Decision Making Under Uncertainty

 This chapter provides a formal framework for analyzing decision problems that involve
uncertainty. Our discussion includes the following:
 criteria for choosing among alternative decisions
 ■ how probabilities are used in the decision-making process
 ■ how early decisions affect decisions made at a later stage
 how a decision maker can quantify the value of information
 ■ how attitudes toward risk can affect the analysis
 Decision Making Under Uncertainty

 Many examples of decision making under uncertainty exist in the business world,
including the following.
 Whenever a company contemplates introducing a new product into the market,
there are a number of uncertainties that affect the decision, probably the most
important being the customers’ reaction to this product. If the product generates
high customer demand, the company will make a large prfoit. But if demand is
low—and, after all, the vast majority of new products do poorly—the company
could fail to recoup its development costs.
 Decision Making Under Uncertainty

 Whenever manufacturing companies make capacity expansion decisions, they face

uncertain consequences. First, they must decide whether to build new plants. If they
don’t expand and demand for their products is higher than expected, they will lose
revenue because of insuficient capacity. If they do expand and demand for their products
is lower than expected, they will be stuck with expensive underutilized capacity.
Of course, in today’s global economy, companies also need to decide where to build
new plants. This decision involves a whole new set of uncertainties, including exchange
rates, labor availability, social stability, competition from local businesses, and others
 Decision Making Under Uncertainty

 Banks must continually make decisions on whether to grant loans to businesses or

individuals. As we all know, many banks made many very poor decisions, especially
on mortgage loans, during the years leading up to the financial crisis in 2008

 Companies routinely place bids for contracts to complete a certain project within a
fixed time frame.

Sports teams continually make decisions under uncertainty

 ELEMENTS OF DECISION ANALYSIS

 Although decision making under uncertainty occurs in a wide variety of contexts, all problems
 have three common elements: (1) the set of decisions (or strategies) available to the
decision maker,
 (2) the set of possible outcomes and the probabilities of these outcomes,
and
 (3) a value model that prescribes monetary values for the various decision–outcome
combinations. Once these elements are known, the decision maker can find an optimal
decision, depending on the optimality criterion chosen.
 Decision Making Under Uncertainty

 Before moving on to realistic business problems, we discuss the basic elements of any
decision analysis for a very simple problem. We assume that a decision maker must
choose among three decisions, labelled D1, D2, and D3. Each of these decisions has three
possible outcomes, labeled O1, O2, and O3
 Payoff Tables
 This payoff might actually be a cost, in which
 case it is indicated as a negative value. The listing of payoffs for all decision–outcome pairs is called the
payoff table.1 For our simple decision problem, this payoff table appears in
 Table 6.1. For example, if the decision maker chooses decision D2 and outcome O3 then occurs, a payoff
of $30 is received.
 A payoff table lists the payoff for each decision–outcome pair. Positive values correspond to rewards (or
gains) and negative values correspond to costs (or losses
 Payoff Table for Simple Decision Problem
 Outcome
 O1 O2 O3
 Decision D1 10 10 10
 D2 -10 20 30
 D3 − - 30 30 80
 Decision Making Under Uncertainty

 This table shows that the decision maker can play it safe by choosing decision D1.
 This provides a sure $10 payoff. With decision D2, rewards of $20 or $30 are possible,
 but a loss of $10 is also possible. Decision D3 is even riskier; the possible loss is greater,
 and the maximum gain is also greater. Which decision would you choose?
 Possible Decision Criteria

 ? The maximin criterion finds the worst payoff in each row of the payoff table and
 chooses the decision corresponding to the best of these.
 Table 6.1, one possibility is to choose the decision that maximizes the worst payoff.
This criterion, called the maximin criterion, is appropriate for a very conservative (or
pessimistic) decision maker. The worst payoffs for the three decisions are the minimums in the three rows:
10, −10, and −30. The maximin decision maker chooses the decision corresponding to the best of these:
decision D1 with payoff 10. Such a criterion tends to avoid large losses, but it fails to even consider large
rewards. Hence, it is typically too conservative and is seldom used.
 Possible Decision Criteria

 The maximax criterion finds the best payoff in each row of the payoff table and
 chooses the decision corresponding to the best of these.
At the other extreme, the decision maker might choose the decision that maximizes
the best payoff. This criterion, called the maximax criterion, is appropriate for a risk taker
(or optimist). The best payoffs for the three decisions are the maximums in the three rows:
10, 30, and 80. The maximax decision maker chooses the decision corresponding to the
best of these: decision D3 with payoff 80. This criterion looks tempting because it focuses
on large gains, but its very serious downside is that it ignores possible losses. Because this
type of decision making could eventually bankrupt a company, the maximax criterion is
also seldom used.
 Expected Monetary Value (EMV)

 The expected monetary value, or EMV, for any decision is a weighted average of
the possible payoffs for this decision, weighted by the probabilities of the outcomes.
Using the EMV criterion, you choose the decision with the largest EMV. This is
sometimes called “playing the averages.”
 With this general framework in mind, let’s assume that a decision maker assesses the
probabilities of the three outcomes in Table 6.1 as 0.3, 0.5, and 0.2 if decision D2 is made, and as 0.5, 0.2,
0.3 if decision D3 is made. Then the EMV for each decision is the sum of products of payoffs and
probabilities
 EMV for D1: 10 1a sure thing2
 EMV for D2: −10(0.3) + 20(0.5) + 30(0.2) = 13
 EMV for D3: −30(0.5) + 30(0.2) + 80(0.3) = 15
 These calculations lead to the optimal decision: Choose decision D3 because it has the
largest EMV
 Decision Trees

 The decision problem we have been analyzing is very basic. You make a decision, you
then observe an outcome, you receive a payoff, and that is the end of it.
 In these more complex problems, you make a decision, you observe an outcome, you make a second
decision, you observe a second outcome, and so on. A graphical tool called a decision tree has been
developed to represent decision problems. Decision trees can be used for any decision problems, but they
are particularly useful for the more complex types
 Decision Trees

 This table shows that the decision maker can play it safe by choosing decision D1.
 The nodes represent points in time. A decision node (a square) represents a time
when the decision maker makes a decision. A chance node (a circle) represents a
time when the result of an uncertain outcome becomes known. An end node
(a triangle) indicates that the problem is completed—all decisions have been made,
all uncertainty has been resolved, and all payoffs and costs have been incurred.
(When people draw decision trees by hand, they often omit the actual triangles,
as we have done in Figure 6.2. However, we still refer to the right-hand tips of the
branches as the end nodes.)
 Risk Profiles

 In our small example each decision leads to three possible monetary payoffs with various probabilities. In
more complex problems, the number of outcomes could be larger, maybe considerably larger. It is then
useful to represent the probability distribution of the monetary
 values for any decision graphically. Specifically, we show a “spike” chart, where the
 spikes are located at the possible monetary values, and the heights of the spikes correspond to the
probabilities. In decision-making contexts, this type of chart is called a risk proile. By looking at the risk
proile for a particular decision, you can see the risks and rewards involved.
 The risk proile for decision D3 appears in Figure 6.3. It shows that a loss of $30 has
 probability 0.5, a gain of $30 has probability 0.2, and a gain of $80 has probability 0.3.
 Sampling and Sampling Distributions

 A population is the set of all members about which a study intends to make inferences, where an
inference is a statement about a numerical characteristic of the population, such as an average income or
the proportion of incomes below $50,000. It is important to realize that a population is deined in
relationship to any particular study. Any analyst planning a survey should irst decide which population the
conclusions of the study will concern, so that a sample can be chosen from this population

A frame is a list of all members, called sampling units, in the population

 Simple Random Sampling

 A simple random sample of size n is one where each possible sample of size n has
 the same chance of being chosen.

 The simplest type of sampling scheme is appropriately called simple random sampling.
 Consider a population of size N and suppose you want to sample n units from this population. Then a
simple random sample of size n has the property that every possible
sample of size n has the same probability of being chosen. Simple random samples are
the easiest to understand, and their statistical properties are the most straightforward
 Simple Random Sampling

 Let’s illustrate the concept with a simple random sample for a small population.
Suppose the population size is N = 5, and the ive members of the population are labeled
a, b, c, d, and e. Also, suppose the sample size is n = 2. Then the possible samples are
(a, b), (a, c), (a, d), (a, e), (b, c), (b, d), (b, e), (c, d), (c, e), and (d, e). That is, there are 10
possible samples—the number of ways two members can be chosen from ive members.
Then a simple random sample of size n = 2 has the property that each of these 10 possible
samples has the same probability, 1/10, of being chosen.
 Stratified Sampling

 In stratified sampling, the population is divided into relatively homogeneous subsets

 called strata, and then random samples are taken from each stratum.

 There are several advantages to stratiied sampling. One obvious advantage is that
 separate estimates can be obtained within each stratum—which would not be obtained with a simple
random sample from the entire population
 A more important advantage of stratiied sampling is that the accuracy of the resulting
 population estimates can be increased by using appropriately deined strata
 Systematic Sampling

 In general, one of the irst k members is selected randomly, and then every kth member
after this one is selected. The value k is called the sampling interval and equals the ratio N/n,where N is the
population size and n is the desired sample size

 For instance, if a local NGO is seeking to form a systematic sample of 500 volunteers from a population
of 5000, they can select every 10th person in the population to build a sample systematically.
 Cluster Sampling

 In cluster sampling, the population is separated into clusters, such as cities or city
blocks, and then a random sample of the clusters is selected.
 An example of cluster sampling would be a survey conducted by a company to better understand the
preferences and needs of their customers. The company could divide its customer base into clusters based
on age, gender, location, etc., and then select a random sample from each cluster for further analysis
 Multistage Sampling Schemes

 In multistage sampling, you divide the population into clusters and select some clusters at the first stage.
At each subsequent stage, you further divide up those selected clusters into smaller clusters, and repeat
the process until you get to the last step