alternative strategies are to order 100 shirts (A1), 200 (A2) or 300 (A3).
 The states of nature (which are external to and beyond the control of the
inventory manager) are the events and in this case are three levels of
demand: 100 (D1), 150 (D2), or 200 (D3). Since the inventory manager does
not know which of the events will occur, he is forced to make his decision
in the face of uncertain outcomes.
 The consequences are measures of the net benefit or payoff (reward)
association with each of the levels of demand. The specific consequence or
outcome depends not only on the decision (A1, A2, or A3) that is made but
also on the event (D1, D2, or D3) that occurs.
That is, there is a consequence or outcome associated with each
combination of decision or action and event. These consequences are
generally summarized in a payoff matrix.
The Payoff Matrix:
 A payoff matrix is an essential tool of decision-making.
 It is a nice way of summarizing the interactions of various alternative action
and events.
 Thus we can say that a payoff matrix provides the decision-maker with
quantitative measures of the payoff for each possible consequence and for
each alternative under consideration.
 Positive payoff implies profit and negative pay-off implies loss. For the T-
shirts inventory and ordering problem, the payoff matrix is presented in
the following table:

 If the future event that will occur could be predicted with certainty, the
decision-maker would merely look down the column and select the optimal
decision.
 If, for instance, it were known for certain that demand would be 150 T-
shirts, the decision-maker would order 200, in order to maximize his pay-
off.
 However, since the decision-maker does not have any knowledge about
which event (state of nature) will occur or what is the chance of a particular
event occurring, he is faced with a situation of total uncertainty.

2. Decision-Making Environment under Uncertainty:

 We may now utilize that pay-off matrix to investigate the nature and
effectiveness of various criteria of decision making under uncertainty.
 Four major criteria that are based entirely on the payoff matrix
approach are:
(1) Maximin (Wald),
(2) Maximax,
(3) Hurwicz alpha index, and
(4) Minimax regret (Savage).
 In those situations where the decision-maker is willing to assign
subjective probabilities to the possible outcomes, the two other criteria
are
a. The Laplace (Bayes’) and
b. The maximization of expected value.
 It may be noted that once subjective probabilities are introduced, the
distinction between risk and uncertainty gets blurred.
1. Maximin:
 The maximin (or Wald) criterion is often called the criterion of
pessimism.
 It is based on the belief that nature is unkind and that the decision-
maker therefore should determine the worst possible outcome for each
of the actions and select the one yielding the best of the worst (maximin)
results. That is, the decision-maker should choose the best of the worst.

2. Maximax:
 An exactly opposite criterion is the maximax criterion.
 It is known as the criterion of optimism because it is based on the
assumption that nature is benevolent (kind).
 Thus, this criterion is suitable to those who are particularly venturesome
(extreme risk takers).
 In direct contrast to the maximin criterion the maximax implies selection
of the alternative that is the “best of the best”.
 This is equivalent to assuming with extreme optimism that the best
possible outcome will always occur.
3. Hurwicz Alpha Index:
 The Hurwicz alpha criterion seeks to achieve a pragmatic compromise
between the two extreme criteria presented above.
 The focus is on an index which is based on the derivation of a coefficient
known as the coefficient of optimism.
 Here the decision-maker considers both the maximum and the
minimum payoffs from each action and weighs these extreme outcomes
in accordance with subjective evaluations of either optimism or
pessimism.

4. Minimax Regret:
 The minimax regret has been proposed by Savage.
 This criterion suggests that after a decision has been made and the
outcome has been noted, the decision-maker may experience regret
because by now he knows what event occurred and possibly wishes that
he had selected a better alternative.
 Thus, this criterion suggests that the decision-maker should attempt to
minimize his maximum regret.
 The implication is that the decision-maker would develop a regret
(opportunity loss) matrix and then apply the minimax rule to select an
action.
 Regret is defined as the difference between the actual payoff and the
expected pay-off, i.e., the payoff that would have been received if the
decision maker had known what event was going to occur.

a. Laplace (Bayes’) Criterion:

 The Laplace criterion of insufficient reason differs from the minimax
regret criterion in that it involves the use of probabilities, that is, if we
are uncertain as to which event will occur, we can assume (correctly or
incorrectly) that all states (levels of demand) are equally likely and then
assign the same probability to each of the events, i.e., we assume that
each event is equi-probable.
 These probability assignments can then be utilized to calculate the
expected payoff for each action and to choose that action with the
maximum (smallest) expected payoff (loss).

b. Maximizing Expected Value:

 This criterion is also based on the assignment of probabilities.
 However, the assumption that each event is equi-probable is not made.
Instead, the analyst makes a more critical appraisal before assigning
subjective probabilities to each event.
 By assigning subjective probabilities, the decision maker is, in essence,
converting an uncertain situation into a situation of risk.
3. Decision-Making Environment under Risk Analysis:
 Here we drew a distinction between risk and uncertainty.
 Recall that risk is characterized as a state in which the decision-maker
has only imperfect information about the decision environment, i.e., the
impact of all of the available alternatives.
 But the decision-maker is still able to assign probability estimates to the
possible outcomes of a decision.
 These estimates are either subjective judgments or may be derived from
a theoretical probability distribution.
 Uncertainty refers to a state in which the decision-maker lacks even the
information to assign subjective probabilities.
 This distinction was first drawn by F. H. Knight who noted that “risk
is objective but uncertainty is subjective”.
 Yet, the two terms are often used interchangeably to mean simply ‘a lack
of certainty’.
 However, the important point to note is that the use of subjective
probabilities has diminished the significance of the distinction between
risk and uncertainty.
 In other words, by assigning subjective probabilities to decision
problems, decision-making under uncertainty can easily be converted
into risk analysis.
Treatment of Risk in Economic Analysis:
 Risk analysis involves a situation in which the probabilities associated
with each of the payoffs are known.
 There are two alternative ways of deriving these probabilities:
(a) By an analysis of historical patterns, or
(b) By reference to a theoretical probability distribution (such as the
binomial distribution, Poisson distribution or normal distribution).
 Risk analysis is based on the concept of random variable.
 A random variable is any variable whose value is uncertain, that is,
whose value is subject to probabilistic variation.
 For example, when one rolls a die the number that comes up is a random
variable.
 The price of tea next week may also be random owing to unforeseen
shifts in supply and demand. Now the values that a random variable can
assume may not be equally likely (i.e., equi-probable events).
 For this reason it is necessary to look at the probability distribution of
the random variable, which is a listing- of the possible outcomes with
the associated probabilities of those outcomes.