UNIT 5 – DECISION MAKING

UNDER UNCERTAINTY
• This unit:

– Discusses the
techniques to deal
with uncertainties

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 INTRODUCTION
• Few decisions in construction industry are made with
certainty.

• Need to look at:

– The magnitudes of uncertainties

– How uncertainties might affect decisions

– How uncertainties influence subsequent outcomes of

decisions

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 TRADITIONAL STRATEGY
• A decision problem is characterized by decision
alternatives, states of nature, and resulting payoffs.

• The decision alternatives are the different possible

strategies the decision maker can employ.

• The states of nature refer to future events, not under the

control of the decision maker, which may occur. States
of nature should be defined so that they are mutually
exclusive and collectively exhaustive.

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 PAYOFF TABLES
• The consequence resulting from a specific combination
of a decision alternative and a state of nature is a payoff.

• A table showing payoffs for all combinations of decision

alternatives and states of nature is a payoff table.

• Payoffs can be expressed in terms of profit, cost, time,

distance or any other appropriate measure.

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 EXPECTED VALUE APPROACH
• If probabilistic information regarding the states of nature
is available, one may use the expected value (EV)
approach.

• Here the expected return for each decision is calculated

by summing the products of the payoff under each state
of nature and the probability of the respective state of
nature occurring.

• The decision yielding the best expected return is chosen.

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 EXPECTED VALUE APPROACH
• The expected value of a decision alternative is the sum
of weighted payoffs for the decision alternative.

• The expected value (EV) of decision alternative di is

defined as:

where: N = the number of states of nature

P(Sj ) = the probability of state of nature sj
Vij = the payoff corresponding to decision
alternative di and state of nature sj

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 EXPECTED VALUE APPROACH
Example – lets consider the example of a housing
contractor who builds residential houses. The contractor is
planning for the number of houses to be built for the
coming year. Assume that each house costs $15,000 and
sells for $0,000 and that the probability distribution of the
market demand in this area for new houses is know as:

P0 = Prob (demand = 00) = 0.2

P1 = Prob (demand = 10) = 0.4
P2 = Prob (demand = 20) = 0.3
P3 = Prob (demand = 30) = 0.1
How many houses should the contractor build for the year?
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 EXPECTED VALUE APPROACH
What are the states of nature? # of houses sold
What are the decision alternatives? # of houses built

The payoff table is shown below.

Decision State of nature

(houses (Sold houses)
to be
built) 0 10 20 30

0 0 0 0 0
10 -150 350 350 350
20 -300 200 700 700
30 -450 50 550 1050

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 EXPECTED VALUE APPROACH
The probability distribution of market demand is added to
the payoff table to calculate the EV of each decision

Decision State of nature

(houses (Sold houses)
to be
built) 0 10 20 30 EV

0 0 0 0 0 0
10 -150 350 350 350 250
20 -300 200 700 700 300
30 -450 50 550 1050 200
Prob DD 0.2 0.4 0.3 0.1

The maximum EV is when the contractor builds 20 houses.

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 EXPECTED VALUE OF
PERFECT INFORMATION
• Frequently information is available which can improve
the probability estimates for the states of nature.

• The expected value of perfect information (EVPI) is the

increase in the expected profit that would result if one
knew with certainty which state of nature would occur.

• The EVPI is the price that one would be willing to pay in

order to gain access to perfect information.

• The EVPI provides an upper bound on the expected

value of any sample or survey information.
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 EXPECTED VALUE OF
PERFECT INFORMATION
• EVPI Calculation
– Step 1:
Determine the optimal return corresponding to each
state of nature.

– Step 2:
Compute the expected value of these optimal returns.

– Step 3:
Subtract the EV of the optimal decision from the
amount determined in step (2).
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 EXPECTED VALUE OF
PERFECT INFORMATION
Decision State of nature
(houses (Sold houses)
to be
built) 0 10 20 30 EV

0 0 0 0 0 0
10 -150 350 350 350 250
20 -300 200 700 700 300
30 -450 50 550 1050 200
Prob DD 0.2 0.4 0.3 0.1
Optimal 0 350 700 1050 455

EVPI = 455 – 300 = 155

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 DECISION TREES
• A decision tree is a chronological representation of the
decision problem.

• They provide a highly effective structure within which

one can lay out options and investigate the possible
outcomes of choosing those options.

• They also help you to form a balanced picture of the

risks and rewards associated with each possible course
of action.

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 DECISION TREES
• A decision tree is read from left to right.

• Each decision tree has two types of nodes:

– round nodes correspond to the states of nature,

outcome or chance event

– square nodes correspond to the decision alternatives

• Lines connecting the nodes show the direction of

influence

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 DECISION TREES
• The branches leaving each round node represent the
different states of nature while the branches leaving
each square node represent the different decision
alternatives.

• At the end of each limb of a tree are the payoffs attained

from the series of branches making up that limb.

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 DECISION TREES

State of Payoffs
Decision node nature nodes

Decision alternatives:
1. Develop temp sensor
2. Develop pressure sensor
3. Do neither
States of nature:
1. Success
2. Failure 16
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 DECISION TREES
WITHOUT PROBABILITIES
• Three commonly used criteria for decision making when
probability information regarding the likelihood of the
states of nature is unavailable are:

– the optimistic (Maximax) approach

– the conservative (Maximin) approach

– the minimax regret approach

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 OPTIMISTIC APPROACH
MAXIMAX
• Used by an optimistic decision maker.

• The decision with the largest possible payoff is chosen.

• If the payoff table was in terms of costs, the decision with

the lowest cost would be chosen.

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 CONSERVATIVE APPROACH
MAXIMIN
• Used by a conservative decision maker.

• For each decision the minimum payoff is listed and then

the decision corresponding to the maximum of these
minimum payoffs is selected. (Hence, the minimum
possible payoff is maximized.)

• If the payoff was in terms of costs, the maximum costs

would be determined for each decision and then the
decision corresponding to the minimum of these
maximum costs is selected. (Hence, the maximum
possible cost is minimized.)
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 MINIMAX REGRET APPROACH
• Requires the construction of a regret table or an
opportunity loss table.

• This is done by calculating for each state of nature the

difference between each payoff and the largest payoff for
that state of nature.

• Then, using this regret table, the maximum regret for

each possible decision is listed.

• The decision chosen is the one corresponding to the

minimum of the maximum regrets
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 EXAMPLE 1
• Consider the following problem with three decision
alternatives and three states of nature with the following
payoff table representing profits

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 EXAMPLE 1

4
S1
S2 4
S3
-2
d1 0
S1
d2 S2 3
S3
-1
d3 1
S1
S2 5
S3
-3
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 EXAMPLE 1 - MAXIMAX
• An optimistic decision maker would use the optimistic
(maximax) approach. We choose the decision that has
the largest single value in the payoff table.

Maximax
decision Maximax
payoff 23
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 EXAMPLE 1 - MAXIMAX

4
S1
4 S2 4
S3
-2
d1 0
S1
d2 3
S2 3
S3
-1
d3 1
S1
5
S2 5
S3
-3
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 EXAMPLE 1 - MAXIMIN
• A conservative decision maker would use the
conservative (maximin) approach. List the minimum
payoff for each decision. Choose the decision with the
maximum of these minimum payoffs

Minimum
Payoff
-2
-1
-3

Maximin Maximin
decision payoff
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 EXAMPLE 1 - MAXIMIN

4
S1
-2 S2 4
S3
-2
d1 0
S1
d2 -1
S2 3
S3
-1
d3 1
S1
-3
S2 5
S3
-3
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EXAMPLE 1 – MINIMAX REGRET
• For the minimax regret approach, first compute a regret
table by subtracting each payoff in a column from the
largest payoff in that column.
States of nature
Decision S1 S2 S3
d1 4 4 -2
d2 0 3 -1
d3 1 5 -3

Column Max 4 5 -1

Regret table S1 S2 S3
d1 0 1 1 =-1-(-2)
=4-0
d2 4 2 0
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EXAMPLE 1 – MINIMAX REGRET
• For each decision list the maximum regret. Choose the
decision with the minimum of these values.
.

Regret table S1 S2 S3 Max regret

Minimax
d1 0 1 1 1
regret
d2 4 2 0 4
d3 3 0 2 3

Minimax
regret
decision

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EXAMPLE 1 - MINIMAX REGRET

4
S1
1 S2 4
S3
-2
d1 0
S1
d2 4
S2 3
S3
-1
d3 1
S1
3
S2 5
S3
-3
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 DECISION TREES
WITH PROBABILITIES
• Decision trees are also used for displaying decision
problems with uncertainty.

• If probabilistic information regarding the states of nature

is available, use the expected value (EV) approach.

• The EV for each decision is calculated by summing the

products of the payoff under each state of nature and the
probability of the respective state of nature occurring.

• The decision yielding the best EV is chosen.

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 EXAMPLE 2
Company ABC has developed a new line of products. Top management
is attempting to decide on the appropriate marketing and production
strategy. 3 strategies are being considered: A (Aggressive), B (basic) and
C (Cautious). The market conditions under study are denoted by S
(Strong) or W (Weak). Management's best estimate of the net profits (in
$, mil) in each case is given in the following payoff table.

State of nature
Decision
S W
A 30 -8
B 20 7
C 15 10

Management's estimates of the probabilities of a strong or a weak market

are 0.45 and 0.55 respectively. Which strategy should be chosen.
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 SOLUTION 2

30
P=0.45
EV=9.1
-8
P=0.55

A 20
P=0.45
B EV=12.85
7
P=0.55

C P=0.45 15
EV=12.25

P=0.55 10
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 SENSITIVITY ANALYSIS
• Other critical points of the studied decision can be
concluded from the decision tree analysis.

• Using the same facts from example 2:

EVA = 30*P(S) – 8*P(W); since P(S) + P(W) =1, then

EVA = 30*P(S) – 8*[1-P(S)]; which simplifies into

EVA = 38P(S) – 8; which is the equation of a straight line

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 SENSITIVITY ANALYSIS
• Similarly solving for EVB & EVC gives:

EVB = 7 + 13P(S); and

EVC = 10 + 5P(S)

• All 3 equations can be plotted with EV as the y-axis and

P(S) as the x-axis.

• The resultant graph is shown in next slide

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 SENSITIVITY ANALYSIS

EV
35

C strategy A strategy
30 B strategy
P(S) < 0.38 P(S) > 0.6
25

20

15

10

0
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1
P(S)
-5

-10

EVA EVB EVC

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 CLASS EXERCISE 1

An investment performance is significantly affected by two

variables: the economic environment and whether a
competing building is developed. The cash flow under the
various scenarios is as follows:

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 CLASS EXERCISE 1
Through an assessment of the economic environment, the
probability estimates of the likelihood of each of the 3 economic
situations under consideration is:

The conditional probability of whether the competing building will

be built under the 3 economic conditions is estimated as follows:

What is the expected value of the investment?

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 CLASS EXERCISE 2
Burger Prince Restaurant is considering opening a new
restaurant on Main Street. It has three different models, each
with a different seating capacity. Burger Prince estimates that the
average number of customers per hour will be 80, 100, or 120.
The payoff table for the three models is:

Given that the probability of S1, S2 and S3 is 0.4, 0.2 and 0.4
respectively, calculate the expected value for each decision & the
expected value of perfect information.
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 CLASS EXERCISE 3

A contractor is concerned about the capacity of the existing

dewatering system to be used in a new project to keep the site
dry in order to prevent progress delay. Additional pumps will
add costs to the budget, and progress delay will cause
penalties to the contractor. Three scenarios (S1, S2 and S3)
are expected to make the water level in the construction site
high. S1 (the rain will be < 6 inch in 12 hour period) has the
probability of 0.5, S2 (the rain will reach 6 inch only one time in
12 hour period) has the probability of 0.3, and S3 (the rain will
reach 6 inch many times in 12 hour period) has the probability
of 0.2. The cost of pumps installation and the penalties for any
delay are shown in the following table.
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 CLASS EXERCISE 3

Alternative S1 S2 S3
Install 15,000 15,000 65,000
Do nothing 0 20,00 100,000

A. Draw a decision tree to represent this problem

B. Which alternative is the best choice? And Why?

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 CLASS EXERCISE 4

Two pumping systems “A” and ”B” are proposed for supplying
water to a residential area. The construction costs for system
“A” is $250,000 and for system “B” is $750,000. if partial failure
occurs, it is expected that the damage cost for system “A” is
$80,000 and for system “B is $15,000. If complete failure
occurs, it is expected that the damage cost for system “A” is
$450,000 and for system “B” is $400,000. the probabilities of
partial and complete failures are 5% and 1% respectively.

a. Draw a decision tree to represent this problem

b. Which alternative is the best choice? And Why?
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 CLASS EXERCISE 5

Adrian is a developer and must build factories for the coming

year. Construction for the factories must be in quantities of 20.
The cost per factory is $70 if they build 20, $67 if they build 40,
$65 if they build 60, and $64 if they build 80. The factory will
be sold for $100 each. Any factory left over at the end of the
season can be sold (for certain) at $45 each. If Adrian run out
of factories during the year, then they will suffer a loss of
"goodwill" among their customers. They estimate this goodwill
loss to be $5 per customer who was unable to buy a factory.
Adrian estimate that the demand for factory this season will be
10, 30, 50, or 70 factory with probabilities of 0.2, 0.4, 0.3, and
0.1 respectively.
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 CLASS EXERCISE 5

a. What are the decisions facing Adrian?

b. What are the states of nature?

c. Construct the payoff table.

d. What would be Adrian’s decision based on Maximax,

Maximin and Minimax Regret criterion?

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 THE END

Any questions?

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