DECISION MAKING WITH

UNCERTAINTY: DECISION
CRITERIA

STQM6034 Decision and Game Analysis

Terms in decision making
 Objectives
◦ Issues to solve
 Decision alternatives
◦ Choices/options
 Chance events
◦ Uncertain future events affecting the
consequences/payoffs associated with a decision
 States of nature
◦ Possible outcomes for chance events that affect the payoff
associated with a decision alternative
 Payoffs
◦ Measures of consequences of decisions
◦ Can also be in function forms
 Probability of all states of nature
Uncertainty
 One reason why making decisions are
difficult
 Example:
◦ A cosmetic company trying to decide whether to
introduce a new anti-aging product
◦ What are the events that may have an impact on
the company’s eventual payoff/profit?
1. _______________________________________
2. _______________________________________
3. _______________________________________
4. _______________________________________
Uncertainty
 Definition:
◦ A condition when a decision maker is uncertain of
the factors involved or relevant in a problem or
situation
 Reasons for uncertainty:
◦ Generally when there is no historical
evidence/data on the problem
◦ The problem is new
◦ Absence of records/data on product sales
resulting in difficulties to determine possible
payoffs
 Normally use personal subjective judgments
to make decisions
Decision analysis needed

 Assists in identifying important sources of

uncertainty
 Assists in representing uncertainty in a
quantitative manner
Decision analysis needed
 Study situations in which decisions are
made in an uncertain environment
◦ Without probability
◦ With probability
 Decision criteria
◦ Optimistic/maximax
◦ Conservative/maximin
Without probability
◦ Minimax regret
◦ Hurwicz alpha
◦ Expected monetary value
With probability
◦ Expected opportunity loss
Aspects of decision making
model under uncertainty
1. A decision maker must choose an action ai
from a set A={a1, a2, a3, …, ak} of available
actions
2. A set of states of nature is observed to be
sj ε S = {s1, s2, s3, …, sn}
3. If there is a probability for the state of
nature, then pj denotes the probability for sj
4. Payoff rij is awarded if action ai is chosen
and the state of nature is sj
Decision making model
representation
 Some representations:
◦ Decision tree
◦ Influence diagram
◦ Payoff table
Decision tree
 Shows the natural or logical progression that
will occur over time
 Example: 2 decision alternatives and 2
states of nature

s1 r11
a1
s2 r12

s1
r21
a2
s2
r22
Influence diagram
 Shows the relationships among the
decisions, the chance events and the
consequences for a decision problem

States
of
nature

Decision
Alternatives Consequences
Payoff table/matrix
 Tabular representation that shows payoffs for
all combinations of decision alternatives and
states of nature
 Example: 2 decision alternatives and 2 states of
nature

State of nature

Decision s1 s2
alternative
a1 r11 r12

a2 r21 r22
Decision problem example
 NNIZ Boutique Cafe is considering three
options for maximizing its annual profit:
produce more traditional clothing, produce
more modern clothing, or expand its’ café
menu. The annual profits anticipated from
these decisions depend on future demand.
The annual profit of each decision
alternative (in hundreds of RM) depends on
demand as in the next table. Help NNIZ
Boutique Café to maximize its annual profit.
Example continued
Demand
Decision High Medium Low
alternative
More Traditional
900 600 300
Clothing
More Modern
650 650 600
Clothing
Expand Menu 800 650 500

 A={more traditional clothing (a1), more

modern clothing (a2), expand menu (a3)}
 S = {high demand (h), medium demand (m),
low demand (l)}
Optimistic/Maximax Criterion
 The decision alternative ai with the largest
value of maxjεSrij is chosen.
 Step 1:
◦ Determine the best outcome (largest payoff) for
each decision alternative
 Step 2:
◦ The optimistic criterion chooses the decision
alternative with the “BEST” best outcome.
 But risk of getting lower payoff if events are
not as expected.
Optimistic/Maximax Criterion:
Example
Demand
Decision High Medium Low Best payoff
alternative (maxjεS rij )
More
Traditional 900 600 300 900
Clothing
More
Modern 650 650 600 650
Clothing
Expand
800 650 500 800
Menu

Largest value of maxjεSrij = 900,

Best decision alternative : produce more
traditional clothing
Conservative/Maximin Criterion
 The decision alternative ai with the largest value
of minjεSrij is chosen.
 Step 1:
◦ Determine the worst outcome (smallest payoff)
for each decision alternative
 Step 2:
◦ The optimistic criterion chooses the decision
alternative with the “BEST” worst outcome.
 Choose the best alternative among the worst
possibilities
 A reasonable decision to take if competitors are
fierce and good, and if not able to risk making
mistakes or losses.
Conservative/Maximin Criterion:
Example
Demand
Decision High Medium Low Worst payoff
alternative (minjεS rij )
More
Traditional 900 600 300 300
Clothing
More
Modern 650 650 600 600
Clothing
Expand
800 650 500 500
Menu

Largest value of minjεSrij = 600,

Best decision alternative : produce more
modern clothing
Minimax Regret Criterion
 A decision strategy based on the concept of
opportunity cost
 Chooses the decision alternative that gives the
minimum opportunity loss (regret) if the correct
decision is not made
 Step 1:
◦ For each state of nature sj, determine the decision
alternative ai that maximizes payoff rij. Denotes
with ri*j.
 Step 2:
◦ For any decision alternative ai and state of nature sj,
the opportunity loss (regret) for ai in sj is lij=ri*j - rij.
Minimax Regret Criterion
 Step 3:
◦ Determine the maximum opportunity loss for each
decision alternative
 Step 4:
◦ The minimax regret criterion chooses the decision
alternative with the “WORST” maximum opportunity
loss.
Minimax Regret Criterion :
Example
 Step 1:

Demand
Decision High Medium Low
alternative
More Traditional
900 600 300
Clothing
More Modern
650 650 600
Clothing
Expand Menu 800 650 500
Maximum payoff 900 650 600
Minimax Regret Criterion :
Example
 Step 2:

Demand
Decision High Medium Low
alternative
More Traditional
0 50 300
Clothing
More Modern
250 0 0
Clothing
Expand Menu 100 0 100
Minimax Regret Criterion:
Example
 Step 3:
Demand
Decision Low Maximum
High Medium
alternative regret
More
Traditional 0 50 300 300
Clothing
More
Modern 250 0 0 250
Clothing
Expand
100 0 100 100
Menu

 Step 4: Minimax regret is 100.

 Best decision is to expand menu
Hurwicz Alpha Criterion
 The Hurwicz alpha (α) is a criterion for
decision making under complete uncertainty
that represents a compromise between the
Maximin and Maximax criteria (weighted
average).
 α is a number (optimism index) between 0
and 1.
◦ α= 0  completely pessimistic
◦ α= 1  completely optimistic
Hurwicz Alpha Criterion
 By "Decision Making Under Complete
Uncertainty" it is meant that a decision table
is available. This means that it is known
which alternatives are available, which states
of nature are possible, and what utility each
alternative would derive in each possible state
of nature. The "complete uncertainty" means
that the probabilities of each state of nature
occurring are unknown.
Hurwicz Alpha Criterion
 Proportional Average:
◦ Expected payoff for a decision alternative ai =
α(maximum payoff) + (1-α)(minimum payoff)
 Hurwicz alpha criterion chooses the decision
alternative with the BEST expected payoff

 An advantage: allows personal judgment in

decision
Hurwicz Alpha Criterion :
Example
 Determine maximum and minimum payoff for each
decision alternative:

Decision Maximum Minimum

alternative payoff payoff
More Traditional
900 300
Clothing
More Modern
650 600
Clothing
Expand Menu 800 500
Hurwicz Alpha Criterion :
Example
 If α = 0.6, then calculate the expected payoff
for each decision alternative
Maximum Minimum Expected
Decision alternative
payoff payoff payoff
More Traditional 0.6(900) +
900 300
Clothing 0.4(300) = 660
More Modern 0.6(650) +
650 600
Clothing 0.4(600) = 630
0.6(800) +
Expand Menu 800 500
0.4(500) = 680

 Maximum expected payoff is 680.

 Best decision is to expand menu
NNIZ Boutique Cafe example
revisited
 Supposed now the probabilities of the three
demands are known.
 Probabilities for high, medium and low
demand are 0.3, 0.5 and 0.2 respectively.

 Which decision alternative is the best to

help NNIZ Boutique Café in maximizing its
annual profit?
Expected Monetary Value
Criterion
 Let N be the number of decision alternatives
 Let P(sj) be the probability of state of nature
sj
 Since one and only one of the N states of
nature can occur, the probabilities must
satisfy two conditions:
◦ P(sj) ≥ 0 for all states of nature
◦ Total probability = 1:
N

 P(s ) P(s )  P(s )  ...  P(s

j 1
j 1 2 N ) 1
Expected Monetary Value
Criterion
 The expected value (EV) of decision
alternative ai is defined as:
N
EV (ai )   P(s j )rij
j 1
 i.e. the expected value of a decision
alternative is the sum of weighted payoffs for
the decision alternative

 The Expected Monetary Value criterion

chooses the decision alternative with the
BEST (Maximum) expected value.
Expected Monetary Value
Criterion: Example
Demand
Decision High Medium Low Expected
alternative (0.3) (0.5) (0.2) value
More 0.3(900) +
Traditional 900 600 300 0.5(600) +
Clothing 0.2(300) = 630
More 0.3(650) +
Modern 650 650 600 0.5(650) +
Clothing 0.2(600) = 640
Expand 0.3(800) +
Menu 800 650 500 0.5(650) +
0.2(500) = 665
Largest value = 665,
Best decision alternative : expand menu
Expected Opportunity Loss
Criterion
 The Expected Opportunity Loss (EOL) for a
given decision alternative is the sum of the
possible opportunity loss (lij) for decision
alternative ai under the state of nature sj,
each weighted by the probability of that
opportunity loss occurring.
 The EOL of decision alternative ai is defined
as:
Expected Opportunity Loss
Criterion
 The EOL of decision alternative ai is defined
as:

 The Expected Opportunity Loss criterion

chooses the decision alternative with the
LEAST (Minimum) expected value.
Expected Opportunity Loss
Criterion: Example
 Obtain the opportunity loss (regret) values first
Demand
Decision High Medium Low Expected
alternative (0.3) (0.5) (0.2) value
More
Traditional 0.3(0) + 0.5(50) +
0 50 300
0.2(300) = 85
Clothing

More Modern 0.3(250) + 0.5(0) +

250 0 0
Clothing 0.20) = 75

Expand Menu
0.3(100) + 0.5(0) +
100 0 100
0.2(100) = 50

Smallest value = 50,

Best decision alternative : expand menu
Summary of Results
 Decision Making under Uncertainty without
probability
Criterion Decision Conclusion

Profit of RM90,000 but if there is

Optimistic Produce more low demand for the traditional
(Maximax) traditional clothing clothing, then profit is only
RM30,000

Profit of RM60,000 but if demand

Pessimistic Produce more modern
is high, will only get an extra of
(Maximin) clothing
RM5000

Minimax Maximum opportunity loss of

Expand café’s menu
Regret RM10,000

Hurwicz Profit of RM68,000 with

Expand café’s menu
Alpha optimism level of 60%
Summary of Results
 Decision Making under Uncertainty with probability

Criterion Decision Conclusion

Expected
Monetary Expand café’s menu Expected profit of RM66,500
Value

Expected
Expected regret value of
Opportunity Expand café’s menu
RM5,000
Loss