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Decision & Trees, Risk and Uncertainty

University Mathematics I: Olaniyi Evans

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8 views

Decision & Trees, Risk and Uncertainty

University Mathematics I: Olaniyi Evans

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Olaniyi Evans
Copyright
© © All Rights Reserved
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17

DECISION ANALYSIS & TREES:


RISK & UNCERTAINTY

CONTENTS
Decision Analysis 148
Decision-Making Criteria Under Uncertainty 149
Decision-Making Under Risk 150
Decision Trees 153

DECISION ANALYSIS
Decision analysis is a systematic and quantitative approach to decision-making
that involves evaluating and choosing among different courses of action based
on their potential outcomes and associated uncertainties. The goal is to make
informed decisions that maximize positive outcomes or minimize potential
losses. This analytical process is particularly valuable in complex situations
where various factors and uncertainties come into play.

By combining quantitative methods, probability theory, and decision criteria,


decision analysis guides decision-makers in selecting the most favorable courses
of action based on their objectives and potential outcomes. Ultimately, decision
analysis enables rational and informed decision-making in the face of
uncertainty.

Six Steps in Decision Making Process


1. Problem Definition: Begin by clearly articulating and understanding the
problem that needs a decision.
2. Alternative Generation: Enumerate the various alternatives or possible
courses of action available to address the defined problem.
3. Outcome Identification: Identify the potential outcomes or states of nature
associated with each alternative, considering all possibilities.
4. Payoff Listing: List the payoffs, often in terms of profits or benefits, for each
combination of alternatives and outcomes.
5. Decision Theory Model Selection: Choose a suitable mathematical decision
theory model based on the nature of the decision problem and the available
data.
6. Model Application and Decision: Apply the selected model to the collected
data and information to arrive at a decision or recommendation based on
the analysis.

Type of Decision-making Environments


Decision-making is influenced by the level of knowledge about a situation,
leading to three distinct decision-making environments:
• Decision making under certainty.
• Decision making under uncertainty.
• Decision making under risk.

The type of decision-making environment significantly impacts the choices


individuals make, with decision making under uncertainty posing greater
challenges due to unknown probabilities and varying perspectives.
Chapter 17| Decision Analysis & Trees: Risk & Uncertainty 149

Aspect Decision Making Under Risk Decision Making Under


Uncertainty
Information Complete information is Information may be
Availability available for all possible incomplete or insufficient
states. for analysis.
Probability Probabilities for each state of Probabilities for outcomes
Assessment nature are objectively known. are not objectively
quantifiable.
Decision Decision criteria include Decision criteria may involve
Criteria Expected Monetary Value subjective assessments,
(EMV), qualitative analysis, or non-
Standard Deviation, and probabilistic methods.
Coefficient of Variation.
Outcomes Outcomes can be quantified Outcomes may be uncertain,
and measured with certainty. and their measurement is
often subjective or
qualitative.
Examples Investment decisions with New product launches,
known probabilities and strategic decisions in
market conditions. uncertain markets, or
responses to unforeseen
events.
Risk Risks are often quantifiable, Managing uncertainty may
Tolerance allowing for risk involve a higher level of risk
management. tolerance due to the lack of
precise information.

D E C I S I O N -M A K I N G C R I T E R I A U N D E R U N C E R T A I N T Y
In decision-making under uncertainty, where outcome probabilities are
uncertain or unavailable, various criteria are employed to guide choices. The
decision-making criteria under uncertainty are outlined as follows:
1. Optimism (Maximax) criterion:
i. Identify the maximum payoff values for each decision alternative.
ii. Choose the decision alternative with the highest payoff value
(maximum for profit).
2. Pessimism (Maximin) criterion:
i. Identify the minimum payoff value for each decision alternative.
ii. Select the decision alternative with the highest payoff value (maximum
for profit).
3. Equal probabilities (Laplace) criterion:
i. Assign equal probability values to each state of nature using the
formula:
1 ÷ (number of states of nature)
ii. Calculate the expected (or average) payoff for each alternative by adding
all payoffs and dividing by the number of possible states of nature.
iii. Choose the alternative with the highest expected payoff value
(maximum for profit).
4. Hurwicz criterion:
i. Determine the coefficient of optimism, α, and the coefficient of
pessimism, (1 – α).
ii. For each decision alternative, select the highest and lowest payoff values
and multiply them by α and (1 – α) values, respectively. Calculate the
weighted average as follows:
w = α(Maximum in column) + (1 – α)(Minimum in column).
iii. Select the alternative with the highest weighted average payoff value.
150 Olaniyi Evans | University Mathematics

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