Decision Making Under Risk

Between two extremities of certainty and uncertainty lies the case of risk. The probability of
occurrence for each state of nature is known. A widely used approach under such circumstance
is the (EMV) expected monetary value criteria. The expected value is computed for each
alternative and the one with the best expected value is selected.

Ex: Using the EMV criteria, identify the best alternative for the previous payoff table using these
probabilities: low=.30, moderate=.50 and high=.20.

Solution:
Find the expected value of each alternative by multiplying the probability of occurrence for
each state of nature by the pay-off for that state of nature and summing them.

EV (Small) = .3($10) +.5($10)+.20($10) = $10

EV (Medium) = .3($7) +.5($12)+.20($12) = $10.5
EV (Large) = .3($-4) +.5($2)+.20($16) = $3

Hence, choose the medium facility because it has the highest expected value.
Decision Tree

A decision tree is a schematic representation of the alternatives available to a decision

maker and their possible consequences. The term get its name from the treelike appearance of
the diagram. A decision tree is composed of nodes that have branches emanating from them.

Square Nodes – denotes decision points

Circular Nodes – denotes chance events or states of natures

If we will convert our previous example to decision tree, it will look like this:
Example: A manager must decide on the size of a video arcade to construct. The manager has
narrowed the choices to two: large or small. Information has been collected on payoffs, and a
decision tree has been constructed. Determine the course of action that the manager should
make: