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    Decision Making Under Uncertainty

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    Jason Recana
    This document discusses concepts related to decision making under uncertainty. It defines uncertainty as a lack of knowledge and describes three main sources of uncertainty: data errors from measurement issues, forecasting errors about future unknown events, and model errors from imperfect mathematical representations. It then outlines several decision rules that can be used when outcomes are uncertain, including: the Laplace principle of treating all outcomes as equally probable; the maximin/minimax principles of choosing the strategy with the highest minimum payoff or lowest costs; the maximax principle of choosing the strategy with the highest maximum payoff; the Hurwicz principle that balances optimism and pessimism; and the Savage principle of minimizing maximum regret.

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    Decision Making Under Uncertainty

    Uploaded by

    Jason Recana
    117 views3 pages
    This document discusses concepts related to decision making under uncertainty. It defines uncertainty as a lack of knowledge and describes three main sources of uncertainty: data errors from measurement issues, forecasting errors about future unknown events, and model errors from imperfect mathematical representations. It then outlines several decision rules that can be used when outcomes are uncertain, including: the Laplace principle of treating all outcomes as equally probable; the maximin/minimax principles of choosing the strategy with the highest minimum payoff or lowest costs; the maximax principle of choosing the strategy with the highest maximum payoff; the Hurwicz principle that balances optimism and pessimism; and the Savage principle of minimizing maximum regret.

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    Managerial Economics

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    This document discusses concepts related to decision making under uncertainty. It defines uncertainty as a lack of knowledge and describes three main sources of uncertainty: data errors from measurement issues, forecasting errors about future unknown events, and model errors from imperfect mathematical representations. It then outlines several decision rules that can be used when outcomes are uncertain, including: the Laplace principle of treating all outcomes as equally probable; the maximin/minimax principles of choosing the strategy with the highest minimum payoff or lowest costs; the maximax principle of choosing the strategy with the highest maximum payoff; the Hurwicz principle that balances optimism and pessimism; and the Savage principle of minimizing maximum regret.

    Copyright:

    © All Rights Reserved
    Download as PDF, TXT or read online from Scribd
    Download as pdf or txt
    117 views3 pages

    Decision Making Under Uncertainty

    Uploaded by

    Jason Recana
    This document discusses concepts related to decision making under uncertainty. It defines uncertainty as a lack of knowledge and describes three main sources of uncertainty: data errors from measurement issues, forecasting errors about future unknown events, and model errors from imperfect mathematical representations. It then outlines several decision rules that can be used when outcomes are uncertain, including: the Laplace principle of treating all outcomes as equally probable; the maximin/minimax principles of choosing the strategy with the highest minimum payoff or lowest costs; the maximax principle of choosing the strategy with the highest maximum payoff; the Hurwicz principle that balances optimism and pessimism; and the Savage principle of minimizing maximum regret.

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    © All Rights Reserved
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    of 3

    CONCEPT OF

    RISK
    (Decision making under uncertainty)

    Submitted by:
    Kristine Joy J. Sales

    BSA I-13
    Prof. Lucia Wong Lazo
    DECISION MAKING UNDER UNCERTAINTY
    What is uncertainty?
    Uncertainty is state of lack of knowledge. The various fields which is concerned with
    uncertainty have no common agreement on the definition, terminology, or classification of uncertainty.
    Also we can say that the Uncertainty – uncertain events that we do not even know how to describe.
    The word “uncertainty” emphasizes that choice of decision-making must be made on the basis of
    incomplete knowledge about projects that do not yet physically exist.

    Uncertainties arise from three sources of errors, namely:

    1. Data Errors

    The errors related with the technical problems are known as the data error. Data errors
    stem from measurement errors, sampling errors and simple human errors. Uncertainties due to
    data error can be measured by using statistical techniques. Data errors can be reduced by
    collecting more past data.

    2. Forecasting Errors

    Forecasting error is related with the uncertainty about “future events”. As we know
    economic evaluation of the future is questionable. There is a limit to our ability to reduce
    forecasting errors. No matter how hard we tried and used advanced techniques the reason is
    the future is unknowable.

    3. Model Errors

    Model errors represents the residual error which is output of difference between
    observed and model values. Model error may occur due to the impossibility towards perfectly
    representing the real world in a mathematical model. Quantifications of economic benefits
    involves the use of forecast traffic speeds and delays, fuel prices, national income and time
    valuation, and etc. contain model errors.

    Decision Rules for Decision under Uncertainty


    A situations where there is no way in which the decision- maker can assess the probabilities of
    the various states of nature are called decision under uncertainty. The several principles which may
    be employed for taking decision in such condition are as follows:

    a.) Laplace principal


    The Laplace principle is based on the simple philosophy that if we are uncertain about the
    various events then we may treat them as equally probable. Under this assumption, the expected
    (mean) value of pay-off for each strategy is determined and the strategy with highest mean value is
    adopted. Of course, if the pay-off are in terms of costs, we choose the strategy with the lowest
    average cost.
    b.) Maximin or Minimax
    Principle This principle is adopted by pessimistic decision-maker who are conservative in their
    approach. Using this principle, the minimum pay-offs resulting from adoption of various strategies are
    considered and among these values the maximum one is selected. It involves, therefore, choosing
    the maximum profit from the set of worst or the minimum profits.

    c) Maximax or Minimin Principle


    The maximax principle is optimist’s principle of choice. This principle suggests that for each
    strategy, the maximum profit should be considered and the strategy with which the highest of these
    values is associated should be chosen. The optimist obviously desires a chance for the maximum
    pay-off in the decision matrix.

    d) Hurwicz Principle
    The Hurwicz principle of decision-making stipulates that a decision-maker’s view may fall
    somewhere between the extreme pessimism of the maximin principle and the extreme optimism of
    the maximax principle. This principle provides a mechanism by which different levels of optimism and
    pessimism may be shown. For this, an index of optimism, α, is defined on scale ranging from 0 to 1.
    An α = 0 indicates extreme pessimism while α = 1 represents extreme optimism.

    e) Savage Principle
    The savage principle is based on the concept of regret and calls for selecting the course of
    action that minimizes the maximum regret. It is alternatively known as the principle of minimax regret.
    The regret matrix is derived from the pay-off matrix then the maximum regret value corresponding of
    each of the strategies is determined and the strategy which minimizes the maximum regret is chosen.

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