Decision Making under

Uncertainty/Risk
Steps in Decision Theory Approach
• List all the viable alternatives (strategies) that
can be considered in decision
• List all the future events that can occur. These
future events are also called states of nature.
 Example
STRATEGIES

FUTURE EVENTS
 Approaches to decision making under risk
conditions without probabilities
• Maximin Criterion
• Minimax Criterion
• Maximax Criterion
• Laplace Criterion
• Minimax Regret Criterion
• Hurwicz Criterion
 Maximin (Pessimistic) Criterion
Decision maker find the minimum possible
payoff for each alternative and then choose the
alternative with maximum payoff within this
group
 Maximin (Pessimistic) Criterion

Minimum payoff for different strategies

20 is the maximum of all these numbers

Thus, Strategy 1 (Having stock option 10) will be selected strategy using
Maximin criterion.
 Minimax Criterion
The Minimax Criterion selects the minimum of
the maximum profits for the different stock
options.
 Minimax Criterion

Maximum payoff for different strategies

20 is the minimum of all these numbers

Thus, Strategy 1 (Having stock option 10) will be selected strategy using
Minimax criterion.
 Maximax (Optimistic) Criterion
The decision maker finds maximum possible
payoff for each alternative and then choose the
alternative with maximum payoff within this
group.
 Maximax (Optimistic) Criterion

Maximum payoff for different strategies

28 is the maximum of all these numbers

Thus, Strategy 5 (Having stock option 14) will be selected strategy using
Maximax criterion.
Laplace Criterion (Criterion of Rationality)

This criterion assigns equal probability to all

events of each alternative and select the
alternative associated with maximum expected
payoff.
Laplace Criterion (Criterion of Rationality)

Probability value for Strategy 1 (10 stock option)

Probability value for Strategy 2 (11 stock option)
Probability value for Strategy 3 (12 stock option)
Probability value for Strategy 4 (13 stock option)

Probability value for Strategy 1 (14 stock option)

Thus, Strategy 2 or 3 (Having stock option 11 or 12) will be selected strategy
using Laplace criterion.
 Minimax Regret/Savage Criterion
The decision maker might experience regret
after decision has been made and future events
have occurred. Therefore, he tries to minimize
this regret before actually selecting particular
alternative. He determines the maximum regret
amount for each alternatives and then choose
the alternatives with minimum of above
maximum regrets.
Minimax Regret/Savage Criterion check
solution
Pay off matrix
Minimax Regret/Savage Criterion
Regret matrix (Regret=maximum profit-actual profit)

Thus, Strategy 1 (Having stock option 10) will be selected strategy using
Minimax Regret criterion.
Hurwicz Criterion (Criterion of Realism)
 Decision Making under Risk
Here, more than one state of nature exist and decision maker
has sufficient information to assign probabilities to each of
these states.
There are a number of approaches to decision making under
risk conditions:
• Expected Monetary Value (EMV) Criterion – Objective is to
maximize profit
• Expected Opportunity Loss (EOL) Criterion – Objective is to
minimize loss
• Expected Profit with Perfect Information (EPPI)
• Decision Trees
• Marginal Analysis
• Bayesian Rule
Expected monetary value (EMV) criterion

• Construct payoff table listing of alternative

decisions and the various states of nature. Enter
conditional profit for each decision event
combination along with associated probabilities.
• Calculate EMV for each decision alternative by
multiplying the conditional profit by assigned
probabilities and adding the resulting
conditional value.
• Select the alternative with highest EMV.
Example
 EMV criterion: conditional profit table
Possible Probabilit Possible stock options
demand (No y 10 11 12 13 14
of copies)

10 0.1
11 0.15 20 22 19 16 13
12 0.20 20 22 24 21 18
13 0.25 20 22 24 26 23
14 0.30 20 22 24 26 28
 EMV criterion: expected profit table
Possible Probabilit Possible stock options
demand (No y 10 11 12 13 14
of copies) 10 11 12 13 14

10 0.1
10 0.1
11 0.15 3 3.30 2.85 2.40 1.95
12 0.20 4 4.40 4.80 4.20 3.60
11 0.15 3 3.30 2.85 2.40 1.95
13 0.25 5 5.50 6.00 6.50 5.75
12 0.20 4 4.40 4.80 4.20 3.60
14 0.30 6 6.60 7.20 7.80 8.40
13 0.25 5 5.50 6.00 6.50 5.75
EMV 20.00 21.50 22.25 22.00 20.50
14 0.30 6 6.60 7.20 7.80 8.40
EMV 20.00 21.50 22.25 22.00 20.50

Since the aim of the EMV criterion is to maximize profit, choose maximum EMV value
∴ Decision is to stock 12 magazines per day in order to maximize profit.
Expected Opportunity Loss (EOL) criterion

• Prepare the conditional profit table for each decision-

event combination and write the associated
probabilities.
• For each event, calculate the conditional opportunity
loss (COL) by subtracting pay off from maximum pay
off for the event.
• Calculate expected opportunity loss (EOL) for each
decision alternative by multiplying the COL by
associated probabilities and then adding the values.
• Select the alternative with lowest EOL.
 Example

SOLVE THE SAME PROBLEM BY EOL CRITERIAN.

 EOL criterion: conditional profit table
Possible Probabilit Possible stock options
demand (No y 10 11 12 13 14
of copies)

10 0.1
11 0.15 20 22 19 16 13
12 0.20 20 22 24 21 18
13 0.25 20 22 24 26 23
14 0.30 20 22 24 26 28
EOL criterion: conditional loss table
Possible Probabilit Possible stock options
demand (No y 10 11 12 13 14
of copies)

10 0.1
11 0.15 2 0 3 6 9
11 0.15 2 0 3 6 9
12 0.20 4 2 0 9 6
12 0.20 4 2 0 9 6
13 0.25 6 4 2 0 3
13 0.25 6 4 2 0 3
14 0.30 8 6 4 2 0
14 0.30 8 6 4 2 0
 EOL criterion: expected loss table
Possible Probabilit Possible stock options
demand (No y 10 11 12 13 14
of copies)

10 0.1
11 0.15 0.3 0.0 0.45 0.9 1.35
11 0.15 0.3 0.0 0.45 0.9 1.35
12 0.20 0.8 0.4 0.0 0.6 1.2
12 0.20 0.8 0.4 0.0 0.6 1.2
13 0.25 1.5 1.0 0.5 0.0 0.75
13 0.25 1.5 1.0 0.5 0.0 0.75
14 0.30 2.4 1.8 1.2 0.6 0.0
14 0.30 2.4 1.8 1.2 0.6 0.0
EOL 5 3.5 2.75 3.0 4.5
EOL 5 3.5 2.75 3.0 4.5

Since the aim of the EOL criterion is to minimize loss, choose minimum EOL value
∴ Decision is to stock 12 magazines per day in order to minimize loss.