DECISION MAKING UNDER UNCERTAINITY

Uncertainty is a state of having limited knowledge of current

conditions or future outcomes. It is a major component of risk,
which involves the likelihood and scale of negative
consequences. Managers often deal with uncertainty in their
work; to minimize the risk that their decisions will lead to
undesired outcomes, they must develop the skills and judgment
necessary for reducing this uncertainty. Managing uncertainty
and risk also involves mitigating or even removing things that
inhibit effective decision-making or adversely effect
performance
 One cause of uncertainty is proximity: things that
are about to happen are easier to estimate than
those further out in the future. One approach to
dealing with uncertainty is to put off decisions
until data become more accessible and reliable.
Of course, delaying some decisions can bring its
own set of risks, especially when the potential
negative consequences of waiting are great.
Identifying Risks
 Managing uncertainty in decision-making relies
on identifying, quantifying, and analyzing the
factors that can affect outcomes. This enables
managers to identify likely risks and their
potential impact. Types of risk include:
Strategic Risks
 Strategic risks: These are risks that arise from the investments
an organization makes to pursue its mission and objectives. They
are often associated with competition and can include
macroeconomic risks (the alignment of buyers and sellers
consistent with the principles of supply and
demand), and investor relations risk (the risks associated with
communicating effectively or ineffectively with the investment
community).
Financial Risks

 Financial risks: These relate to potential economic

losses that can result from poor allocation of resources,
changes in interest rates, shifts in tax policy, increases or
decreases in the price of commodities, or fluctuations in
the value of currency.
 Operational risks: These risks can arise due to choices about
design and use of processes to create and deliver goods and
services. They can include production errors, substandard raw
materials, and technology malfunctions.
 Legal risks: These risks stem from the threat of litigation or
ambiguity in applicable laws and regulations (including whether
they are likely to change); these threats create uncertainty in the
steps an organization should take to address its obligations to
customers, employees, suppliers, stockholders, communities, and
governments.
 Decision Analysis

 The field of decision analysis provides a

framework for making important decisions.
 Decision analysis allows us to select a decision
from a set of possible decision alternatives
when uncertainties regarding the future exist.
 The goal is to optimize the resulting payoff in
terms of a decision criterion.
7
Introduction to Decision Analysis

 Maximizing expected profit is a

common criterion when
probabilities can be assessed.

• Maximizing the decision maker’s utility

function is the mechanism used when risk
is factored into the decision making
process. 8
Payoff Table Analysis

 Payoff Tables

 Payoff table analysis can be applied when:

 There is a finite set of discrete decision alternatives.
 The outcome of a decision is a function of a single future event.
 In a Payoff table -
 The rows correspond to the possible decision alternatives.
 The columns correspond to the possible future events.
 Events (states of nature) are mutually exclusive and collectively
exhaustive.
 The table entries are the payoffs.
9
TOM BROWN INVESTMENT DECISION

 Tom Brown has inherited $1000.

 Hehas to decide how to invest the money for
one year.
A broker has suggested five potential
investments.
 Gold
 Junk Bond
 Growth Stock
 Certificate of Deposit
 Stock Option Hedge
10
TOM BROWN

 The return on each investment depends on the (uncertain) market behavior

during the year.
 Tom would build a payoff table to help make the investment decision

11
TOM BROWN - Solution

• Construct a payoff table.

 Select a decision making criterion, and apply it to the payoff
table.

• Identify the optimal decision.

• Evaluate the solution. S1 S2 S3 S4 Criterion

D1 p11 p12 p13 p14 P1

D2 p21 p22 p23 P24 P2
D3 p31 p32 p33 p34
12
P3
 The Payoff Table

DJA is up more DJA is up DJA moves DJA is down DJA is down more
than1000 points [+300,+1000] within [-300, -800] than 800 points
[-300,+300]

Decision Define the states

States of nature.
of Nature
Alternatives Large Rise Small Rise No Change Small Fall Large Fall
Gold -100 100 200 300 0
Bond 250 The states
200 of nature150
are mutually
-100 -150
Stock 500 exclusive
250and collectively
100 exhaustive.
-200 -600
C/D account 60 60 60 60 60
Stock option 200 150 150 -200 -150
13
The Payoff Table

Decision States of Nature

Alternatives Large Rise Small Rise No Change Small Fall Large Fall
Gold -100 100 200 300 0
Determine the
Bond 250 200 150 -100 -150
set of possible
Stock 500decision250 100 -200 -600
C/D account 60alternatives.
60 60 60 60
Stock option 200 150 150 -200 -150

14
The Payoff Table

Decision States of Nature

Alternatives Large Rise Small Rise No Change Small Fall Large Fall
Gold -100 100 200 300 0
Bond 250 200 150 -100 -150
Stock 500 250 100 -200 -600
C/D account 60 60 60 60 60
Stock option 200 150 150 -200 -150

The stock option alternative is dominated by the

bond alternative 15
6.3 Decision Making Criteria

 Classifying decision-making criteria

 Decision making under certainty.

 The future state-of-nature is assumed known.
 Decision making under risk.
 There is some knowledge of the probability of the states of nature occurring.
 Decision making under uncertainty.
 There is no knowledge about the probability of the states of nature occurring.

16
Decision Making Under Uncertainty

 The decision criteria are based on the decision maker’s

attitude toward life.
 The criteria include the
 Maximin Criterion - pessimistic or conservative approach.
 Minimax Regret Criterion - pessimistic or conservative
approach.
 Maximax Criterion - optimistic or aggressive approach.
 Principle of Insufficient Reasoning – no information about the
likelihood of the various states of nature.
17
Decision Making Under Uncertainty - The
Maximin Criterion

18
 The optimistic decision maker may choose the alternative that
offers the highest possible outcome (the “maximax” solution);
 • The pessimist decision maker may choose the alternative whose
worst outcome is “least bad”(the “maximin” solution);
 decision maker may choose the alternative that has the smallest
difference between the best and worst outcomes (the “minimax
regret” solution). Regret here is understood as proportional to the
difference between what we actually get, and the better position
that we could have received if a different course of action had
been chosen. Regret is sometimes also called “opportunity loss.”
The minimax regret rule captures the behavior of individuals who
spend their post decision time regretting their choices.
 At times a decision maker cannot assess the probability of
occurrence for the various states of nature. Uncertainty
occurs when there exist several (i.e., more than one)
future states of nature but the probabilities of each of
these states occurring are not known. In such situations
the decision maker can choose among several possible
approaches for making the decision.
 A different kind of logic is used here, based on attitudes
toward risk.
 Different approaches to decision making under uncertainty
include the following:
 Decision
Decisionanalysis
analysiswithout
withoutprobabilities
probabilities

Concepts covered: Payoff table.

Different approaches: Maximax, maximin, minimax regret

Example: There are four projects; I can select only one. The payoff
table shows potential “payoff” depending upon likely economic
conditions.

Alternatives Economic Condition Since the payoff in

Recession Normal Boom project C is higher than
the payoff for D for
Project A 4075 5000 6100 every economic
Project B 0 5250 12080 condition, we say that
Project C 2500 7000 10375 project C is dominant.
Project D We can eliminate
1500 6000 9500
project D from
consideration.

DecisionAnalysis 21
 Maximax
Maximax

If you are an optimist, you will decide on the basis of Maximax.

Alternatives Economic Condition Step 1: Pick the max value

Recession Normal Boom for each alternative.

Project A 6100
4075 5000 6100
Project B 0 5250 12080 12080
Project C 2500 7000 10375 10375

Step 2:Then pick the

alternative with max payoff.

DecisionAnalysis 22
 Maximin
Maximin

If you are a conservative you will use Maximin.

Alternatives Economic Condition 1: Pick the min value

Recession Normal Boom for each alternative.
Project A 4075 5000 6100 4075
Project B 0 5250 12080 0
Project C 2500 7000 10375 2500

2: Then pick the alternative

with max payoff.

DecisionAnalysis 23
 Minimax
MinimaxRegret
Regret You are neither optimist nor conservative.

Alternatives Economic Condition Step 1: Calculate

the maximum for
Recession Normal Boom
each outcome.
Project A 4075 5000 6100
Project B 0 5250 12080
Project C 2500 7000 10375
4075| 7000|
12080
Alternatives Regret Table Stet 2: Prepare
“Regret Table”
Recession Normal Boom
by subtracting
Project A 0 2000 5980 each outcome
Project B 4075 1750 0 cell value from
Project C its maximum.
1575 0 1705

At least one number for each regret table outcome is zero and there
DecisionAnalysis are no negative numbers. Why? 24
 Minimax
MinimaxRegret..
Regret..

Alternatives Economic Condition

Recession Normal Boom
Project A 4075 5000 6100
Project B 0 5250 12080
Project C 2500 7000 10375
4075| 7000| 12080
Alternatives Regret Table Step 3: Pick the max value
Recession Normal Boom for each alternative.
Project A 0 2000 5980 5980
Project B 4075 1750 0 4075
Project C 1575 0 1705 1705

Step 4: Pick the alternative

DecisionAnalysis with minimum regret. 25
 General
Generalcomments
comments Payoff table
Alternatives Economic Condition
Recession Normal Boom
Table columns show
Project A 4075 5000 6100
outcomes (also called
state of nature). Project B 0 5250 12080
Project C 2500 7000 10375
• The maximax payoff criterion seeks the largest of the
maximum payoffs among the actions.
• The maximin payoff criterion seeks the largest of the
minimum payoffs among the actions.
• The minimax regret criterion seeks the smallest of the
maximum regrets among the actions.

The above three approaches we used involved Decision Making

without Probabilities.

DecisionAnalysis 26