Unit Four: Decision Making Under Uncertainty &

Risk Situations

This chapter focuses on making decision under:

o Uncertainty conditions
o Risk Conditions

By: Getachew Gobena (Asst. Prof.)

4.1. Decision Making Under Condition of Uncertainty
 Under complete uncertainty, either no estimates of the
probabilities for the occurrence of the different states of nature are
available.

 Under this circumstance, the decision maker lacks confidence in

the state of nature to make decision.

 For this kind of decision, probabilities are not used at the choice
of the best alternative.

 Most of the rules for decision making under uncertainty express a

different degree of decision maker´s optimism.
4.2. Decision Making Criteria under Uncertainty Situation

For making decisions under uncertainty condition, different

techniques to be used. Some of these are as follows:

4.2.1.The Maximax Criterion

 The maximax criteria is appropriate for extreme optimists that
expect the most favorable situation.
 Decision makers choose the alternative that could result in the
maximum payoff.
 Under this criteria, the decision maker will find the largest payoff
in the decision matrix and select the alternative associated with it.
 The largest payoff is determined for each alternative and then the
largest payoff from these values (maximax) is selected.
o The procedure for maximax is shown in the following table:
Example 1:
Demand Low Moderate High Row
Order Maximum

Small 50 50 50 50

Medium 42 52 52 52

Large 34 44 54 54 
Maximum

 The best overall profit is $54 in the third row. Hence, the
maximax rule leads to the large order (the grocer hopes that the
demand will be high).
 Exercise:
 The investor wants to make decision for investment on best
alternative under the following given state of nature.

State of nature
Alternatives
Good Medium Poor economic
economic condition condition
condition
Apartment $50,000 $45,000 &30,000
building
Office building $100,000 $70,000 - $40,000
Warehouse $30,000 $20,000 $10,000
building

 Which alternative and what payoff should the investor choose

on the basis of the maximax criteria?
 4.2.2. The Wald Criteria (Maxmin Rule)
 The maximin rule (Wald criterion) represents a pessimistic
approach when the worst decision results are expected.
 The decision maker determines the smallest payoff for each
alternative and then chooses the alternative that has the best
(maximum) of the worst (minimum) payoffs .
Example 2:
Demand Low Moderate High Row
Minimum
Order
Small 50 50 50 50
Maximum
Medium 42 52 52 42
Large 34 44 54 34

 Since 50 is the largest, the small order should be chosen (if demand is low,
the $50 grocer‘s profit is guaranteed).
• Exercise
• The investor wants to make decision for investment
on best alternative under the following given state of
nature.
State of nature
Alternatives
Good economic Medium Poor economic
condition condition condition
Apartment $50,000 $45,000 $30,000
building
Office building $100,000 $70,000 - $40,000
Warehouse $30,000 $20,000 $10,000
building

 Which alternative and what payoff should the investor choose

on the basis of the Wald Criteria (Maxmin Rule)?
 4.2.3. The Hurwicz Criterion
 The Hurwicz - criterion represents a compromise between the
optimistic and the pessimistic approach to decision making
under uncertainty.
 The measure of optimism and pessimism is expressed by an
optimism - pessimism index ( ), 0 <= <=1.
 The more this index is near to 1, the more the decision maker is
optimistic.
 If  = 0, the decision maker is said to be completely pessimistic.
 By means of the index , if  is the coefficient of optimism, 1- 
is the coefficient of pessimism.
 The weighted average will be computed for each alternative and
the alternative with the largest weighted average should be
chosen.
 If we choose = 0.7 at determining the best size of the order in
examples 1 &2 above, the weighted average (WA) of the largest
and the smallest profit for each size of the order has the
following values:
 WA (small) = 0.7* 50 + 0.3 * 50 = 50
 WA (medium) = 0.7* 52 + 0.3 * 42 = 49
 WA (large) = 0.7* 54 + 0.3 *34 = 48

 Maximizing the weighted average of the largest and the smallest

profit, the small order should be selected.
 Exercise:

 Which alternative of investment to be selected using the

Hurwicz criterion for the following given data with 0.5
coefficient of optimism?
State of nature
Alternatives
Good economic Medium condition Poor economic
condition condition

Apartment building $50,000 $45,000 $30,000

Office building $100,000 $70,000 - $40,000

Warehouse $30,000 $20,000 $10,000

building
 4.2.4. The savage criterion (Minimax Regret Rule)
 The maximax and maximin rules and the Hurwicz criterion
can be criticized because they focus only on extreme payoffs
and exclude the other payoffs.

 An approach that does take all payoffs into account is the

minimax regret rule (Savage criterion).
 This rule represents a pessimistic approach used for an
opportunity loss table.
 The opportunity loss reflects the difference between each
payoff and the best possible payoff in a column.
 The opportunity loss can be defined as the amount of profit
foregone by not choosing the best alternative for each state of
nature.
 The opportunity loss amounts are found by identifying the greatest
payoff in a column and, then, subtracting each of the other values
in the column from that payoff.

 The values in an opportunity loss table can be viewed as potential

”regrets” that might be suffered as the result of choosing various
alternatives.

 Minimizing the maximum possible regret requires identifying the

maximum opportunity loss in each row and, then, choosing the
alternative that would yield the minimum of those regrets (this
alternative has the “best worst”).
 To illustrate the Savage criterion procedure, we will recall the
decision problem given in example 1 &2 and first construct the
corresponding regret table.
 Payoff table:

Demand  Low Moderate High

Order
Small 50 50 50
Medium 42 52 52
Large 34 44 54
 In the first column of the payoff matrix, the largest number is 50, so each of
the three numbers in that column must be subtracted from 50.
 In the second column, we must subtract each payoff from 52 and in the third
column from 54 as calculations are summarized in the following Table. A
column with the maximum loss in each row is presented to this table.

Demand Low Moderate High Maximum

Loss
Order
Small 0 2 4 4 
Minimum
Medium 8 0 2 8
Large 16 8 0 16

 To minimize the maximum loss, the small order should be chosen.

 Make a decision for the type of investment to be selected on the
basis of the following data using the Savage criterion (Minimax
Regret Rule).
State of nature
Alternatives
Good economic Medium condition Poor economic
condition condition

Apartment building $50,000 $45,000 $30,000

Office building $100,000 $70,000 - $40,000

Warehouse $30,000 $20,000 $10,000

building
 4. 2.5. The Lap place criterion (Equal Likelihood Criterion)

 The lap place criterion assumes that all states of nature are
equally likely.

 Under this assumption, the decision maker can compute the

average payoff for each row (the sum of the possible
consequences of each alternative is divided by the number of
states of nature).

 Finally, the alternative that has the highest row average will be
selected as best alternative. This procedure is illustrated by the
following calculations with the data in Table 2.2
 The procedure for the Lap Place Criterion (Equal Likelihood
Criterion) is illustrated by the following calculations with the data
given under example 1 and 2.

 Expected monetary value (EMV):

 EMV (small) = (50 + 50 + 50)/3 = 50
 EMV (medium) = (42 + 52 + 52)/3 = 48.7
 EMV (large) = (34 + 44 + 54)/3 = 44

 Since the profits at the small order have the highest average, that
order should be realized.
 Exercise:
 Make a decision for the investment to be made using the lap
place criterion (equal likelihood criterion) under the following
state of nature.

State of nature
Alternatives
Good economic Medium condition Poor economic
condition condition
Apartment building $50,000 $45,000 $30,000

Office building $100,000 $70,000 - $40,000

Warehouse building $30,000 $20,000 $10,000

 4. 3. Decision Making Under Condition of Risk

 In this case, the decision maker doesn´t know which state of

nature will occur but can estimate the probability of occurrence
for each state.

 The probabilities may be subjective (they usually represent

estimates from experts in a particular field), or they may reflect
historical frequencies.

 A widely used approach to decision making under risk is

expected monetary value criterion.

 There are also other techniques that can be used to make

decision under this condition.
 4.3.1. Expected Monetary Value Criterion

 The Expected Monetary Value (EMV) of an alternative is

calculated by multiplying each payoff that the alternative can
yield by the probability for the relevant state of nature and
summing the products.

 The value is computed for each alternative, and the one with the
highest EMV is selected.
 Suppose that the grocer can assign probabilities of low,
moderate and high demand on the basis of his experience with
sale of pastry.
 The estimates of these probabilities are 0.3, 0.5, 0.2,
respectively.
 We will recall the payoff table for the considered problem.
 Payoff table:

Demand Low Moderate High

Order

Small 50 50 50

Medium 42 52 52

Large 34 44 54
 The EMV for various sizes of the order are as follows:

 EMV (small) = 0.3*50 + 0.5*50 + 0.2*50 = 50

 EMV (medium) = 0.3*42 + 0.5*52 + 0.2*52 = 49
 EMV (large) = 0.3*34 + 0.5*44 + 0.2*54 = 43
 Therefore, in accordance with the EMV criterion, the small order
should be chosen.
 Note that the EMV of $50 will not be the profit on any one day.
It represents an expected or average profit.
 If the decision were repeated for many days (with the same
probabilities), the grocer would make an average of $50 per day
by ordering the small amount of pastry.
 Even if the decision were not repeated, the action with the
highest EMV is the best alternative that the decision maker has
available.
 The EMV criterion remains as the most useful of all the
decision criteria for decision making under risk.

 For risky decisions, a sensible approach is first to calculate the

EMV, and then to make a subjective adjustment for the risk in
making the choice.
 Exercise:
 If you need to make a decision for investment using the
expected monetary value criterion (EMV), which alternative
do you select ? Recall the following data. (Assume that the
probabilities are 0.5, 0.3 and 0.2 for good economic, medium
economic and poor economic conditions respectively).
State of nature
Alternatives
Good economic Medium condition Poor economic
condition condition
Apartment building $50,000 $45,000 $30,000

Office building $100,000 $70,000 - $40,000

Warehouse building $30,000 $20,000 $10,000

4.3.2. The Expected Opportunity Loss (ELO) Criterion
 The expected opportunity loss (EOL) is nearly identical to the
EMV approach, except that a table (or matrix) of opportunity
losses (or regrets) is used.

 The opportunity losses for each alternative are weighted by the

probabilities of their respective states of nature and these products
are summed.

 The alternative with the smallest expected loss is selected as the

best choice.
 We will use EOL procedure in the regret matrix shown above
on slide number 39.
Regret table:
Demand Low Moderate High

Order

Small 0 2 4

Medium 8 0 2

Large 16 8 0
 Supposing that the probabilities of various sizes of the demand
are 0.3, 0.5, 0.2, we can determine the EOL for each size of the
order as follows:
 EOL (small) = 0.3*0 + 0.5*2 + 0.2*4 = 1.8
 EOL (medium) = 0.3*8 + 0.5*0 + 0.2*2 = 2.8
 EOL (large) = 0.3*16 + 0.5*8 + 0.2*0 = 8.8
 Since the small order is connected with the smallest EOL, it is
the best alternative.
 The EOL approach resulted in the same alternative as the EMV
approach.

 The two methods always result in the same choice, because

maximizing the payoffs is equivalent to minimizing the
opportunity losses.
 Exercise:
 Make a decision for selection of a type of investment to be made
using EOL criterion by recalling the following data (Assume
probabilities of 0.3, 0.5 and 0.2 for good, medium and poor
economic conditions respectively).
State of nature
Alternatives
Good economic Medium condition Poor economic
condition condition
Apartment building $50,000 $45,000 $30,000
Office building $100,000 $70,000 - $40,000
Warehouse building $30,000 $20,000 $10,000
 4.3.3. Maximum - likelihood Decision Criterion
 According to this criterion, we consider only the state of nature
with the highest probability and choose the best alternative for
that state of nature.
 If we suppose in the decision problem given under EOL that the
probabilities of various sizes of the demand are 0.3, 0.5, 0.2, the
moderate demand is most likely. Under this situation, the
medium order is the best.
 Since the maximum-likelihood criterion takes only one uncertain
state of nature into account, it may lead to bad decisions.

 The expected value approach (the calculation of the EMV or the

EOL) is particularly useful for decision making when a number
of similar decisions must be made; it is a “long-run” approach.
 4.3.4. Decision Tree Analysis
 Decision tree is a graphical diagram consisting of nodes and
branches.

 In a decision tree, the user computes the expected value of each

outcome and makes a decision based on these expected values.

 The primary benefit of a decision tree is that it provides an

illustration (picture) of the decision making process which makes
the decision making process easier.
 A decision tree is composed of nodes and branches (arcs).

 The terminology of nodes and arcs comes from network models

which have a similar pictorial representation.

 A decision tree has three types of nodes: decision nodes, chance

event nodes, and terminating nodes.
 Decision nodes: are denoted by squares.

 Each decision node has one or more arcs beginning at the node and
extending to the right.

 Each of those arcs represents a possible decision alternative at that

decision point.
 Chance event nodes: are denoted by circles.
 Each chance event node has one or more arcs beginning at the node
and extending to the right.

 Each of those arcs represents a possible event at that chance event

point. The decision maker has no control over these chance events.

 The events associated with branches from any chance event node
must be mutually exclusive and all events included.

 The probability of each event is conditional on all of the decision

alternatives and chance events that precede it on the decision tree.

 The probabilities for all of the arcs beginning at a chance event node
must sum to 1.
 A terminating node: represents the end of the sequence of
decisions and chance events.

 No arcs extend to the right from a terminating node.

 Terminating nodes are the starting points for the

computations needed to analyze the decision tree.
Format of a decision tree
 Analysis of Decision Trees
 After the tree has been drawn, it is analyzed from right to left.

 The aim of this analysis is to determine the best strategy of the

decision maker, that means an optimal sequence of the decisions.
 To analyze a decision tree, we must know a decision criterion,
probabilities that are assigned to each event, and revenues and
costs for the decision alternatives and the chance events that
occur.
 Analyzing a decision tree, we begin at the end of the tree and
work backwards.
We carry out two kinds of calculations:
i. For chance event nodes, we calculate the events emanating
from these nodes.

Under the assumption that the decision maker has a neutral

attitude toward risk, certainty equivalent of uncertain
outcomes can be replaced by their expected value.

ii. At decision nodes, the alternative with the best expected

value of the decision criterion is selected.
 The analysis of a decision tree is illustrated by the following
example.

 A firm is deciding between two alternatives: to introduce a new

product or to keep the existing product. Introducing a new product
has uncertain outcomes in dependence on the demand. If the demand
is high, the resulting profit of the firm will be $140. The low demand
will be result in the profit of $ 80. The firm estimates the probabilities
of a high and low demand 0.7 and 0.3, respectively. If the firm keeps
the existing product, its profit will be 110.
 The decision tree for the above decision problem can be shown
as follows: (If the alternative not to be chosen, (// ) will be used.
 Example1:

 The estimated profit is written at the end of the chance branches.

 The probabilities of a high and a low demand for the new product are
written below the branches leaving the chance node.
 The nodes are numbered.
 For the chance node 2, we calculate the expected value of the
profit (0.7*140 + 0.3*80 = 122) and write this value over the node
2.

 At the decision node 1, we select the decision alternative with the

higher expected profit. Because max (122;110) = 122, introducing
the new product is profitable.

 We write the maximum expected profit over the node 1 and draw
double lines (//) through the branch representing the inferior
(worse) decision alternative.
Exercise :
 Formulate the tree that represents a decision tree for the order
planning problem given in the following table with the
probabilities of 0.3, 0.5 and 0.2 for low, moderate and high
demand respectively. Then make a decision.
 The decision tree for order planning:
 The use of a decision table in comparison with the use of a
decision tree may seem easier and simpler when the decision
problem becomes simple.

 As the decision problem becomes more complex, the decision

tree becomes more valuable in organizing the information
needed to make the decision.

 This is especially true if the decision maker must make a

sequence of decisions, rather than a single decision, as the next
example illustrates.
 Suppose the marketing manager of a firm is trying to decide whether or not to
market a new product and at what price to sell it.
 The profit to be made depends on whether or not a competitor will introduce a
similar product and on what price the competitor charges.
 Note that there are two decisions: (1) introduce the product or not, and (2) the
price to charge.
 Likewise, there are two events: (1) competition introduces a competitive
product (or not), and (2) the competitor’s price.
 The timing or sequence of these decisions and events is very important in this
decision.
 If the marketing manager must act before knowing whether or not the
competitor has a similar product, the price may be different than with such
knowledge.
 A decision tree is particularly useful in this type of situation, since it displays
the order in which decisions are made and events occur as can be seen next.
 Suppose that the firm must decide whether or not to market its new product
shortly. However, the price decision can be made later.
 If the competitor is going to act, it will introduce its product within a month.
In three months, the firm will establish and announce its price.
 Note that the given problem is a sequential decision problem.
 The firm must make a decision now about introduction and subsequently set
price, after learning about the competitor’s action.
 This structure of the problem is diagrammed in the decision tree in the
following picture.
 Estimated profits for every path through the tree are shown at the ends of the
tree.
 The probabilities for each event are shown under the event branches.
 Note that the probabilities for the competitor’s price behavior are different
when the firm’s price is high than when the firm’s price is medium or low.
 A decision tree for a sequential decision problem:

 After the analysis of the drawn decision tree the following strategy can be
recommended to the firm:
 Introduce the new product and charge a high price if there is no
competitive entry; but charge a medium price if there is competition.
 For this strategy, the expected profit is $156,000.