Session - Decision-making under Uncertainty and Risk

Motivation

Optimal
product
mix?

The manufacturer has a supplier of wood, who

promises to supply her up to 2000 m2 of wood per month
on demand at a cost of INR 150 per m2.

In addition to wood, she requires other materials, such as paint, varnish,

Table Chair and fabric to create the tables and chairs. These are abundantly available
as long as she orders an adequate quantity well in advance.
Wood (in m2) 3 2
Labor hours 3 1 She has 10 people working for her on a fixed salary. each of whom
puts in eight hours of labor each working day. She assumes a total of
Profit (in INR) 1000 600 20 working days in a month .
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Motivation…
The supplier of wood may
In a realistic scenario, 2,000 m.sq.
not be able to supply the
the manufacturer must required amount of wood. 1,500 m.sq.
face uncertainties that
are not resolved at the 1,600 hrs
time of planning. She may face absenteeism
among her employees. 1,200 hrs

Resources Optimal product mix Optimal

Scenario
Wood (m2) Labor (hrs) Tables Chairs profit (INR)

I 2,000 1,600 400 400 340,000

II 2,000 1,200 133 800 313,333
III 1,500 1,600 500 0 275,000
IV 1,500 1,200 300 300 255,000 3
Motivation…

Product mix Scenarios

Strategy Order
(T,C)
I II III IV
A (400,400) [T,C] 340,000 220,000 265,000 220,000
B (400,400) [C,T] 340,000 266,667 248,333 248,333
C (133,800) [T,C] 313,333 313,333 238,333 238,333
D (133,800) [C,T] 313,333 313,333 225,000 225,000
E (500,0) 275,000 220,000 275,000 220,000
F (300,300) [T,C] 255,000 255,000 255,000 255,000
G (300,300) [C,T] 255,000 255,000 255,000 255,000 4
Introduction

• What is involved in making a good decision?

• Decision theory is an analytic and systematic approach to the study

of decision-making.

• A “good” decision is one that is based on logic, considers all available

data and possible alternatives, and uses a quantitative approach.

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Steps in decision making

1. Clearly define the problem at hand

2. List the possible alternatives
3. Identify the possible outcomes or states of nature
4. List the payoff of each combination of alternatives and outcomes
5. Select one of the mathematical decision theory models
6. Apply the model and make your decision

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Thompson Lumber Company
• In the lumber business for over 40 years
• Whether to expand the product line
 manufacture and market a new product, backyard sheds
• Alternatives:
1. a large plant What
2. a small plant should be
3. no plant at all
the
• Possible outcomes: decision?
1. Favorable market – High demand
2. Unfavorable market – Low demand
• Consequence quantification:
1. a large plant – Profit $200,000 [Favorable] / Loss $180,000 [Unfavorable]
2. a small plant – Profit $100,000 [Favorable] / Loss $20,000 [Unfavorable]
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Decision/Payoff table

State of nature

Favorable market Unfavorable market

Alternative ($) ($)
Construct a large plant 200,000 –180,000

Construct a small plant 100,000 –20,000

Do nothing 0 0

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Decision-making environments

1. Decision making under certainty

• The decision maker knows with certainty the consequences of every
alternative or decision choice

2. Decision making under uncertainty

• The decision maker does not know the probabilities of the various outcomes

3. Decision making under risk

• The decision maker knows the probabilities of the various outcomes

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Decision making under uncertainty

• Criteria for making decisions under uncertainty

1. Optimistic (Maximax)
2. Pessimistic (Maximin)
3. Criterion of realism (Hurwicz criterion)
4. Equally likely (Laplace)
5. Minimax regret

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1. Optimistic (Maximax)
• Alternative that maximizes the maximum payoff
• Steps:
1. Locate the maximum (best) payoff for each alternative
2. Select the alternative with the maximum number

State of nature
Favorable Unfavorable Maximum in a
Alternative market ($) market ($) row ($)

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

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

Do nothing 0 0 0

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2. Pessimistic (Maximin)
• Alternative that maximizes the minimum payoff
• Steps:
1. Locate the minimum (worst) payoff for each alternative
2. Select the alternative with the maximum number

State of nature
Favorable Unfavorable Minimum in a
Alternative market ($) market ($) row ($)

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

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

Do nothing 0 0 0
Maximin
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3. Criterion of realism (Hurwicz criterion)

• Often called weighted average

– Compromise between optimism and pessimism

• Steps:
1. Select a coefficient of realism α, with 0 ≤ α ≤ 1
α = 1 is perfectly optimistic
α = 0 is perfectly pessimistic
2. Compute the weighted averages for each alternative
Weighted average = α (best in row) + (1−α) (worst in row)
3. Select the alternative with the highest value

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3. Criterion of realism (Hurwicz criterion)...

State of nature
Weighted
Favorable Unfavorable average
Alternative market ($) market ($) ( = 0.8) ($)

Construct a large plant 200,000 –180,000 124,000

Realism
Construct a small plant 100,000 –20,000 76,000

Do nothing 0 0 0

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4. Equally likely (Laplace)
• Considers all the payoffs for each alternative

• Steps:
1. Find the average payoff for each alternative
2. Select the alternative with the highest average
State of nature
Favorable Unfavorable Row average
Alternative market ($) market ($) ($)

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

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

Equally likely
Do nothing 0 0 0

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5. Minimax regret
• Based on opportunity loss or regret
– The difference between the optimal profit and actual payoff for a decision

• Steps:
1. Create an opportunity loss table by determining the opportunity loss
from not choosing the best alternative
2. Calculate opportunity loss by subtracting each payoff in the column from
the best payoff in the column
3. Find the maximum opportunity loss for each alternative and pick the
alternative with the minimum number

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 5. Minimax regret…
State of nature
Favorable market Unfavorable market
Alternative ($) ($)
Payoff table Construct a large plant 200,000 –180,000
Construct a small plant 100,000 –20,000
Do nothing 0 0

State of nature
Favorable market Unfavorable market
Alternative ($) ($)
Opportunity
loss table Construct a large plant 0 180,000
Construct a small plant 100,000 20,000
Do nothing 200,000 0
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 5. Minimax regret…

Opportunity
loss table

State of nature
Favorable market Unfavorable market Maximum in a row
Alternative ($) ($) ($)
Construct a large plant 0 180,000 180,000

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

Minimax
Do nothing 200,000 0 200,000

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 Thank you!

Questions/Comments?

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