Decision Making

MODELLING UNCERTAINTY
PRESENTED BY: VIQAR A. USMANI

Decision makers are increasingly willing to consider the uncertainty

associated with model predictions of the impacts of their possible decisions.
Information on uncertainty does not make decision making easier, but to
ignore it, is to ignore
reality.
Incorporating what is known about the uncertainty into input parameters and
variables used in optimization and simulation models can help in quantifying
the uncertainty in the resulting model predictions the model output.
In the last chapters we have studied one of the five dimensions that we use
to classify the quantitative models, was the stochastic-deterministic
dimension.
This dimension reflects the fact that we can choose to model decisions as
having a particular degree of uncertainty.
When managers take certain decisions, they may be reasonably confident of
the precise nature of the consequences should they choose one particular
option.
On the other hand, managers sometimes have to take decisions in the
dark, with little knowledge of the ultimate consequences of their action.
2
PRESENTED BY: VIQAR A. USMANI

So we can imagine a scale on which the amount of uncertainty present in a

decision can be represented.
At one end of the scale decision making can be said to be taking place under
conditions of certainty.
At the other, decisions take place under conditions of total uncertainty.
Under conditions of certainty only one state of nature is possible or,
alternatively, any variation which is possible will not affect the consequences
of choosing a particular option.
Either way, the decision is judged to be insensitive to any uncontrollable
factors present.
Under conditions of total uncertainty, not only can we not predict the
consequences of a decision, but further we will have very little confidence in
our view of either what states of nature are possible, or in the likelihood of
their occurrence; our understanding of the structure of the decision will be
poor, and our information will be extremely limited or ambiguous.
In reality, each of these extremes is unlikely to occur.
Certainty is, perhaps, a philosophical possibility but rarely a practical one.
Conditions of total uncertainty also are extremely rare.
3
PRESENTED BY: VIQAR A. USMANI

Predictions regarding the probabilities that any particular state will occur,
then decision making is said to be occurring under conditions of risk.
Most management decisions lie somewhere between total
uncertainty and risk, in an area usually referred to as plain
uncertainty.
Here we can usually identify the states likely to occur (even if we are aware
of, but disregard, some fringe possibilities).
Furthermore, we have sufficient knowledge to make some estimate of how
likely to occur is each possible state of nature.
Under such conditions, it is generally held to be useful for decision makers to
proceed as if they have confidence in their probability estimates, even if they
do not.
However, the important proviso is that this is done only on the grounds that it
is a useful way to proceed, rather than implying a spurious confidence;
furthermore, the sensitivity of the structure of the decision to the probability
estimates must be well understood.
PRESENTED BY: VIQAR A. USMANI

Incorporating Uncertainty
In practice, when faced with a decision that is clearly to be made under
conditions of uncertainty, there are only three possible ways to proceed;
1) Take single point estimates. In other words, make the best possible guess
on the strength of the information available in the decision and carry on
with the evaluation as though
uncertainty does not exist.
2) Proceed the same as in (1) but build in an allowance to account for the
possibility of estimates being optimistic.
In other words, we discount the value of our calculations on the ground
that we are not taking uncertainty into account.
3) Incorporate uncertainty in our modelling.
PRESENTED BY: VIQAR A. USMANI

This can be done by:

Examining how to quantify uncertainty.
Through models used to aid decision making under conditions of
uncertainty, namely:
I. The decision matrix
II. Decision trees.
III.Risk simulation.

uantifying Uncertainty

The likelihood of something happening is usually quantified either as a

probability figure or as a set of odds.
The two methods are quite simply related; if someone says that the chance of
an event occurring is X to Y then the probability is X/(X + Y).
For example, odds of 10 to 1 against a horse winning a race indicate that for
every one chance of the horse winning there are ten chances of it losing.
Or expressed in another way, out of eleven chances only one is for winning.

PRESENTED BY: VIQAR A. USMANI

Odds express the chance of an occurrence as a measure relative to its nonoccurrence, whereas probability expresses chance relative to the total span of
possibilities.
The basis of the odds method has disadvantages when the chance of an
event occurring becomes either very unlikely or almost certain.

pes of Probability.

There are three approaches to deriving the probability of something

happening:
the classical approach
the relative frequency approach
the subjective approach.
Originally, probability theory was developed for studying games of chance
involving dice or cards. In this context, probability is based on equal chances
of events happening.
Probabilities are derived from the (hopefully fair) nature of the game.
Thus the intrinsic nature of a fair coin means that we can assess the chances
of tossing a head as 50% before we have experience of the coin.
In fact, we define the fairness of the coin by the expectation of a 50:50
PRESENTED BY: VIQAR A. USMANI

Unfortunately, most uncertain events are governed by an intrinsic mechanism

which is far from clear.
If the event is something which is easily repeatable, or occurs frequently of its
own accord, we can deduce the likelihood that the event will occur by
examining its history.
For example, if we need to know the probability that a machine will break
down during the coming week, and we find that during, the last 50 weeks it
has broken down once or more during the week 10 times, then we put the
probability of the machine breaking down this coming week as 10/50 or 0.2.
Using this approach to defining probability, we are counting the frequency of
an event occurring and expressing it as a proportion of the total number of
times the event could have occurred. This method of deriving probabilities is
often called the relative frequency method.
Both the classical and the relative frequency methods could only be used to
forecast events which are repeatable or repeating.
But many management decisions involve assessing the chance of something
happening which has not happened before, and possibly will not happen8
PRESENTED BY: VIQAR A. USMANI

Yet this does not mean that managers cannot estimate probability when faced
with a unique event.
On the contrary, managers are often proud of their ability to make shrewd
predictions about future events, even if the circumstances are novel.
Suppose a manager is assessing the chances of a new product being a
success
say by capturing a certain market share.
There is certainly no objectively assessed intrinsic logic, as with a tossed coin,
on which a classical approach could be based.
Neither has the product been launched before, so there is no exact historical
information which could let us use the relative frequency method.
Yet, past experience of some kind will be sure to play some part in the
managers thinking.
If the new product is trying to enter a market which is notoriously difficult to
break into, then the past failures of other products will presumably depress
the managers estimation of his chances of success.
This third type of probability, no matter how soundly based on past
experience, is unashamedly subjective. When a manager says that a product
9
PRESENTED BY: VIQAR A. USMANI

Discreet and Continuous Probabilities

Suppose a manager is asked to estimate the chances of a development

project being finished by the date originally forecast at the start of the project
(the due date).
After looking at the work in hand the manager makes an estimate
the chance of making it by the due date is 60%.
Now implicit in what the manager is saying are two very important things.
Only two states are possible;
finishing before the due date or not finishing before the due date.
In other words, the two events are exhaustive.
Nothing else is possible outside them.
If one state occurs, the other cannot;
the two possible states are mutually exclusive .
it is not possible for both states to happen at the same time.
Suppose that the manager is now asked to refine his estimate by including a
third possibility, namely the project finishing in the month after the due date.
PRESENTED BY: VIQAR A. USMANI

10

The managers assessment could be that there is a 30% chance of this

happening.
So now the possible states and their chances are as follows:
o Project completed prior to the due date
= 60%
40%
o Project completed in the month after the due date
= 30%
o Project completed more than one month after due date
= 10%
Similarly the manager could estimate the probability of finishing in the month
prior to the due date, say 35%.
The states and their probabilities would then be:
Project completed before 1 month prior to the due date =60%
25%
Project completed in the month prior to the due date
= 35%
40%
Project completed 1 month after due date
= 30% `
Project
more
than the
1 month
after due
datefurther
= 10%
It mightcompleted
be possible
to break
probabilities
down
on a month by
month date.

PRESENTED BY: VIQAR A. USMANI

11

mulative Probability Distributions

The manager started by giving probability estimates as to the chance of the
finished date occurring on each side of one particular point in time (the due
date).
This type of information is often more valuable than knowing the probability
of an occurrence between two intervals.
The cumulative probability distribution format shows the total probability of
an event occurring by a particular point.
The managers estimates of the finish time for the project can be expressed
cumulatively as follows:
Project completed before 3 months prior to due date = 0
Project completed before 2 months prior to due date = 10%
Project completed before 1 month prior to due date
= 25%
Project completed before due date
= 60%
Project completed before 1 month after due date
= 90%
Project completed before 2 months after due date
= 95%
Project completed before 3 months after due date
= 100%
PRESENTED BY: VIQAR A. USMANI

12

A number of decision rules are commonly put forward as being helpful in

understanding the nature of the decision.
We shall look at four of these.
The first three do not involve the manager in forecasting future uncertain
events, but the fourth does.
The four decision rules are:
1. The Optimistic decision rule
2. The Pessimistic decision rule
3. The Regret decision rule
4. The Expected Value decision rule.
The Optimistic Decision Rule
This approach to selecting the preferred option is to consider all possible
circumstances and choose that option which yields the best possible
outcome.
In detail, this decision rule involves examining each option, selecting the
minimum cost outcome, and choosing the option which provides the lowest
minimum cost.
For this reason the rule is sometimes called the minimin cost rule 13
PRESENTED BY: VIQAR A. USMANI

The Pessimistic Decision Rule

A decision maker who took the very opposite view to the one described above
would follow the reverse procedure.
Each option would be examined, and the worst possible outcome for that
option identified.
The option would be selected which provided the best of the worst outcomes.
Because this decision rule involves choosing the option which has the
minimum of the maximum costs, it is often called the minimax cost rule (or
maximin revenue rule).
The Regret Decision Rule
The Regret decision rule is based on a deceptively simple but extremely
useful question.
That is If we decide on one particular option, then', with hindsight,
how much would we regret not having chosen what turns out to be
the best option for a particular set of circumstances?
Under the Regret decision rule we would choose the option which gave14us the
PRESENTED BY: VIQAR A. USMANI

onsistency in the Regret Rule

The Regret decision rule is a powerful and intuitively attractive idea.
It attempts to minimize the embarrassment we might feel at making the
wrong decision.
It is closely related to the economists traditional concept of the
opportunity cost of a decision; that is, by choosing one alternative course
of action, what opportunity are we forgoing by not choosing another course of
action?
Unfortunately, as a decision rule the concept has a major disadvantage;
if we are choosing the alternative which will give us the least cause for regret
when compared with another alternative, then the degree of regret will
depend upon which other options are considered.
This can cause problems of logical inconsistency.

PRESENTED BY: VIQAR A. USMANI

15

Expected Value Decision Rule

The three criteria so far discussed may clarify the decision for us, but they do
not use one of the potentially most useful factors within any management
decisions.
That is our estimate of the likelihood of a particular situation occurring.
The principle of expectations weighs each outcome by the likelihood of it
occurring.

PRESENTED BY: VIQAR A. USMANI

16

SUMMARY
Any manager facing a decision which takes place under some
degree of uncertainty must decide whether its worthwhile
treating the uncertainty in an explicit manner, or alternatively
assuming that the best estimate of the future will in fact occur.
If uncertainty is to be made explicit, then the most common
ways of quantifying it are either by means of odds or by a
probability figure.
Because odds are difficult to manipulate mathematically, we
generally use probabilities.

PRESENTED BY: VIQAR A. USMANI

17