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, a
– coefficient of optimism (a) 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
a = 0.3, 1- a = 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 outco me 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

A glass factory specializing in crystal is experiencing a

substantial backlog, and the firm's management is
considering three courses of action:

A) Arrange for subcontracting

B) Construct new facilities
C) Do nothing (no change)

The correct choice depends largely upon demand, which

may be low, medium, or high. By consensus, management
estimates the respective demand probabilities as 0.1, 0.5,
and 0.4.
 Example of a Decision Tree Problem
(Continued): The Payoff Table
The management also estimates the profits
when choosing from the three alternatives (A,
B, and C) under the differing probable levels of
demand. These profits, in thousands of dollars
are presented in the table 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 demand (0.4) $90

Medium demand (0.5) $50
$62 Low demand (0.1) $10

A
EVA=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 B generates the greatest expected profit, so
our choice is B or to construct a new facility
 Format of a Decision Tree
Payoff 1
Decision Point
Chance Event Payoff 2

2
Payoff 3
B
1
Payoff 4

Payoff 5

Payoff 6
 Case of Decision Tree application
 Problem: The palm oil based Futuristic Company is considering two alternatives:
to expand its existing production operation to manufacture a new line of derivative
material; or to purchase land to construct a new facility on in the future. Each of
these decisions has outcomes based on product market growth in the future that
result in another set of decisions (during a ten-year planning horizon).
The first decision facing the company is whether to expand or buy land. If
the company expands, two states of nature are possible. Either the market will
grow (with probability of 0.60) or it will not grow (with a probability of 0.40). Either
state of nature will result in a payoff. On the other hand, if the company chooses to
purchase land, three years in the future another decision will have to be made
regarding the development of the land.
At decision node 1, the decision choices are to expand or to purchase land,
that the costs of the ventures ($800,000 and $200,000 respectively). If the plant is
expanded, two state of nature are possible at probability node 2: the market will
grow, with a probability of 0.60, or it will not grow or will decline, with a probability
of 0.40. If the market grows, the company will achieve a payoff of $2,000,000 over
a ten-year period. However, if no growth occurs, a payoff of only $225,000 will
result.
 If the decision is to purchases land, two states of nature are possible at probability node
3. These two states of nature and their probabilities are identical to those at node 2;
however, the payoffs are different. If market growth occurs for a three-year period, no
payoff will occur, but the company will make another decision at node 4 regarding
development of the land. At that point, either the plant will be expanded at a cost of
$800,000 or the land will be sold, with a payoff of $450,000. The decision situation at
node 4 can occur only if market growth occurs first. If no market growth occurs at node
3, there is no payoff, and another decision situation becomes necessary at node 5: A
warehouse can be constructed at a cost of $600,000 or the land can be sold for
$210,000. (Notice that the sale of the land result in less profit it there is no market
growth than if there is growth.).
If the decision at decision node 4 is to expand, two states of nature are possible:
The market may grow, with a probability of market growth is higher (and the probability
of no growth is lower) than before because there has already been growth for the first
three years, as shown by the branch from node 3 to node 4. The payoffs for these two
states of nature at the end of the ten year period are $3,000,000 and $700,000.
If the company decides to build a warehouse at node 5, then two state of nature
can occur: Market growth can occur, with a probability of 0.30 and an eventual payoff,
of $2,300,000, or no growth can occur, with a probability of 0.70 and payoff of
$1,000,000. The probability of market growth is low (i.e. 0.30) because there has
already been no market growth. Construct the decision tree structure and then solve the
structure so you can suggest the company whether to expand or purchase the land.