DECISION MAKING UNDER UNCERTAINTY

Decision Making under Uncertainty

- when several states of nature exist and manager cannot assess the outcome probability with confidence or when virtually no probability data are available, the environment is called decision making under uncertainty.

Problem in Decision Making The president of Thompson Lumber Company is deciding whether to expand his product line by manufacturing and marketing a new product, backyard storage sheds. He then decides that his alternatives are to construct (1) large new plant to manufacture the storage sheds, (2) s small plant, or (3) no plant at all (i.e., he has the option of not developing the new product line). Thompson determines that there are two possible outcomes: the market for storage sheds could be favorable, meaning that there is a high demand for the product, or it could be unfavorable, meaning that there is a low demand for the sheds. Of course Thompson wants to maximize his profits, he then evaluates each consequence. With favorable market, he thinks a large facility would result in a net profit of $200,000 to his firm. This $200,000 is a conditional value because Thompsons receiving the money is conditional upon both his building a large factory and having a good market. The conditional value if the market is unfavorable would be $ 180,000 net loss. A small plant would result in a net profit of $ 100,000 in a favorable market, but a net loss of $ 20,000 would occur if the market was unfavorable. Finally, doing nothing would result in $ 0 profit in either market.

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

Construct a large plant

200,000.00

-180,000.00

Construct a small plant

100,000.00

-20,000.00

Do Nothing

Criteria for Decision making under uncertainty

1.

2.
3. 4. 5.

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

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 optimistic decision criterion

STATE OF NATURE FAVORABLE MARKET ALTERNATIVE Construct a large plant ($) UNFAVORABLE MARKET ($) Maximum in a Row ($)

200,000.00

-180,000.00

200,000.00
Maximax

Construct a small plant Do Nothing

100,000.00 0

-20,000.00 0

100,000.00 0

Maximin criterion
- used to find the alternative that maximizes the minimum payoffs or consequence for every alternative. - 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.

STATE OF NATURE FAVORABLE MARKET ALTERNATIVE Construct a large plant Construct a small plant Do Nothing ($) 200,000.00 100,000.00 0 UNFAVORABLE MARKET ($) -180,000.00 -20,000.00 0 Minimum in a Row ($) (180,000.00) (20,000.00) 0 Maximin

Criterion of Realism (Hurwicz Criterion)

- often called the weighted average - is compromise between an optimistic and a pessimistic decision. a coefficient of realism, , is selected; this measures the degree of optimism of the decision maker. This coefficient is between 0 & 1. When is 1, the decision maker is 100% optimistic about the future. When is 0, the decision maker is 100% pessimistic about the future. Formula: weighted average= (maximum in row+(1-)(minimum in row)

STATE OF NATURE FAVORABLE MARKET UNFAVORABLE MARKET Criterion of Realism

ALTERNATIVE
Construct a large plant

($)
200,000.00

($)
-180,000.00

(=0.8)$
124,000.00 Realism

Construct a small plant Do Nothing

100,000.00 0

-20,000.00 0

76,000.00 0

Equally Likely (LAPLACE)

-

Criterion that uses all the payoffs for each alternative. This 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.

STATE OF NATURE FAVORABLE MARKET ALTERNATIVE Construct a large plant Construct a small plant ($) 200,000.00 100,000.00 UNFAVORABLE MARKET ($) -180,000.00 -20,000.00 Row Average ($) 10,000.00 40,000.00 Equally likely Do Nothing 0 0 0

Minimax Regret
This criterion is based on opportunity loss or regret. 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. In other words, its the amount lost by not picking the best alternative in a given state of nature.

First create the opportunity loss table by determining the opportunity loss for not choosing the best alternative for each state of nature. It is calculated by subtracting each payoff in the column from the best payoff in the same column.

STATE OF NATURE FAVORABLE ALTERNATIVE Construct a large plant Construct a small plant Do Nothing Market ($) 200,000 200,000 200,000 100,000 200,000 - 0 UNFAVORAB LE Market ($) 0 - (180,000) 0 - (-20,000) 0-0

Using the opportunity loss (regret) table, the minimax regret criterion finds the alternative that minimizes the maximum opportunity loss within each alternative.

STATE OF NATURE
FAVORABLE ALTERNATIVE Construct a large plant Construct a small plant Do Nothing Market ($) 0.00 100,000.00 200,000.00 UNFAVORABLE Market ($) 180,000.00 20,000.00 0