Decision Making Environment

There a four main environment within which decisions can be made. These are:
 Certainty
 Risk
 Fundamental uncertainty
 Competition

 Certainty environment

In this environment complete information is available as to which states of nature will occur.
The decision making process just involves picking the best alternative.

Risk
Risk involves situations or events which may or may not occur but whose probability of
occurrence can be predicted from past records. In this environment, the states of nature are not
certain but probability distribution can be assigned.

Fundamental uncertainty
Uncertain events are those whose outcome cannot be predicted with statistical confidence. In
this environment the states of nature are not known nor are their probability distribution. The
decision making process depends on the risk attitude of the decision maker.

Competition
In this environment the decisions made by the firm are affected by decisions made by other firms
with opposing interests.

Decision Making Under Risk and Uncertainty

RISK ATTITUDES

1. Risk seeking

A risk seeker is a decision maker who is interested in the best possible outcome no matter how
small the chance that they may occur i.e. he takes high risks in anticipation of high profitability.
For such a decision maker, the marginal utility for wealth is positive and increasing.

2. Risk neutral

A decision maker is risk neutral if he is concerned with what will be the most likely outcome i.e.
he is indifferent to risk. For such a decision maker the marginal utility of wealth is positive and
constant.
3. Risk Averse

A decision maker is risk averse, if he acts on the assumption that the worst possible outcome will
occur, and chooses the decision with the least risk possible.
For such a decision maker, the marginal utility of wealth is positive but decreasing.

Methods Of Decision Making Under Uncertainty

1. Maximax decision rule

This decision rule looks at the best possible result and it chooses the maximum payoff for each
alternative and then the maximum of this maximum.
This criterion appeals to risk takers or optimists who are ready to undertake huge losses if they
occurred. Small and new companies should not use this method.
Maximax Criterion
Steps
1. PREPARE PAYOFF TABLE
2. Choose maximum payoff for each Act
3. Select maximum out of these maximum.
4. Corresponding Act is a best decision
This criterion is also known as criteria of optimism because it reflects
optimistic attitude of the decision maker.

ILLUSTRATION
Assume that ABC Ltd is trying to set the selling price for one of its products and three prices are
under consideration. These are Sh.4, Sh.4.30 & Sh.4.40
The following information is also provided

Alternatives

Conditions Sh.4.00 Sh.4.30 Sh.4.40

Best possible 16,000 14,000 12,500
Most likely 14,000 12,500 12,000
Worst possible 10,000 8,000 6,000

Fixed costs = Sh. 20,000

variable cost per unit = Sh. 2

Required:
Advice the company on the best price to set under maximax rule
Solution
The first step is to prepare as payoff table a shown below:

Payoff matrix (profits in Shs.)

Sh.4 Sh.4.30 Sh.4.40

Conditions
Best possible 12000 12200 10000
Most likely 8000 8750 8800
Worst possible 0 (1600) (5600)

Decision Making Criteria

Sh.4 Sh.4.30 Sh.4.40

Conditions
Best possible 12000 12200 10000
Most likely 8000 8750 8800
Worst possible 0 (1600) (5600)
Maximum 12000 12200 10000

The decision is to set a price of Sh.4.30 since it maximises the maximum pay off.

2. Maximin decision rule

Under this criterion, the decision maker looks at the worst possible outcome of each decision
alternative and then chooses the alternative that offers the least unattractive (worst) outcome i.e.
He chooses the alternative that maximises the minimum profit. This criterion appeals to risk
averse decision makers since it is a criterion of extreme caution. It can be applied by those firms
which cannot be able to absorb huge losses if they occurred.
Maximin Criterion
Steps
1. Choose minimum payoff for each Act
2. Select maximum out of these minimum.
3. Corresponding Act is a best decision
This criterion is also known as criteria of pessimism because it reflects
pessimistic attitude of the decision maker

ILLUSTRATION
Assume that ABC Ltd is trying to set the selling price for one of its products and three prices are
under consideration. These are Sh.4, Sh.4.30 & Sh.4.40
The following information is also provided
 Alternatives

Conditions Sh.4.00 Sh.4.30 Sh.4.40

Best possible 16,000 14,000 12,500
Most likely 14,000 12,500 12,000
Worst possible 10,000 8,000 6,000

Fixed costs = Sh. 20,000

variable cost per unit = Sh. 2

Required:
Advice the company on the best price to set under maximin criterion

3. Laplace Criterion of Rationality

This criterion holds that if decision makers do not know the probabilities of the various states of
nature and have no reason to think otherwise, then the states of nature should be considered to be
equally likely. On the basis of this assumption, the expected monetary value for each alternative
is calculated and the alternative with the highest expected monetary value is chosen.
Laplace Criterion
Steps
1. Calculate average pay off for each Act
2. Choose maximum out of these averages
3. Corresponding Act is a best decision

ILLUSTRATION
Assume that ABC Ltd is trying to set the selling price for one of its products and three prices are
under consideration. These are Sh.4, Sh.4.30 & Sh.4.40
The following information is also provided

Alternatives

Conditions Sh.4.00 Sh.4.30 Sh.4.40

Best possible 16,000 14,000 12,500
Most likely 14,000 12,500 12,000
Worst possible 10,000 8,000 6,000
 Fixed costs = Sh. 20,000
variable cost per unit = Sh. 2

Required:
Advice the company on the best price to set under Laplace Criterion criterion

4. Minimax Regret Criterion

This method seeks to minimise the maximum regret that would occur from choosing a particular
strategy or alternative. The regret is the opportunity loss that occurs from taking one decision
given that a certain contingency occurs.
Minimax Regret Criterion
Steps
1. Choose maximum payoff for each Event
2. Calculate maximum payoff – individual payoff for each combination of
Act &Event. This is known as Regret value for that particular
combination of Act and Event
3. Select maximum Regret for each course of Action.
4. Select minimum out of these maximum.
5. Corresponding Act is a best decision

ILLUSTRATION
Assume that ABC Ltd is trying to set the selling price for one of its products and three prices are
under consideration. These are Sh.4, Sh.4.30 & Sh.4.40
The following information is also provided

Alternatives

Conditions Sh.4.00 Sh.4.30 Sh.4.40

Best possible 16,000 14,000 12,500
Most likely 14,000 12,500 12,000
Worst possible 10,000 8,000 6,000

Fixed costs = Sh. 20,000

variable cost per unit = Sh. 2

Required:
Advice the company on the best price to set under minimax regret criterion
 5. The Hurwiz method
This method was the concept of coefficient of
optimism (or pessimism) introduced by L.
Hurwicz. The decision maker takes into account
both the maximum and minimum pay off for each
alternative and assigns them weights according to
his degree of optimism (or pessimism). The
alternative which maximizes the sum of these
weighted payoffs is then selected

Alternatives

Conditions Sh.4.00 Sh.4.30 Sh.4.40

Best possible 16,000 14,000 12,500
Most likely 14,000 12,500 12,000
Worst possible 10,000 8,000 6,000

Fixed costs = Sh. 20,000

variable cost per unit = Sh. 2

Required:
Advice the company on the best price to set under HURWIZ
criterion (alpha = 0.3)

Illustration
Rank the products A B and C applying the Maximin
rule, Minimax regret criteria, maxmax rule and
laplace criteria using the following payoff table
showing potential profits and losses which are
expected to arise from launching these three
products in three market conditions
(see table 1 below)

Boom Steady Recessi

conditio state on
n
Product +8 1 -10
A
Product -2 +6 +12
B
Product +16 0 -26
C