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Decision Making Under Uncertainty: Maximax Criterion

The document discusses various criteria for decision making under uncertainty and risk, including maximax, maximin, minimax, Laplace, and Hurwicz criteria for uncertainty, and expected monetary value, expected opportunity loss, and expected value of perfect information for risk. It provides examples to illustrate each criterion, showing how to calculate the optimal decision based on the payoffs in a decision matrix under different states of nature and probabilities. The optimal decisions may differ depending on whether the decision maker is optimistic, pessimistic, or neutral.

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2K views6 pages

Decision Making Under Uncertainty: Maximax Criterion

The document discusses various criteria for decision making under uncertainty and risk, including maximax, maximin, minimax, Laplace, and Hurwicz criteria for uncertainty, and expected monetary value, expected opportunity loss, and expected value of perfect information for risk. It provides examples to illustrate each criterion, showing how to calculate the optimal decision based on the payoffs in a decision matrix under different states of nature and probabilities. The optimal decisions may differ depending on whether the decision maker is optimistic, pessimistic, or neutral.

Uploaded by

I.E. Business School
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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DECISION MAKING UNDER UNCERTAINTY

There are 5 criteria by which decisions can be made under uncertainty, namely:

 Maximax Criterion
 Minimax Criterion
 Maximin Criterion
 Laplace Criterion
 Harwicz Alpha Criterion

The above will be illustrated with the use of the following example:
Let there be a situation in which a decision-maker has three possible alternatives A 1, A2 and
A3, where the outcome of each of them can be affected by the occurrence of any one of the
four possible events S1, S2, S3 and S4.
The monetary payoffs of each combination of Ai and Sj are given in the following table:

MAXIMAX CRITERION

 This criterion is also known as the criterion of optimism


 It is used when the decision-maker is optimistic about future.
 Maximax implies the maximisation of maximum payoff.
 The optimistic decision-maker locates the maximum payoff for each possible course of
action. The maximum of these payoffs is identified and the corresponding course of action is
selected.
 The optimal course of action according to maximax criterion , based on this criterion, is A3
(52).

MAXIMIN CRITERION

 This criterion is also known as the criterion of pessimism.


 It is used when the decision-maker is pessimistic about future.
 Maximin implies the maximisation of minimum payoff.
 The pessimistic decision-maker locates the minimum payoff for each possible course of
action. The maximum of these minimum payoffs is identified and the corresponding course
of action is selected.
 The optimal course of action according to maximin criterion is A2 (17).
MINIMAX CRITERION

 This is also known as Regret or Opportunity Cost Criterion.


 This criterion focuses upon the regret that the decision-maker might have from selecting a
particular course of action.
 Regret is defined as the difference between the best payoff and the realised payoff.
Regret = (Best Payoff) – (Realised Payoff)
 This difference, which measures the magnitude of the loss incurred by not selecting the best
alternative, is also known as opportunity loss or the opportunity cost.
 The regret criterion is based upon the minimax principle, i.e., the decision-maker tries to
minimise the maximum regret.
 The decision-maker selects the maximum regret for each of the actions and selects the
action which corresponds to the minimum regret out of them. (optimal)

From the maximum regret column, we find that the regret corresponding to the course of
action is A3 is minimum. Hence, A3 (11) is optimal.

HURWICZ CRITERION

 This is a realistic approach to decision making which considers the degree or index of
optimism  or pessimism  of the decision-maker in the process of decision-making.
 If a, denotes the degree of optimism, (where 0<a<1), then the degree of pessimism will
be denoted as (1 –  a).
 Then a weighted average of the maximum and minimum payoffs of an action,
with a  and 1 - a  as respective weights, is computed.
The action with highest average is regarded as optimal.
 a value  nearer to unity (1) indicates that the decision-maker is optimistic
a value nearer to zero (0) indicates that he is pessimistic.
If a  = 0.5, the decision maker is said to be neutralist.

In the above example, assume a = 0.7

Since the average for A3 is maximum (40.9), it is optimal.


LaPLACE CRITERION

 This criterion assumes that all of possibilities are equally likely to occur, and hence uses
average payoff.
 We compute the expected payoff for each course of action and the action with
maximum expected value is regarded as optimal.

For the above question, the average payoffs are as follows:

Actions Expected Payoffs (Average)


A1 19.75
A2 29.25
A3 33

Here, A3 (33) is regarded as optimal.


DECISION MAKING UNDER RISK
When the probability of occurrence is known or can be estimated, the choice of an optimal
action, is termed as decision making under risk.

There are 3 criteria by which decisions can be made under risk, namely:

 Expected Monetary Value (EMV)


 Expected Opportunity Loss (EOL)
 Expected Value of Perfect Information (EVPI)

The above will be illustrated with the use of the following example:
The payoffs (in Rs) of three Acts A1, A2 and A3 and the possible states of nature S1, S2 and S3 are
given below:

The probabilities of the states of nature (S1, S2 and S3) are 0.3, 0.4 and 0.3 respectively.

EXPECTED MONETARY VALUE (EMV)

EMV uses the probabilities to calculate the average payoff for each alternative.

EMV (for alternative i) = ∑ (probability of outcome) x (payoff of outcome)

A1 is the optimal solution, since it has the highest EMV (194).


EXPECTED OPPURTUNITY LOSS

EOL is based on the amount of regret we can expect based on the probabilities

EOL (for alternative i) = ∑ (probability of outcome) x (regret of outcome)

This indicates that the optimal act is A1 (126) with least EOL.

EXPECTED VALUE OF PERFECT INFORMATION

The expected payoff of having perfect information before making a decision -

EVPI = EVwPI – EMV

EVwPI = ∑ (probability of outcome) x ( best payoff of outcome)

Note:

 EVwPI = Expected value with perfect information


 EMV = the best EMV without perfect information

Based on the above the table and with perfect information, 200 ( A3), 200 (A1) & 600 (A2)
would be the best payoffs with the respective probability of 0.3, 0.3 and 0.4 respectively.

EVwPI = (200x0.3) + (200x0.3) + (600x0.4) = 360

Therefore, EVPI = (360 – 194) = 166


The “perfect information” increases the expected value by Rs. 166.

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