Decision Making Under

Uncertainty:
Pay Off Table and Decision Tree
 Decision Making Under
Uncertainty

A set of quantitative decision-making

techniques for decision situations
where uncertainty exists
 Decision Making
States of nature
– events that may occur in the future
– decision maker is uncertain which state of
nature will occur
– decision maker has no control over the states
of nature
 Payoff Table
 A method of organizing & illustrating the
payoffs from different decisions given
various states of nature

 A payoff is the outcome of the decision

 Payoff Table
States Of Nature
Decision a b
1 Payoff 1a Payoff 1b
2 Payoff 2a Payoff 2b
 Decision-Making Models
Under Uncertainty
 Maximax
choose decision with the maximum of the
maximum payoffs
 Maximin
choose decision with the maximum of the
minimum payoffs
 Minimax regret
choose decision with the minimum of the
maximum regrets for each alternative
 Hurwicz
– choose decision in which decision payoffs are
weighted by a coefficient of optimism, 
– coefficient of optimism () is a measure of a
decision maker’s optimism, from 0 (completely
pessimistic) to 1 (completely optimistic)

 Equal likelihood (La Place)

– choose decision in which each state of nature
is weighted equally
 Decision Making Under
Uncertainty Example
States Of Nature
Good Foreign Poor Foreign
Decision Competitive Conditions Competitive Conditions
Expand $ 800,000 $ 500,000
Maintain status quo 1,300,000 -150,000
Sell now 320,000 320,000
 Maximax Solution
Expand: $ 800,000
Status quo: 1,300,000 Maximum
Sell: 320,000

Decision: Maintain status quo

 Maximin Solution
Expand: $ 500,000 Maximum
Status quo: -150,000
Sell: 320,000

Decision: Expand
 Minimax Regret Solution
Good Foreign Poor Foreign
Competitive Conditions Competitive Conditions
$ 1,300,000 - 800,000 = 500,000 $ 500,000 - $500,000 = 0
1,300,000 - 1,300,000 = 0 500,000 - (-150,000) = 650,000
1,300,000 - 320,000 = 980,000 500,000 - 320,000 = 180,000

Regret Value
Expand: $ 500,000 Minimum
Status quo: 650,000
Sell: 980,000
Decision: Expand
 Hurwicz Solution
 = 0.3, 1-  = 0.7

Expand: $ 800,000 (0.3) + 500,000 (0.7) = $590,000 **

Status quo: 1,300,000 (0.3) -150,000 (0.7) = 285,000
Sell: 320,000 (0.3) + 320,000 (0.7) = 320,000

Decision: Expand
** Maximum
 Equal Likelihood Solution
Two decisions, weight = 0.50 for each state of nature

Expand: $ 800,000 (0.50) + 500,000 (0.50) = $650,000 **

Status quo: 1,300,000 (0.50) -150,000 (0.50) = 575,000
Sell: 320,000 (0.50) + 320,000 (0.50) = 320,000

Decision: Expand

**Maximum
 Decision Making With
Probabilities
 Risk involves assigning probabilities to
states of nature

 Expected value is a weighted average of

decision outcomes in which each future
state of nature is assigned a probability of
occurrence
 Expected Value
n
EV( x)   p xi xi
i1
where
xi  outcome i
p xi  probability of outcome i
 Expected Value Example
70% probability of good foreign competition
30% probability of poor foreign competition

EV(expand) $ 800,000 (0.70) + 500,000 (0.30)

= $710,000
EV(status quo) $1,300,000 (0.70) - 150,000 (0.30)
= 865,000 Maximum
EV(sell) $ 320,000 (0.70) + 320,000 (0.30)
= 320,000

Decision: Maintain status quo

 Case of Pay off Table application
An ICT (Information and communication technology) company wants to
analyze the future of its business. There are 4 decision alternatives:
expand the company, maintain status quo, decrease the business size
up to 50% of the current size and sell the company. From the
business analysis there will be two possibilities: good economic
condition and bad economic condition. If the economic condition is
good the profit of the expansion will be Rp. 900 million and only Rp.
400 million when the economic condition is bad. If the economic
condition is good the profit of maintain status quo will be Rp. 1.000
million and only Rp. 50 million when the economic condition is bad. If
the economic condition is good the profit of decrease the business will
be Rp. 600 million and only Rp. 300 million when the economic
condition is bad. When the company is sold the current price is Rp.
350 million. Solve this decision problem by using maximax, maximin,
minimax, hurwicz (with alpha = 0.3) and Equal likelihood. Based on
the analysis provide your best suggestion.
 Sequential Decision Trees
 A graphical method for analyzing decision
situations that require a sequence of
decisions over time
 Decision tree consists of
Square nodes - indicating decision points
Circles nodes - indicating states of nature
Arcs - connecting nodes
Decision tree basics: begin with
no uncertainty
Example: deciding where to eat
dinner
 Basic setup:
Trees run left to right
Japanese chronologically.
North Side Decision nodes are
represented as squares.
Greek
Possible choices are
represented as lines (also
Vietnam called branches).
The value associated with
South Side
each choice is at the end of
Thai the branch.
Assigning values to the nodes
involves defining goals.
Example: deciding where to eat
dinner

Taste versus Speed

Japanese
4 1
North Side

Greek
3 2

Vietnam
1 4
South Side

Thai
2 3
To solve a tree, work backwards,
i.e. right to left.
Example: deciding where to eat
dinner

Speed
Japanese
1
North Side
Value =2
Greek
2
Value =4
Vietnam
4
South Side
Value =4
Thai
3
 Decision making under
uncertainty
Example: a company deciding whether
to go to trial or settle a lawsuit

Win [p=0.6] Chance nodes are

Go to trial represented by circles.
Lose [p= ]
Probabilities along each
branch of a chance
node must sum to 1.
Settle
 Solving a tree with uncertainty:
The expected value (EV) is
the probability-weighted sum
Win [p=0.6] of the possible outcomes:
$0
Go to trial pwinx win payoff + plosex lose
EV= -$3.2M
-$3.7M -$.5M payoff
Lose [p=0.4]
-$8M In this tree, “Go to trial” has a
EV= -$3.7M cost associated with it that
“Settle” does not.
Settle We’re assuming the decision-
-$4M maker is maximizing
expected values.
 Decision tree notation
Expected value of Probabilities
(above the branch) Terminal values
chance node (or corresponding to
Chance nodes certainty equivalent) each branch (the
(circles)
sum of payoffs
Win [p=0.6] along the branch).
-$.5M
$0
Go to trial
EV= -$3.2M
-$3.7M -$.5M
Lose [p=0.4]
-$8.5M
-$8M
EV= -$3.7M
Decision nodes
(squares)
Settle
-$4m
-$4M -$4M

Value of optimal Running total

decision Payoffs
of net expected (below the branch)
payoffs
(below the branch)
Example of a Decision Tree Problem

AAglass
glassfactory
factoryspecializing
specializingin
incrystal
crystalis
isexperiencing
experiencingaa
substantial
substantialbacklog,
backlog,and
andthe
thefirm's
firm'smanagement
managementis is
considering
consideringthree
threecourses
coursesof ofaction:
action:

A)
A) Arrange
Arrangefor
forsubcontracting
subcontracting
B)
B) Construct
Constructnew
newfacilities
facilities
C)
C) Do
Donothing
nothing(no
(nochange)
change)

The
Thecorrect
correctchoice
choicedepends
dependslargely
largelyupon
upondemand,
demand,which
which
may
maybebelow,
low,medium,
medium,ororhigh.
high. By
Byconsensus,
consensus,management
management
estimates
estimatesthetherespective
respectivedemand
demandprobabilities
probabilitiesas
as0.1,
0.1,0.5,
0.5,
and
and0.4.
0.4.
 Example of a Decision Tree Problem
(Continued): The Payoff Table
The
The management
management alsoalso estimates
estimates the
the profits
profits
when
when choosing
choosing from
from thethe three
three alternatives
alternatives (A,
(A,
B,
B, and
and C)
C) under
under the
the differing
differing probable
probable levels
levels of
of
demand.
demand. These
These profits,
profits, in
in thousands
thousands ofof dollars
dollars
are
are presented
presented in
in the
the table
table below:
below:
0.1 0.5 0.4
Low Medium High
A 10 50 90
B -120 25 200
C 20 40 60
Step 1. We start by drawing the three
decisions

A
B

C
Step 2. Add our possible states of
nature, probabilities, and payoffs
High demand (0.4) $90
Medium demand (0.5) $50
Low demand (0.1) $10

A High demand (0.4) $200

B Medium demand (0.5) $25
Low demand (0.1) -$120
C
High demand (0.4) $60
Medium demand (0.5) $40
Low demand (0.1) $20
Step 3. Determine the expected value
of each decision

High
Highdemand
demand(0.4)
(0.4) $90
$90
Medium
Mediumdemand
demand(0.5)
(0.5) $50
$50
$62
$62 Low
Lowdemand
demand(0.1)
(0.1) $10
$10
AA
EV
EVAA=0.4(90)+0.5(50)+0.1(10)=$62
=0.4(90)+0.5(50)+0.1(10)=$62
 Step 4. Make decision
High demand (0.4) $90
Medium demand (0.5) $50
$62 Low demand (0.1) $10

A High demand (0.4) $200

$80.5
B Medium demand (0.5) $25
Low demand (0.1) -$120
C
High demand (0.4) $60
$46 Medium demand (0.5) $40
Low demand (0.1) $20
Alternative
AlternativeBBgenerates
generatesthe
thegreatest
greatestexpected
expectedprofit,
profit,so
so
our
ourchoice
choiceis
isBBor
orto
toconstruct
constructaanew
newfacility
facility
 Format of a Decision Tree
a t ure 1 Payoff 1
Decision Point Stat e of n
Chance Event eA ’1 Payoff 2
’ Choos
A State
se of
o natur 2
o e2
Ch Choose
A’2 Payoff 3
B
1
s e A ’3 Payoff 4
Ch oo
u re 1
a t
C

o f n 2
ho

State
os

Choose Payoff 5
e

A’4
A
’2

State
o f natu Payoff 6
re 2
Case of Decision Tree application

See Attached Problem