Decision Making under Uncertainty

Reported by

Jason A. Maratas
MM ITM 20 November 2011

Learning Objectives
After completing this report, students will be able to:

List

the steps of the decision-making process. Describe the decision-making under uncertainty. Make decisions under uncertainty.

Good and Bad Decisions

A good

decision is one that is based on logic, consider all available data and possible alternatives, and applies the quantitative approach we are about to describe. Occasionally, a good decision results in an unexpected or unfavorable outcome. But if it is made properly, it is a good decision. A bad decision is one that is not based on logic, does not use all available information, does not consider all alternatives, and does not employ appropriate quantitative techniques. If you made a bad decision but are lucky and a favorable outcome occurs, you have still made a bad decision. Although occasionally good decisions yield bad results, in the long run, using decision theory will result in successful outcomes.

The Six Steps in Decision Making

1.

2.
3. 4. 5. 6.

Clearly define the problem at hand. List the possible alternatives. Identify the possible outcomes or states of nature. List the payoff of profit of each combination of alternatives and outcomes. Select one of the mathematical decision theory models. Apply the Model and make your decision.

Types of Decision Making Environment

Decision

making under certainty Decision making under risk Decision making under uncertainty

Decision making under uncertainty

In

decision making under uncertainty, there are several possible outcomes for each alternatives, and the decision maker does not know the probabilities of the various outcomes. Probability data are not available

Decision making under uncertainty criteria

1.

2.
3. 4. 5.
Note:

Maximax (optimistic) Maximin (pessimistic) Criterion of realism (Hurwicz) Equally likely (LaPlace) Minimax regret

The first four criteria can be computed directly form the decision (payoff) table, whereas the minimax regret criterion requires use of the opportunity loss table.

Maximax
(Optimistic Approach)

The

maximax criterion is used to find the alternative that maximizes the maximum payoff or consequence for every alternative. First locate the maximum payoff for each alternative, and then pick that alternative with the maximum number. This decision criterion locates the alternative with the highest possible gain: therefore it has been called an optimistic decision criterion.

Maximax (cont.)
In

this table we see that maximax choice is the first alternative, construct a large plant. This is the alternative associated with the maximum of the maximum number with in each row or alternative. By using this criterion, the highest of all possible payoff may be achieved.

Maximin
(a pessimistic approach)
The

maximin criterion is used to find the alternative that maximizes the minimum payoff or consequence for every alternative. First locate the minimum payoff for each alternative and then pick that alternative with the maximum number. This decision criterion locates the alternative that gives the best of the worst (minimum) payoffs, and thus it has been called a pessimistic decision criterion. This criterion guarantees the payoff will be at least the maximin value. Choosing any other alternative may allow a lower (worse) payoff to occur.

Maximin (cont.)

Example: Thompsons Maximin choice, do nothing, is show in this table below. This decision is associated with the maximum of the minimum number within each row or alternative. Both the maximax and maximin criteria consider only one extreme payoff for each alternative, while all other payoffs are ignored. The other criterion considers both of these extremes.

Criterion of Realism (Hurwicz Criterion)

(weighted average approach)

Often

called the weighted average, The criterion realism (the Hurwicz criterion) is a compromise between an optimistic and a pessimistic decision. A coefficient of realism, , is selected; this measures the degree of optimism decision maker. This coefficient is between 0 and 1. when is 1, the decision maker is 100% optimistic about the future.

Cont. (Criterion realism)

is 0, the decision maker is 100% pessimistic about the future. Approach Advantage: allows the decision maker to build personal feelings about relative optimism and pessimism. Weighted average computed as follows:
When

Weighted average = (maximum in row) +(1 )(minimum in row)

Cont. (Criterion realism)

NOTE:

when = 1, this is the same as the optimistic criterion, and when = 0 this is the same as the pessimistic criterion. This value is computed for each alternative, and the alternative with the highest weighted average is them chosen.

Criterion realism (sample)

If

we assume that John Thompson sets his coefficient of realism, , to be 0.80, the best decision would be to construct a large plant. As seen in Table 3.4, this alternative has highest weighted average: $124,000 = (0.80) ($200,000) + (0.20)(-$180,000). Because there are only tow states of nature in the Thompson Lumber example, only tow playoff for each alternative are present and both are considered. However, if there are more than two states of nature, this criterion will ignore al payoffs except the best and the worst. The next criterion will consider all possible payoffs for each decision.

Criterion realism Table 3.4

Equally Likely (LaPlace)

(Average Outcome)

Equally

Likely (also called LaPlace) uses all the payoffs for each alternative or uses the average outcome. Equally Likely involves finding the average payoff for each alternative and selecting the alternative with the highest average. The equally likely approach assumes that all probabilities of occurrence for the states of nature are equal, and thus each state of nature is equally likely.

Equally Likely Table 3.5

The

equally likely choice for Thompson Lumber is the second alternative, construct a small plant. This strategy shown in table 3.5, is the one with the maximum average payoff.

Minimax Regret
(Based on Opportunity Loss)

Minimax

Regret is based on opportunity

loss. Opportunity loss refers to the difference between the optimal profit or payoff for a given state of nature and the actual payoff received for a particular decision or its the amount lost by not picking the best alternative in a given state of nature.

Minimax Regret (Cont.)

The

first step is to create the opportunity loss table by determining the opportunity loss for not choosing the best alternative for each state of nature. Opportunity loss for any state of nature, or any column, is calculated by subtracting each payoff in the column from the best payoff in the same column. For favorable market, the best payoff is $200,000 as a result of the first alternative, construct a large plant. If the second alternative is selected, a profit of $100,000 would be realized in a favorable market, and this is compared to the best payoff of $200,000. thus, the Opportunity loss is 200,000 100,000 = 100,000. Similarly, if do nothing is selected, the opportunity loss would be 200,000 0 = 200,000.

Minimax Regret (Cont.)

For

an unfavorable market, the best payoff is $0 as a result of the third alternative do nothing, so this has 0 opportunity loss. The opportunity losses for the other alternative are found by subtracting the payoffs form this best payoff ($0) in this state of nature as shown in Table 3.6 Thompsons opportunity loss table is shown as Table 3.7.

Minimax Regret (Cont.)

Minimax Regret (Cont.)

Using

the opportunity loss (regret) table, the minimax regret criterion finds the alternative that minimizes the maximum opportunity loss within each alternative. You find first the maximum (worst) opportunity loss for each alternative. Next, looking at these maximum values, pick that alternative with the minimum (or best) number. By doing this, the opportunity loss actually realized is guaranteed to be no more than this minimax value. In table 3.8 we can see that the minimax regret choice is the second alternative, construct a small plant. Doing so minimizes the maximum opportunity loss.

Minimax Regret (Cont.)

END