3 Decision Making Under Uncertainty

(or Decision Making without Probabilities)

ZHAN, Wenjie (Professor)

School of Management, Huazhong
University of Science & Technology
Tel: 027-87556472
Email: wjzhan@mail.hust.edu.cn
3 Decision Making Under Uncertainty
(or Decision Making without Probabilities)

3.1 Decision Making Under Uncertainty

3.2 Examples for Decision Making
Under Uncertainty
 3.1 Decision Making Under Uncertainty (or
Decision Making without Probabilities)
Conditions of Decision Making:
C1: Decision-making under certainty
Instead of state of natures, a true state is known to
the decision maker before s/he has to make
decision
C2: Decision-making under uncertainty
The decision-maker does not know the probabilities

of the various outcomes. Actually s/he knows

nothing!
C3: Decision-making under risk
The decision-maker does know the probabilities of
the various outcomes
 Conditions of Decision
Making
Uncertainty:
Uncertainty refers to outcomes where estimates
have been made but no probabilities can be
attached to the expected comes.
Therefore, no objective probabilities can be
assigned to outcomes, though subjective
likelihood or confidence levels can be ascribed on
statistically unverifiable grounds.
The source of expected probabilities are the
decision makers guesses and hunches about
future patterns of events.
 Conditions of Decision
Making
Risk:
Risk refers to outcomes where the range of
potential future outcomes is known from past
experience.
Future values and objective probabilities can
therefore be attached to all possible
outcomes.
The values of possible alternative outcomes are
known and so too are the likelihoods of the given
outcomes occurring.
 3.1 Decision Making Under
Uncertainty
A pure uncertainty situation is that there is no
information available about the future states
of the world to help a decision maker. The
decision maker is in a position of complete
ignorance.
In the absence of any other information on
the likelihood of each state of nature actually
occurring, we can consider a number of
common attitudes.
 3.1 Decision Making Under
Uncertainty
Five criteria for the decision making
under uncertainty (or pure uncertainty):
(1) The maximax criterion
(2) The maximin criterion
(3) The Hurwicz criterion
(4) The Laplace criterion
(5) The minimax Regret (Savage) criterion
 (1) The maximax criterion
Let us assume for the moment that you have a very
optimistic view of the future. If this were the
case you would tend to choose the decision which
could generate the highest possible pay-off.

Such an approach is known as the maximax criterion,

since we are searching for the maximum of the
maximum pay-offs.

Such an approach follows two steps:

1. For each possible decision, identify the maximum possible
pay-off.
2. Comparing these pay-offs, select the decision that will
give the maximum pay-off.
(1) The maximax criterion:
example
Low
-15
M Medium
10
High
55
Low 10
HP BD Medium
25
High 30
Low
5
BA Medium
20
High
40
Fig.2-4 The maximax criterion
 (1) The maximax criterion
(cont.)
Decision
Future sales Manufacture Buy domestic Buy abroad
level (M) (BD) (BA)

Low -15 10 5
Medium 10 25 20
High 55 30 40
maximax 55 30 40
 (1) The maximax criterion
(cont.)
Mathematic definition of the maximax criterion
with benefit
m m n
o'k max {o'i } max max {u j i }
i 1 i 1 j 1

Mathematic definition of the minimin criterion

with lose
m m n
ok min {oi } min min {l j i }
i 1 i 1 j 1
 (2) The maximin criterion
However, we are not all optimistic about the future. There
is something to be said for examining the worst-case
scenario - being pessimistic about future outcomes.

In such a situation we can apply the maximin criterion,

since we search for the maximum of the minimum pay-offs.
For each possible decision we determine the minimum
(worst) possible pay-off and then choose the largest of
these.

The summary of the approach is:

1. For each possible decision, identify the minimum possible pay-off.
2. Comparing these pay-offs, select the decision that will give the
maximum pay-off.
 (2) The maximin criterion
(cont.)
Low
-15
M Medium
10
High
55
Low 10
HP BD Medium
25
High 30
Low
5
BA Medium
20
High
40
Fig.2-5 The maximin criterion
 (2) The maximin criterion
(cont.)
Decision

Future sales Manufacture Buy domestic Buy abroad

level (M) (BD) (BA)

Low -15 10 5
Medium 10 25 20
High 55 30 40
maximin -15 10 5
 (2) The maximin criterion
(cont.)
Mathematic definition of the maximin criterion
with benefit
m m n
s'k max{s'i } max min {u j i }
i 1 i 1 j 1

Mathematic definition of the minimax criterion

with loss
m m n
s k min {si } min max {l j i }
i 1 i 1 j 1
 (3) The Hurwicz criterion
In an attempt to achieve a compromise between the
optimism of maximax criterion and the pessimism of
the maximin criterion, Hurwicz proposed a criterion
which is a weighted average of the two extremes.

Ok + (1- ) Sk

where [0,1], named the optimism parameter; then

(1- ) is named the pessimism parameter.
 (3) The Hurwicz criterion
(cont.)
Mathematic definition of the Hurwicz criterion with benefit
(1 ) s'k o'k max {1 s'i o'i } max {1 min u ji max u ji }
m m n n

i 1 i 1 j 1 j 1

Mathematic definition of the Hurwicz criterion with lose

(1 ) s k ok min {1 si oi } min {1 max l ji min l ji }

m m n n

i 1 i 1 j 1 j 1
 (3) The Hurwicz criterion
(cont.)
Decision
Future sales level Manufacture Buy domestic Buy abroad
(M) (BD) (BA)
Low -15 10 5
Medium 10 25 20
High 55 30 40
Maximax (Ok) 55 30 40
Maximin (Sk) -15 10 5
Hurwicz () 55 - 30 + 40 +
15 (1- ) 10 (1- ) 5 (1- )
 Sensitivity analysis of
60
f()
50
BD()=30+10(1- )
40

30

20

10
BA()=40+5(1- )
0

-10 M()=55-15(1- )
-20
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1

 Sensitivity analysis to
Sensitivity analysis () is the study
of how the variation (uncertainty) in the
output of a mathematical model can be
apportioned, qualitatively or quantitatively, to
different sources of variation in the input of
the model.

It is a technique for systematically changing

parameters in a model to determine the
effects of such changes
 (4) The Laplace criterion
The Laplace criterion is based on the assumption
that the decision-maker is in a state of ignorance
about the probabilities of Natures states.

Each of the Natures state has equal probability

and is uniformly distributed.

The decision-maker will choose the action that

will get the maximum expected monetary value
(EMV).
 (4) The Laplace criterion
(cont.)
Decision
Future sales Probability Manufacture Buy domestic Buy abroad
level (M) (BD) (BA)
Low 1/3 -15 10 5
Medium 1/3 10 25 20

High 1/3 55 30 40

Laplace criterion (-15+10+55)/3 (10+25+30)/3 (5+20+40)/3

=50/3 =65/3 =65/3
 (5) The minimax Regret criterion
(or the Savage criterion)
The minimax regret criterion is possible using
the concept of opportunity loss or regret.

For each state of Nature and each action of

the decision-maker, we can calculate what is
know as the regret.

Regret: it is the difference between the

maximum pay-off Natures state and
the particular pay-off for the decision-
makers action.
 (5) The minimax Regret
criterion (cont.)
Decision

Future Manufacture Buy Buy maximum

sales level (M) domestic abroad pay-off
(BD) (BA) Natures
state
Low -15 10 5 10
Medium 10 25 20 25
High 55 30 40 55
 (5) The minimax Regret
criterion (cont.)
Regret or opportunity loss
Future sales Manufacture Buy domestic Buy abroad
level (M) (BD) (BA)
Low 25 0 5
Medium 15 0 5
High 0 25 15
maximum 25 25 15
regret
 Decision Regret or opportunity loss

Future Manufac Buy Buy max Future Manuf Buy Buy

sales acture domestic abroad
sales ture domestic abroad pay-off
level (M) (BD) (BA)
level (M) (BD) (BA)

L -15 10 5 10 L 25 0 5
M 10 25 20 25 M 15 0 5

H 55 30 40 55 H 0 25 15
Maximax 55 30 40 maximum 25 25 15
regret

Maximin -15 10 5

Hurwicz 55 - 30 + 40 +
(1- ) 15 (1- ) 10 (1- ) 5

Laplace (-15+10 (10+25+30) (5+20+40)/

+55)/3 /3 3
2.2 Examples for Decision Making
Under Uncertainty
Example 1
STATES OF NATURE
Favorable Unfavorable
ALTERNATIVES market market
Construct large plant $200,000 ($180,000)
Construct small plant $100,000 ($20,000)
Do nothing $0 $0
 Maximax Criterion

Choose the alternative with the

maximum optimistic level.

STATES OF NATURE
Favorable Unfavorable Maximum in
ALTERNATIVES market market row (ok)
Construct large plant $200,000 ($180,000) $200,000
Construct small plant $100,000 ($20,000) $100,000
Do nothing $0 $0 $0
 Maximin Criterion

Choose the alternative with the

maximum security level.

STATES OF NATURE
Favorable Unfavorable Minimum in
ALTERNATIVES market market row (sk)
Construct large plant $200,000 ($180,000) ($180,000)
Construct small plant $100,000 ($20,000) ($20,000)
Do nothing $0 $0 $0
 Hurwicz criterion
(or Criterion of Realism)

Choose the alternative with the maximum weighted

average of optimistic and security levels.
Combining maximin and maximax with an index of
optimism .

STATES OF NATURE
Favorable Unfavorable Weighted
ALTERNATIVES market market average a=0.7
Construct large plant $200,000 ($180,000) 380a-180 86
Construct small plant $100,000 ($20,000) 120a-20 64
Do nothing $0 $0 $0 0
 Hurwicz criterion
(or Criterion of Realism)

Sensitivity analysis to :
120 -20 = 0 = 0.1667
380 -180 = 120 -20 = 0.6154

0< <0.1667 Do nothing

0.1667< <0.6154 Construct small plant
0.6154< <1 Construct large plant
 The Laplace criterion
(or Criterion of Equally Likelihood)
Laplace argued that knowing nothing
at all about the true state of nature is
equivalent to all states having equal
probability
STATES OF NATURE
Favorable Unfavorable Row
ALTERNATIVES market market average
Construct large plant $200,000 ($180,000) $10,000
Construct small plant $100,000 ($20,000) $40,000
Do nothing $0 $0 $0
 The minimax Regret Criterion
(or Savage Criterion)

Choose the alternative with the

minimum worst (maximum) regret

Regret Values STATES OF NATURE

Favorable Unfavorable Maximum in
ALTERNATIVES market market row
Construct large plant $0 $180,000 $180,000
Construct small plant $100,000 $20,000 $100,000
Do nothing $200,000 $0 $200,000
 Summary of Example Results

CRITERION DECISION
Maximax Construct large plant
Maximin Do nothing
Hurwicz depends on
Lapalace Construct small plant
Savage Construct small plant

The appropriate criterion is dependent on

the personality and philosophy of the
decision maker.
 Example 2: Tom Browns
Investment Decision
Tom Brown has inherited $1000. He has 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
 Example 2: 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 States of nature

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
 Example 2: 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
 Example 2: The Maximax Criterion

The Maximax Criterion Maximum

Decision Large rise Small rise No change Small fall Large fall Payoff
Gold -100 100 200 300 0 300
Bond 250 200 150 -100 -150 200
Stock 500 250 100 -200 -600 500
C/D 60 60 60 60 60 60
 Example 2: The Maximin Criterion

The
TheMaximin
MaximinCriterion
Criterion Minimum
Minimum
Decisions
Decisions Large
LargeRise
Rise Small
Smallrise
rise NoNoChange
Change Small
SmallFall
Fall Large
LargeFall
Fall Payoff
Payoff
Gold
Gold -100
-100 100
100 200
200 300
300 00 -100
-100
Bond
Bond 250
250 200
200 150
150 -100
-100 -150
-150 -150
-150
Stock
Stock 500
500 250
250 100
100 -200
-200 -600
-600 -600
-600
C/D
C/Daccount
account 60
60 60
60 60
60 60
60 60
60 60
60
 Example 2: The Hurwitz Criterion

The Maximin Criterion MaximumMinimum Hurwitz

Decisions
Large Rise Small riseNo ChangeSmall Fall
Large FallPayoff Payoff 0.6
Gold -100 100 200 300 0 300 -100 140
Bond 250 200 150 -100 -150 200 -150 60
Stock 500 250 100 -200 -600 500 -600 60
C/D account
60 60 60 60 60 60 60 60
 Example 2: The Laplace Criterion

The Maximin Criterion Laplace

Decisions Large Rise Small rise No Change Small Fall Large Fall Criterion
Gold -100 100 200 300 0 500/5
Bond 250 200 150 -100 -150 350/5
Stock 500 250 100 -200 -600 50/5
C/D account 60 60 60 60 60 300/5
 Example 2:The Savage Criterion
The
ThePayoff
PayoffTable
Table
Decision
Decision Large
Largerise
rise Small
Smallrise
rise No
Nochange
changeSmall
Smallfall
fall Large
Largefall
fall
Gold
Gold -100
-100 100
100
Investing in200
200 300
300 no 00
Stock generates
Bond
Bond 250
250 200
200 when
regret 150
150 -100
the market exhibits-150
-100 -150
Stock
Stock 500
500 250
250 a100
large rise-200
100 -200 -600
-600
C/D
C/D 60
60 60
60 60
60 60
60 60
60

The Regret Table

Decision Large rise Small rise No change Small fall Large fall
Gold 600 150 0 0 60
Bond 250 Let50us build the50Regret Table
400 210
Stock 0 0 100 500 660
C/D 440 190 140 240 0
 Decision Making Under Uncertainty
- The Savage Criterion
The
ThePayoff
PayoffTable
Table
Decision
Decision Large
Largerise
rise Small
Smallrise
rise No
Nochange
changeSmall
Smallfall
fall Large
Largefall
fall
Gold
Gold -100
-100 100
Investing 200
100 in200 300
300 a regret
gold generates 00
Bond
Bond 250
250 200
200 150 -100
150 the market
of 600 when -150
-100 exhibits-150
Stock
Stock 500
500 250
250 100
100 -200
-200
a large rise -600
-600
C/D
C/D 60
60 60
60 60
60 60
60 60
60
500 (-100) = 600
The
The Regret
RegretTable
Table Maximum
Maximum
Decision
Decision Large
Large rise
rise Small
Smallrise
riseNo
Nochange
change Small
Smallfall
fall Large
Large fall
fall Regret
Regret
Gold
Gold 600
600 150
150 00 00 60
60 600
600
Bond
Bond 250
250 50
50 50
50 400
400 210
210 400
400
Stock
Stock 00 00 100
100 500
500 660
660 660
660
C/D
C/D 440
440 190
190 140
140 240
240 00 440
440
 In-Class Example:
Lets practice what weve learned. Use the decision table
below to compute a choice using all the models
Criterion of realism =0.6
State of Nature
Alternative Good Average Poor
Market ($) Market ($) Market ($)

Construct a small plant 75,000 25,000 -40,000

Construct a large plant 100,000 35,000 -60,000

Do nothing 0 0 0
 In-Class Example: Maximax

State of Nature
Alternative Good Average Poor Maximax
Market($) Market($) Market ($)

Construct a
75,000 25,000 -40,000 75,000
small plant
Construct a
100,000 35,000 -60,000 100,000
large plant
Do nothing 0 0 0 0
 In-Class Example: Maximin

State of Nature
Alternative Good Average Poor Maximin
Market($) Market($) Market ($)
Construct a
75,000 25,000 -40,000 -40,000
small plant
Construct a
100,000 35,000 -60,000 -60,000
large plant
Do nothing 0 0 0 0
 In-Class Example:
Criterion of Realism
=0.6
State of Nature
Alternative Good Average Poor Maximax Maximim Hurwitz
Market($) Market ($) Market ($)

Construct a
small plant
75,000 25,000 -40,000 75,000 -40,000 29,000
Construct a 100,00
large plant
100,000 35,000 -60,000 -60,000 36,000
0
Do nothing 0 0 0 0 0 0
 Sensitivity analysis to
4
x 10
10
f()
8 Nothing()=0+0(1- )
6
Large()=100,000-60,000(1- )
4

-2

-4
Small()=75,000-40,000(1- )
-6
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1

 In-Class Example: Equally Likely

State of Nature
Alternative Good Average Poor Avg
Market($) Market($) Market($)
Construct a
25,000 8,333 -13,333 20,000
small plant
Construct a
33,333 11,665 -20,000 25,000
large plant
Do nothing 0 0 0 0
 In-Class Example:
Minimax Regret Opportunity Loss Table

State of Nature
Maximum
Alternative Good Average Poor
Opp. Loss
Market($) Market($) Market ($)
Construct a
25,000 10,000 40,000 40,000
small plant
Construct a
0 0 60,000 60,000
large plant
Do nothing 100,000 35,000 0 100,000
 Homework 2: (1/2)
The chief executive officer of ABC company has to take a
decision among three alternatives, namely : (a) Expand,
(b) Build, (iii) Subcontract. Table 1 shows pay-off table for
ABC company's expansion decision (pay-off expressed in
terms of profits over next 5 years).
1) What option the company will choose with five criteria
for the decision making under uncertainty (or pure
uncertainty): (1) The maximax criterion;(2) The maximin
criterion; (3) The Hurwicz criterion (=0.4); (4) The
Laplace criterion;(5) The minimax Regret criterion.
2) Sensitivity analysis to .
 Homework 2: (2/2)
Table 1pay-off table for ABC company's decision
Alternatives
Expand Build Subcontract
($) ($) ($)
High 50,000 70,000 30,000
States of Moderate 25,000 30,000 15,000
Nature
Low -25,000 -40,000 -1,000
(demand)
Failure -4,500 -80,000 -10,000
The end