criteria for decision-making under uncertainty that are based entirely on the payoff matrix approach

criteria for decision-making under uncertainty that are based entirely on the payoff matrix approach

All decisions in life, whether in business or at home, have particular characteristics that constitute a formal description of the problem and also help in formulating the appropriate solution. The characteristics include a decision-maker, events or outcomes, alternative courses of action, also known as strategies, and the consequences or payoffs. The implications of a decision can be summarized using the payoff matrix, which is an essential decision-making tool. It provides a summary of each available alternative with a quantitative consequence or payoff. Using the matrix, a decision-maker takes a positive payoff to mean profits and negative payoffs imply loss. There are four major criteria for decision-making under uncertainty that are based entirely on the payoff matrix approach, and they include the maximin, the maximax, Hurwitz alpha index, and minimax regret.

Maximin Criterion

The maximin criterion is also known as the Wald or pessimism. It aligns with the pessimistic view of situations. The criterion is based on the philosophy that nature is unfair. As a result, decision-makers should determine the worst possible outcome for each of the available strategies then choose the one with a more reasonable outcome. Decision-makers using this approach examine only the consequences of each alternative and selects the one that is relatively lenient to the organization. The criterion is conservative in nature and works best for firms that are facing stiff competition in the industry and are looking for ways of surviving in the market. For example, in a business situation, the decision-maker will assume that all the methods will results in losses and list down the levels of loss from each strategy. The strategy with the least losses is then implemented.

Maximax Criterion

This criterion is the opposite of the pessimism approach and is thus known as optimism. The criterion is based on the belief that nature is fair that things will always turn out for the best. The criterion best suits entrepreneurs and other extreme risk-takers. In this approach, the decision-maker has to list the best outcomes from each of the available alternatives and then select the best of them all. If applied in business, the decision-maker chooses the strategy that results in the highest profits regardless of the risks involved.

Hurwicz Alpha Index Criterion

The Hurwicz Alpha Index aims to achieve a pragmatic compromise between the maximin and maximax criteria. It involves the use of an index, which is obtained by deriving a coefficient, commonly known as the coefficient of optimism. Under this approach, the decision-maker has to list both the payoffs and consequences of each alternative and weighs the extreme outcomes in accordance with subjective evaluations of either pessimism or optimism. The deciding value for each strategy is obtained by adding the probability of the maximum payoff to that of the minimum payoff. The decision-maker then implements the option with the maximum deciding factor.

Minimax Regret Criterion

The minimax regret criterion aims to help a decision-maker to select an approach that brings the least regret. It aims to reduce the regret that a decision-maker would have for selecting one alternative at the expense of a better option. Regret, in this case, refers to the difference between the actual and the expected payoff. According to the approach, a decision-maker should prepare a regret matrix and use the minimax rule to choose which strategy to implement. To construct the matrix, the individual subtracts each entry in the payoff matrix from the highest value in the column. The assumption is that the highest entry would yield the maximum benefits.

More ways of making decisions under uncertainty include applying risk analysis whereby the decision-maker analyzes the risk and nature of the risk before deciding on the appropriate course of action. Decision trees are also effective when making decisions under uncertainty. The decision-maker uses a tree diagram with probabilities, strategies, and chance events. The user can use the diagram to trace the course of action with maximum results.

Criteria for decision-making under risk

Risky environments in decision-making situations refer to a state where the decision-maker is faced with imperfect information concerning the environment. The main difference between uncertainty and risky environments is that in uncertainty is a state where the decision-maker does not have any information that can be assigned to probabilities, whereas, in risky states, the decision-maker has some estimates to the likely outcomes of a strategy chosen. The approaches for decision-making under risky are as follows.

Risk analysis

Under risk situations, the probabilities are known. The probabilities are obtained through analysis of historical trends or by reference to probability distributions. The criterion involves the use of a random variable. A decision-maker has to find the probability distribution of the random variable. The process entails listing of possible the possible payoffs and the probabilities of the payoffs.

Expected monetary value (EMV)

The expected monetary value criterion provides the decision-maker with adequate information to use in making a decision. The true expected value refers to the mean of a probability distribution that carries a summary of an entire distribution of outcomes, both consequences and payoffs. The expected monetary value criterion is based on the assumption that a decision-maker can overcome short-run fluctuations and uses the expected monetary value decision approach regularly. Studies have, however, noted that decision-makers choose an alternative that has a higher likelihood of providing substantial reasonable returns that is subjected to some specified levels of risk.

Experts believe that the best way in which a decision-maker can determine the level of risk is through the use of probability distribution since it is spread about a mean. It is believed that when the level of dispersion of the probability distribution of possible outcomes is relatively lower, the degree of risk for the given approach reduces significantly.

Difference between decision-making under uncertainty and decision-making under risky situations.

Decision-making under certainty occurs when the future events are unpredictable, and elements are in a state of flux. Decision-makers find themselves in a position where they are unaware of all the existing options, the risks attached to each alternative and the consequences of specific approaches. The manager possesses inadequate information and is thus forced to make decisions based on past experiences and their judgment. Conversely, decision-making under risk situations occurs when the decision-maker has some information but which is not adequate. The individual may not be aware of all the existing alternatives, but has some probability to attach to each alternative. Decision-makers are forced to use their experience and the available information to determine the probability that is associated with each alternative.