Alido, Kevin F.

PetE – 3306

Decision Admitting Uncertainty

A decision under uncertainty is when there are many unknowns and no possibility of

knowing what could occur in the future to alter the outcome of a decision. We
feel uncertainty about a situation when we can't predict with complete confidence what the
outcomes of our actions will be.

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.

Sensitivity Analysis

Sensitivity analysis is a financial model that determines how target variables are affected
based on changes in other variables known as input variables. This model is also referred to as
what-if or simulation analysis. It is a way to predict the outcome of a decision given a certain
range of variables. By creating a given set of variables, an analyst can determine how changes in
one variable affect the outcome.

Both the target and input—or independent and dependent—variables are fully analyzed
when sensitivity analysis is conducted. The person doing the analysis looks at how the variables
move as well as how the target is affected by the input variable.

Sensitivity analysis can be used to help make predictions about the share prices of public
companies. Some of the variables that affect stock prices include company earnings, the number
of shares outstanding, the debt-to-equity ratios (D/E), and the number of competitors in the
industry. The analysis can be refined about future stock prices by making different assumptions
or adding different variables. This model can also be used to determine the effect that changes in
interest rates have on bond prices. In this case, the interest rates are the independent variable,
while bond prices are the dependent variable.

Sensitivity analysis allows for forecasting using historical, true data. By studying all the
variables and the possible outcomes, important decisions can be made about businesses, the
economy, and making investments.
Decision Analysis Model

Decision analysis is a systematic, quantitative, and transparent approach to making

decisions under uncertainty. The fundamental tool of decision analysis is a decision-analytic
model, most often a decision tree or a Markov model. A decision model provides a way to
visualize the sequences of events that can occur following alternative decisions (or actions) in a
logical framework, as well as the health outcomes associated with each possible pathway.
Decision models can incorporate the probabilities of the underlying (true) states of nature in
determining the distribution of possible outcomes associated with a particular decision. These
probabilities are not known to the decisionmaker but are critically important.

 Maximin

A maximin strategy is a strategy in game theory where a player makes

a decision that yields the 'best of the worst' outcome. All decisions will have costs and
benefits, and a maximin strategy is one that seeks out the decision that yields the smallest
loss.

 Minimax

Minimax decision making is based on opportunistic loss. They are the kind that
look back after the state of nature has occurred and say "Now that I know what happened,
if I had only picked this other action instead of the one I actually did, I could have done
better". So, to make their decision (before the event occurs), they create an opportunistic
loss (or regret) table. Then they take the minimum of the maximum. That sounds
backwards, but remember, this is a loss table. This similar to the maximin principle in
theory; they want the best of the worst losses.

 Maximax

The Maximax decision rule is used when a manager wants the possibility of having

the highest available payoff. It is called Maximax beacuse the manager will find
the decision alternative that MAXImizes the MAXimum payoff for each alternative.
Monte Carlo Simulation

Monte Carlo Simulation, also known as the Monte Carlo Method or a multiple probability
simulation, is a mathematical technique, which is used to estimate the possible outcomes of an
uncertain event

Monte Carlo simulation performs risk analysis by building models of possible results by

substituting a range of values—a probability distribution—for any factor that has inherent
uncertainty. It then calculates results over and over, each time using a different set of random
values from the probability functions.

Monte Carlo simulation is a computerized mathematical technique that allows people to

account for risk in quantitative analysis and decision making. The technique is used by
professionals in such widely disparate fields as finance, project management, energy,
manufacturing, engineering, research and development, insurance, oil & gas, transportation, and
the environment.

Monte Carlo simulation furnishes the decision-maker with a range of possible outcomes
and the probabilities they will occur for any choice of action. It shows the extreme possibilities—
the outcomes of going for broke and for the most conservative decision—along with all possible
consequences for middle-of-the-road decisions.

The technique was first used by scientists working on the atom bomb; it was named for
Monte Carlo, the Monaco resort town renowned for its casinos. Since its introduction in World
War II, Monte Carlo simulation has been used to model a variety of physical and conceptual
systems.

Consider a simple example of rolling dice. Assume that you want to determine the
probability of rolling a seven using two dice with values one through six. There are 36 possible
combinations for the two dice, six of which will total seven.

This means that mathematical probability of rolling a seven is six in 36, or 16.67 percent.

But is the mathematical probability the same as the actual probability? Or are there other
factors that might affect the mathematical probability, such as the design of the dice themselves,
the surface on which they are thrown, and the technique that is used to roll them?
 To determine the actual probability of rolling a seven, you might physically roll the dice
100 times and record the outcome each time. Assume that you did this and rolled a seven 17 out
of A Monte Carlo simulation is the mathematical representation of this process. It allows you to
simulate the act of physically rolling the dice and lets you specify how many times to roll them.
Each roll of the dice represents a single iteration in the overall simulation; as you increase the
number of iterations, the simulation results become more and more accurate. For each iteration,
variable inputs are generated at random to simulate conditions such as dice design, rolling
surface, and throwing technique. The results of the simulation would provide a statistical
representation of the physical experiment described above100 times, or 17 percent of the time.
Although this result would represent an actual, physical result, it would still represent
an approximate result. If you continued to roll the dice again and again, the result would become
less and less approximate.

References

https://www.wisdomjobs.com/e-university/quantitative-techniques-for-management-
tutorial-297/decision-making-under-uncertainty-10067.html

https://www.economicsdiscussion.net/microeconomics/managerial-decision-making-under-
risk-and-uncertainty/19621

https://www.investopedia.com/terms/s/sensitivityanalysis.asp

https://www.ncbi.nlm.nih.gov/books/NBK127474/

https://www.shsu.edu/law001/site/u3m3p4.html

https://www.ibm.com/cloud/learn/monte-carlo-simulation#:~:text=Monte%20Carlo
%20Simulation%2C%20also%20known,outcomes%20of%20an%20uncertain%20event.

https://www.palisade.com/risk/monte_carlo_simulation.asp

https://www.ge.com/digital/documentation/meridium/V36000/WebHelp/mergedProjects/
WebHelp_Master/mergedProjects/Reliability/
Monte_Carlo_Simulations__A_Simple_Example.htm