Optimization and Decision

Techniques
Decision Making under
Risk & Uncertainty
 Decision Environments
Decision Environments

• Certainty

• Risk

• Uncertainty

Ambiguity and chances of making a bad decision

Certainty Risk Uncertainty
Low Moderate High

Dr. M S Mahapatra
Decision Making Under Certainty

Alternatives Known with certainty

Outcomes Known with certainty

 Decision-making is therefore straightforward as there is no ambiguity

Decision Models:
• Linear Programming
• Analytic Hierarchy Process (AHP)
• EOQ and EPQ Models

Dr. M S Mahapatra
 Decision Making Under Risk
Alternatives and Outcomes
Known

Alternative Outcomes
Known only with a probability associated with them. However, the
probabilities are known.

 Decision-making is therefore at risk because of ambiguities due

to the probabilities.

Dr. M S Mahapatra
Decision Making Under Uncertainty

Alternatives and Outcomes

Not known with certainty

Alternative Outcomes
Not known – even the probabilities associated with them are
not known.

 Decision-making is therefore uncertain because of very high

ambiguity.

Dr. M S Mahapatra
Criteria for Decision Making under
Uncertainty
1. Maximax or Optimism Criterion

2. Maximin or Pessimism Criterion

3. Hurwicz or Criterion of Realism

4. Laplace or Equally likely Criterion

5. Savage or Minimax regret Criterion

Dr. M S Mahapatra
Maximax: Optimism Criterion
• Find the maximum possible payoff for each decision
alternative
• Select the decision alternative with the maximum of the
above maximum payoffs

STATE OF NATURE
No Favorable Unfavorable Payoff for a
Decision Market market Market Decision
Alternatives Changes changes changes Strategy
Redesign on a
30 100 –80
small scale
Rebuild and
50 200 –200
Refurbish
Do nothing 0 30 –50

Dr. M S Mahapatra
Maximin: Pessimism Criterion
• Find the minimum possible payoff for each decision
alternative
• Select the decision alternative with the maximum of the
above minimum payoffs

STATE OF NATURE
No Favorable Unfavorable Payoff for a
Decision Market market Market Decision
Alternatives Changes changes changes Strategy
Redesign on a
30 100 –80
small scale
Rebuild and
50 200 –200
Refurbish
Do nothing 0 30 –50

Dr. M S Mahapatra
 Hurwicz: Criterion of Realism
• Choose a degree of Optimism (a). Obtain Maximum Payoff
(Max) and Minimum Payoff (Min) for each decision alternative.
Obtain Hurwicz Payoffs for each strategy as
a*Max + (1 – a)*Min
• Select the decision alternative with the maximum of the above
Hurwicz payoffs
STATE OF NATURE
No Favorable Unfavorable Payoff for a
Decision Market market Market Decision
Alternatives Changes changes changes Strategy
Redesign on a
30 100 –80
small scale
Rebuild and
50 200 –200
Refurbish
Do nothing 0 30 –50

Dr. M S Mahapatra
Laplace: Equally Likely Criterion
• Find the average value of payoff for each decision alternative
• Select the decision alternative with the maximum of the average
payoff values

STATE OF NATURE
No Favorable Unfavorable Payoff for a
Decision Market market Market Decision
Alternatives Changes changes changes Strategy
Redesign on a
30 100 –80
small scale
Rebuild and
50 200 –200
Refurbish
Do nothing 0 30 –50

Dr. M S Mahapatra
Savage: Minimax Regret Criterion
• Find the regret matrix (For each payoff under a state of nature,
compute the difference from the maximum payoff). Obtain
maximum regret for each decision alternative
• Select the decision alternative with the minimum of the above
maximum regrets

STATE OF NATURE
No Favorable Unfavorable Payoff for a
Decision Market market Market Decision
Alternatives Changes changes changes Strategy
Redesign on a
30 100 –80
small scale
Rebuild and
50 200 –200
Refurbish
Do nothing 0 30 –50

Dr. M S Mahapatra
Criteria for Decision Making under
Risk

Expected Value Approach

Steps:
1) Obtain Probability of Occurrence (𝑝𝑝𝑖𝑖 ) for each state of
nature (i).
2) Find the Expected Value for each decision alternative as
the sum of (𝑝𝑝𝑖𝑖 x 𝑝𝑝𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑖𝑖 ) for all the states of nature.
3) Select the decision alternative with the best expected value.

Dr. M S Mahapatra
 Expected Value Approach

STATE OF NATURE
No Favorable Unfavorable Expected
Decision Market market Market Value for a
Alternatives Changes changes changes Decision
(0.3) (0.4) (0.3) Strategy

Redesign on a
30 100 –80 25
small scale
Rebuild and
50 200 –200 35
Refurbish
Do nothing 0 30 –50 -3

Dr. M S Mahapatra
 Sensitivity Analysis
A payoff matrix is given below with three decision alternatives and two states
of nature. At present, the decision strategy “Constructing a small plant” shows
the largest expected value.
Perform the sensitivity analysis for this decision problem.

STATE OF NATURE
FAVORABLE UNFAVORABLE
ALTERNATIVE MARKET ($) MARKET ($) EV ($)

Construct a large plant 200,000 –180,000 10,000

Construct a small plant 100,000 –20,000 40,000

Do nothing 0 0 0
Probability 0.50 0.50

Dr. M S Mahapatra
Sensitivity Analysis

Let P = probability of a favorable market

(1 – P) = probability of an unfavorable market

EV(Large Plant) = 200,000P – 180,000)(1 – P)

= 380,000P – 180,000
EV(Small Plant) = 100,000P – 20,000)(1 – P)
= 120,000P – 20,000
EV(Do Nothing) = 0P + 0(1 – P) = 0
=0

Dr. M S Mahapatra
 Sensitivity Analysis
$300,000

$200,000 EV (large plant)

Expected value (EV)

Point 2

$100,000 EV (small plant)

Point 1

0 EV (do nothing)
0.167 0.615 1
–$100,000 Probability (P)

–$200,000

EV(Large Plant) = 380,000P – 180,000

EV(Small Plant) = 120,000P – 20,000
EV(Do Nothing) = 0

Dr. M S Mahapatra
 Sensitivity Analysis
Point 1:
EV(do nothing) = EV(small plant)
20,000
0 = $120,000 P − $20,000 P= = 0.167
120,000
Point 2:
EV(small plant) = EV(large plant)
$120,000 P − $20,000 = $380,000 P − $180,000
160,000
P= = 0.615
260,000
BEST RANGE OF P
ALTERNATIVE VALUES
Do nothing Less than 0.167

Construct a small plant 0.167 – 0.615

Construct a large plant Greater than 0.615

Dr. M S Mahapatra
 Expected Value of Perfect Information
(EVPI)

• EVPI signifies the gain in expected return obtained from

knowing with certainty the future state of nature.

• EVPI is the maximum amount a decision maker would pay

for additional information

• EVPI can be obtained by assuming that a consultant will be

able to give perfect information about the true state of nature.

• EVPI will always equal the minimum expected regret.

Dr. M S Mahapatra
 Expected Value of Perfect Information
(EVPI)

EVPI = ERPI – best EREV

where,
EREV: Expected Return of the EV approach
ERPI: Expected Return with Perfect Information

ERPI =
(best payoff for the first state of nature) x (probability of the first state of nature) +
(best payoff for the second state of nature) x (probability of the second state of
nature) + … + (best payoff for the last state of nature)x (probability of the last
state of nature

Dr. M S Mahapatra
Expected Value of Perfect Information
State of Nature
Alternative Favorable Unfavorable Expected Value (EV)
Market ($) Market ($)
Construct a large
200,000 -180,000 10,000
plant
Construct a small
100,000 -20,000 40,000
plant
Do nothing 0 0 0
Probability 0.5 0.5
Perfect
200,000 0 ERPI = 100,000
Information

Compute ERPI
State of Nature: Favorable Market, Best Payoff: 200,000
State of Nature: Unfavorable Market, Best Payoff: 0
ERPI = (200,000)(0.5) + (0)(0.5) = $100,000
Compute EVPI
EVPI = ERPI – max EREV = $100,000 − $40,000 = $60,000 - the most we should
pay for additional information.
Dr. M S Mahapatra
 Decision Trees
A Decision Tree represents decisions and outcomes in sequential
(chronological) order

Symbols
A decision node from which one of several alternatives may be
selected.
A state of nature node (chance node) out of which one state of
nature will occur.
An arc (branch) represents possible decisions or states of nature

Dr. M S Mahapatra
 Example

STATE OF NATURE

FAVORABLE UNFAVORABLE
ALTERNATIVE MARKET ($) MARKET ($)
Construct a large plant 200,000 –180,000

Construct a small plant 100,000 –20,000

Do nothing 0 0

Probability 0.5 0.5

Dr. M S Mahapatra
 Decision Tree: Example
Probability Payoff
A State-of-Nature Node
Favorable Market (0.5)
$200,000
A Decision Node
1
Unfavorable Market (0.5)
–$180,000

Favorable Market (0.5)

$100,000
Construct
2
Small Plant Unfavorable Market (0.5)
–$20,000

$0

Dr. M S Mahapatra
Decision Tree: Example
Probability Payoff
EV for Node 1= $10,000
Favorable Market (0.5)
$200,000
1
Unfavorable Market (0.5)
–$180,000

Favorable Market (0.5)

$100,000
Construct
2
Small Plant Unfavorable Market (0.5)
–$20,000
EV for Node 2
= $40,000

$0

Dr. M S Mahapatra
 Decision Making with Experimentation
STATE OF NATURE
FAVORABLE UNFAVORABLE
ALTERNATIVE MARKET ($) MARKET ($)
Construct a large plant 200,000 –180,000
Construct a small plant 100,000 –20,000
Do nothing 0 0
Probability 0.5 0.5

• Before deciding about building a new plant, the company has the option to
conduct its own marketing survey, at a cost of $10,000.
• Information from the survey could help in deciding which alternative to
pursue (large, small, or no plant)

Dr. M S Mahapatra
 The Experimentation
• The market survey is the experimentation conducted at a cost of $10,000.

• However, the market survey will not be able to predict the state of nature with 100%
accuracy.

• The market survey can only give additional information on the probable states of nature
in the form of the following conditional probabilities:

P(Survey Favorable / Favorable Market) = 0.70

P(Survey Unfavorable / Favorable Market) = 0.30

P(Survey Favorable / Unfavorable Market) = 0.20

P(Survey Unfavorable / Unfavorable Market) = 0.80

Dr. M S Mahapatra
Bayesian Analysis for Probability
Survey Fav P=0.7

Fav. Market
P(FM)=0.50 Survey Unfav P=0.3

Unfav. Market Survey Fav P=0.2

P(UM)=0.50
Survey Unfav P=0.8

Prior Probabilities: WITHOUT any market survey information, the best

estimates of a favorable and unfavorable market are:
P(FM) = 0.50 P(UM) = 0.50

Dr. M S Mahapatra
 Bayesian Analysis for Probability
Survey Fav P=0.7
P(FM∩SF)=0.35
Fav. Market
P(FM)=0.50 Survey Unfav P=0.3
P(FM∩SU)=0.15
P(UM∩SF)=0.10
Unfav. Market Survey Fav P=0.2
P(UM)=0.50 P(UM∩SU)=0.40
Survey Unfav P=0.8
Joint Probabilities:
P(FM∩ SF) = 0.5x0.7 = 0.35
Thus, Unconditional Probabilities:
P(FM ∩ SU) = 0.5x0.3 = 0.15
P(Survey Favorable) = 0.35 + 0.10 = 0.45
P(UM∩ SF) = 0.5x0.2 = 0.10
P(Survey Unfavorable) = 0.15+0.40 = 0.55
P(UM∩ SU) = 0.5x0.8 = 0.40

Dr. M S Mahapatra
 Bayesian Analysis for Probability
Survey Fav P=0.7
P(FM∩SF)=0.35
Fav. Market
P(FM)=0.50 Survey Unfav P=0.3
P(FM∩SU)=0.15
P(UM∩SF)=0.10
Unfav. Market Survey Fav P=0.2
P(UM)=0.50 P(UM∩SU)=0.40
Unconditional Probabilities: Survey Unfav P=0.8
P(Survey Favorable) = 0.35 + 0.10 = 0.45 P(Survey Unfavorable) = 0.15+0.40 = 0.55
So, Posterior Probabilities:
P(Fav. Market | Survey Favorable) = P(FM∩SF) / P(SF) = 0.35/0.45 = 0.78
P(Unfav. Market | Survey Favorable) = P(UM ∩SF)/ P(SF) = 0.10/0.45 = 0.22
P(Fav. Market | Survey Unfavorable) = P(FM ∩SU)/ P(SU) = 0.15/0.55 = 0.27
P(Unfav. Market | Survey Unfavorable) = P(UM ∩SU)/ P(SU) = 0.40/0.55 = 0.73
Dr. M S Mahapatra
Decision Tree of the Problem
Note: the $10,000 cost was subtracted from each of the first 10 branches. The,
$190,000 payoff was originally $200,000 and the $-10,000 was originally $0.
First Second Decision Payoffs
Decision Point
Point
Favorable Market (0.78)
$190,000
2 Unfavorable Market (0.22)
–$190,000
Favorable Market (0.78)
Small $90,000
Plant
3 Unfavorable Market (0.22)
–$30,000
No Plant
–$10,000
1 Favorable Market (0.27)
$190,000
4 Unfavorable Market (0.73)
–$190,000
Favorable Market (0.27)
Small $90,000
Plant
5 Unfavorable Market (0.73)
–$30,000
No Plant
–$10,000

Favorable Market (0.50)

$200,000
6 Unfavorable Market (0.50)
–$180,000
Favorable Market (0.50)
Small $100,000
Plant
7 Unfavorable Market (0.50)
–$20,000
No Plant
$0

Dr. M S Mahapatra
 Estimation of the payoffs
1. Given favorable survey results (positive survey)
EV(node 2) = EV(large plant | positive survey)
= (0.78)($190,000) + (0.22)(–$190,000) = $106,400
EV(node 3) = EV(small plant | positive survey)
= (0.78)($90,000) + (0.22)(–$30,000) = $63,600
EV for no plant = –$10,000
If survey results are favorable, a large plant should be built with an expected value of $106,400

2. Given unfavorable survey results (negative survey)

EV(node 4) = EV(large plant | negative survey)
= (0.27)($190,000) + (0.73)(–$190,000) = –$87,400
EV(node 5) = EV(small plant | negative survey)
= (0.27)($90,000) + (0.73)(–$30,000) = $2,400
EV for no plant = –$10,000
If survey results are unfavorable, a small plant should be built with an expected value of $2,400

Dr. M S Mahapatra
32
 Estimation of the Payoffs
3. Thus, the expected value of the market survey,
EV(node 1) = EV(conduct survey)
= (0.45)($106,400) + (0.55)($2,400) = $49,200

4. If the market survey is not conducted,

EV(node 6) = EV(large plant)
= (0.50)($200,000) + (0.50)(–$180,000) = $10,000
EV(node 7) = EV(small plant)
= (0.50)($100,000) + (0.50)(–$20,000) = $40,000
EV for no plant = $0

If the market survey is not conducted, a small plant should be built with an expected
value of $40,000

Decision: The best choice is to seek marketing information.

If survey results are favorable, a large plant should be built or
If survey results are unfavorable, a small plant should be built
Dr. M S Mahapatra
Expected Values on Decision Tree
First Decision Second Decision Payoffs
Point Point
$106,400 Favorable Market (0.78) $190,000
2 Unfavorable Market (0.22)
–$190,000
$63,600 Favorable Market (0.78)

$106,400
Small 3 $90,000
Unfavorable Market (0.22)
Plant –$30,000
No Plant –$10,000
$49,200
1 –$87,400 Favorable Market (0.27) $190,000
4 Unfavorable Market (0.73) –$190,000
$2,400 Favorable Market (0.27)
$2,400 Small 5 $90,000
Unfavorable Market (0.73) –$30,000
Plant
No Plant –$10,000
$49,200

$10,000 Favorable Market (0.50)

$200,000
6 Unfavorable Market (0.50)
–$180,000
$40,000 Favorable Market (0.50)
$40,000

Small 7 $100,000
Unfavorable Market (0.50)
Plant –$20,000
No Plant
$0

Dr. M S Mahapatra