Republic of the Philippines

EASTERN VISAYAS STATE UNIVERSITY

Tacloban City
ISO 9001:2015 Certified
Industrial Engineering Department

ECON 323: Engineering Economics

WRITTEN REPORT:
DECISION RECOGNIZING RISK

Submitted by:
Reas, Caren S.
BSIE 3A

Submitted to:
Engr. Merc Rochie Borromeo
Instructor

April 25, 2024

Abstract

Decision making is certainly the most important task of a manager and it is often
a very difficult one. The domain of decision analysis models falls between two extreme
cases. This depends upon the degree of knowledge we have about the outcome of our
actions. One “pole” on this scale is deterministic. The opposite “pole” is pure uncertainty.
Between these two extremes are problems under risk. The main idea here is that for any
given problem, the degree of certainty varies among managers depending upon how
much knowledge each one has about the same problem. This reflects the recommendation
of a different solution by each person. Probability is an instrument used to measure the
likelihood of occurrence for an event. When probability is used to express uncertainty,
the deterministic side has a probability of one (or zero), while the other end has a flat (all
equally probable) probability. This paper offers a decision making procedure for solving
complex problems step by step. It presents the decision analysis process for both public
and private decision making, using different decision criteria, different types of
information and information of varying quality. It describes the elements in the analysis
of decision alternatives and choices, as well as the goals and objectives that guide
decision making. The key issues related to a decision-maker's preferences regarding
alternatives, criteria for choice and choice modes, together with the risk assessment tools,
are also presented.

Keywords:

Decision Making under Risk, Risk Management, Decision Making Technique,

Bayesian Approach, Risk Measuring Tool.
DECISION RECOGNIZING RISK

Modeling for decision making involves two distinct parties—one is the decision
maker, and the other is the model builder known as the analyst. The analyst is to assist
the decision maker in his/her decision-making process. Therefore, the analyst must be
equipped with more than a set of analytical methods. Specialists in model building are
often tempted to study a problem, and then go off in isolation to develop an elaborate
mathematical model for use by the manager (i.e., the decision maker). Unfortunately, the
manager may not understand this model and may either use it blindly or reject it entirely.

The specialist may feel that the manager is too ignorant and unsophisticated to
appreciate the model, while the manager may feel that the specialist lives in a dream
world of unrealistic assumptions and irrelevant mathematical language. Such
miscommunication can be avoided if the manager works with the specialist to develop
first a simple model that provides a crude but understandable analysis. After the manager
has built up confidence in this model, additional detail and sophistication can be added,
perhaps progressively only a bit at a time. This process requires an investment of time on
the part of the manager and sincere interest on the part of the specialist in solving the
manager's real problem, rather than in creating and trying to explain sophisticated models.
This progressive model building is often referred to as the bootstrapping approach and is
the most important factor in determining successful implementation of a decision model.
Moreover, the bootstrapping approach simplifies the otherwise difficult task of model
validating and verification processes.

In deterministic models, a good decision is judged by the outcome alone. However,

in probabilistic models, the decision maker is concerned not only with the outcome value
but also with the amount of risk each decision carries. As an example of deterministic
versus probabilistic models, consider the past and the future. Nothing we can do can
change the past, but everything we do influences and changes the future, although the
future has an element of uncertainty. Managers are captivated much more by shaping the
future than the history of the past.

Uncertainty is the fact of life and business. Probability is the guide for a “good”
life and successful business. The concept of probability occupies an important place in
the decision-making process, whether the problem is one faced in business, in
government, in the social sciences, or just in one's own everyday personal life. In very
few decision-making situations is perfect information—all the needed facts—available.
Most decisions are made in the face of uncertainty. Probability enters into the process by
playing the role of a substitute for certainty—a substitute for complete knowledge.

Probabilistic modeling is largely based on application of statistics for probability

assessment of uncontrollable events (or factors), as well as risk assessment of your
decision. The original idea of statistics was the collection of information about and for
the state. The word statistics is not derived from any classical Greek or Latin roots, but
from the Italian word for state. Probability has a much longer history. Probability is
derived from the verb to probe meaning to “find out” what is not too easily accessible or
understandable. The word “proof” has the same origin that provides necessary details to
understand what is claimed to be true. Probabilistic models are viewed as similar to that
of a game; actions are based on expected outcomes. The center of interest moves from
the deterministic to probabilistic models using subjective statistical techniques for
estimation, testing and predictions. In probabilistic modeling, risk means uncertainty for
which the probability distribution is known.
Therefore, risk assessment means a study to determine the outcomes of decisions along
with their probabilities.

Decision makers often face a severe lack of information. Probability assessment

quantifies the information gap between what is known, and what needs to be known for
an optimal decision. The probabilistic models are used for protection against adverse
uncertainty, and exploitation of propitious uncertainty. Difficulty in probability
assessment arises from information that is scarce, vague, inconsistent or incomplete. A
statement such as “the probability of a power outage is between 0.3 and 0.4” is more
natural and realistic than its “exact” counterpart, such as “the probability of a power
outage is 0.36342”

It is a challenging task to compare several courses of action and then select one
action to be implemented. At times, the task may prove too challenging. Difficulties in
decision making arise through complexities in decision alternatives. The limited
information-processing capacity of a decision-maker can be strained when considering
the consequences of only one course of action. Yet, choice requires that the implications
of various courses of action be visualized and compared. In addition, unknown factors
always intrude upon the problem situation and seldom are outcomes known with
certainty. Almost always, an outcome depends upon the reactions of other people who
may be undecided themselves. It is no wonder that decision makers sometimes postpone
choices for as long as possible. Then, when they finally decide, they neglect to consider
all the implications of their decision.

Business decision making is almost always accompanied by conditions of

uncertainty. Clearly, the more information the decision maker has, the better the decision
will be. Treating decisions as if they were gambles is the basis of decision theory. This
means that we have to trade off the value of a certain outcome against its probability. To
operate according to the canons of decision theory, we must compute the value of a certain
outcome and its probabilities; hence, determining the consequences of our choices. The
origin of decision theory is derived from economics by using the utility function of
payoffs. It suggests that decisions be made by computing the utility and probability, the
ranges of options, and also lays down strategies for good decisions.

Objectives are important both in identifying problems and in evaluating alternative

solutions. Evaluating alternatives requires that a decision maker’s objectives be expressed
as criteria that reflect the attributes of the alternatives relevant to the choice. The
systematic study of decision making provides a framework for choosing courses of action
in a complex, uncertain or conflicting situation. The choices of possible actions, and the
prediction of expected outcomes, derive from a logical analysis of the decision situation.
A possible drawback in the decision analysis approach: You might have already noticed
that the above criteria always result in selection of only one course of action. However,
in many decision problems, the decision maker might wish to consider a combination of
some actions. For example, in the investment problem, the investor might wish to
distribute the assets among a mixture of the choices in such a way to optimize the
portfolio's return.

1. Decision Making Under Risk

Risk implies a degree of uncertainty and an inability to fully control the outcomes
or consequences of such an action. Risk or the elimination of risk is an effort that
managers employ. However, in some instances the elimination of one risk may increase
some other risks. Effective handling of a risk requires its assessment and its subsequent
impact on the decision process. The decision process allows the decision-maker to
evaluate alternative strategies prior to making any decision. The process is as follows:

1) The problem is defined, and all feasible alternatives are considered. The
possible outcomes for each alternative are evaluated.
2) Outcomes are discussed based on their monetary payoffs or net gain in
reference to assets or time.
3) Various uncertainties are quantified in terms of probabilities.
4) The quality of the optimal strategy depends upon the quality of the
judgments. The decision maker should identify and examine the sensitivity
of the optimal strategy with respect to the crucial factors.

Whenever the decision maker has some knowledge regarding the states of nature,
he/she may be able to assign subjective probability estimates for the occurrence of each
state. In such cases, the problem is classified as decision making under risk [27]. The
decision maker is able to assign probabilities based on the occurrence of the states of
nature. The decision making under risk process is as follows:

a) Use the information you have to assign your beliefs (called subjective
probabilities) regarding each state of the nature, p(s),
b) Each action has a payoff associated with each of the states of nature X(a,s),
c) Compute the expected payoff, also called the return (R), for each action
n
R(a) = ∑X (ai , si ).p(si )
i=1
d) We accept the principle that we should minimize (or maximize) the
expected payoff,
e) Execute the action which minimizes (or maximizes) R(a).
1.1 Expected Payoff

The actual outcome will not equal the expected value. What you get is not what
you expect, i.e. the “Great Expectations!”

a) For each action, multiply the probability and payoff and then,
b) Add up the results by row,
c) Choose largest number and take that action.

TABLE 1
The Expected Payoff Matrix

MG NC Exp.
G (0.4) (0.3) (0.2) L (0.1) Value
B 0.4(12) + 0.3(8 + 0.2(7 + 0.1(3) = 8.9
S 0.4(15) + ) + ) + 0.1(-2) = 9.5*
D 0.4(7) + 0.3(9 + 0.2(5 + 0.1(7) = 7
) )
0.3(7 0.2(7
) )
1.2 The Most Probable States of Nature

This method is a simple way for decision making under risk but it is good for
non-repetitive decisions. The steps of this method are as follows:

a) Take the state of nature with the highest probability (subjectively break
any ties),
b) In that column, choose action with greatest payoff.

In our numerical example, there is a 40 percent chance of growth so we must buy

stocks with payoff 15 and expected payoff 0.6.

1.3 Expected Opportunity Loss (EOL)

The steps of this method are as follows:

a) Set up a loss payoff matrix by taking largest number in each state of

nature column (say L), and subtract all numbers in that column from it, L
- Xij,
b) For each action, multiply the probability and loss then add up for each action,
c) Choose the action with smallest EOL.

TABLE 2
The Expected Opportunity Loss Matrix
 Loss Payoff Matrix
G (0.4) MG(0.3) NC(0.2) L (0.1) EOL
B 0.4(15-12) + 0.3(9-8) + 0.2(7-7) + 0.1(7-3) 1.9
S 0.4(15-15) + 0.3(9-9) + 0.2(7-5) + 0.1(7+2) 1.3*
D 0.4(15-7) + 0.3(9-7) + 0.2(7-7) + 0.1(7-7) 3.8

Note that the result is coincidentally the same as Expected Payoff and Most
Probable States of Nature.

1.4 Computation of the Expected Value of Perfect Information (EVPI)

EVPI helps to determine the worth of an insider who possesses perfect information.
Recall that EVPI is equal to EOL.

a) Take the maximum payoff for each state of nature,

b) Multiply each case by the probability for that state of nature and then add
them up,
c) Subtract the expected payoff from the number obtained as Expected Payoff.

TABLE 3
EVPI Computation Matrix

G 15(0.4) = 6.0
MG 9(0.3) = 2.7
NC 7(0.2) = 1.4
L 7(0.1) = 0.7
+ ------
10.8

Therefore, EVPI = 10.8 - Expected Payoff = 10.8 - 9.5 = 1.3. Verify that
EOL=EVPI. The efficiency of the perfect information is defined as 100 [EVPI/(Expected
Payoff)]%. Therefore, if the information costs more than 1.3 percent of investment, don't
buy it. For example, if you are going to invest $100,000, the maximum you should pay
for the information is [100,000 * (1.3%)] = $1,300.

1.5 We Know Nothing (the Laplace Equal Likelihood Principle)

Every state of nature has an equal likelihood. Since we don't know anything about
the nature, every state of nature is equally likely to occur:

a) For each state of nature, use an equal probability (i.e., a Flat Probability),
b) Multiply each number by the probability,
c) Add action rows and put the sum in the Expected Payoff column,
d) Choose largest number in step (c) and perform that action.
 TABLE 4
Laplace Equal Likelihood Principle Matrix

G MG NC L Exp. Payoff
Bonds 0.25(12) 0.25(8) 0.25(7) 0.25(3) 7.5 *
Stocks 0.25(15) 0.25(9) 0.25(5) 0.25(-2) 6.75

Deposit 0.25(7) 0.25(7) 0.25(7) 0.25(7) 7

1.6 A Discussion on Expected Opportunity Loss (Expected Regret)

Comparing a decision outcome to its alternatives appears to be an important

component of decision making. One important factor is the emotion of regret. This occurs
when a decision outcome is compared to the outcome that would have taken place had a
different decision been made. This is in contrast to disappointment, which results from
comparing one outcome to another as a result of the same decision. Accordingly, large
contrasts with counterfactual results have a disproportionate influence on decision
making. Regret results compare a decision outcome with what might have been.
Therefore, it depends upon the feedback available to decision makers as to which outcome
the alternative option would have yielded. Altering the potential for regret by
manipulating uncertainty resolution reveals that the decision making behavior that
appears to be risk averse can actually be attributed to regret aversion. There is some
indication that regret may be related to the distinction between acts and omissions. Some
studies have found that regret is more intense following an action, than an omission. For
example, in one study, participants concluded that a decision maker who switched stock
funds from one company to another and lost money would feel more regret than another
decision maker who decided against switching the stock funds but also lost money. People
usually assigned a higher value to an inferior outcome when it resulted from an act rather
than from an omission. Presumably, this is as a way of counteracting the regret that could
have resulted from the act.

2. Decision Tree and Influence Diagram

2.1 Decision Tree Approach

A decision tree is a chronological representation of the decision process. It utilizes

a network of two types of nodes: decision (choice) nodes (represented by square shapes),
and states of nature (chance) nodes (represented by circles). Construct a decision tree
utilizing the logic of the problem. For the chance nodes, ensure that the probabilities
along any outgoing branch sum to one. Calculate the expected payoffs by rolling the tree
backward (i.e., starting at the right and working toward the left). You may imagine
driving your car; starting at the foot of the decision tree and moving to the right along the
branches. At each square you have control, to make a decision and then turn the wheel
of your car. At each circle, fortune takes over the wheel and you are powerless. Here is a
step-by-step description of how to build a decision tree:

1) Draw the decision tree using squares to represent decisions and circles to
represent uncertainty,
2) Evaluate the decision tree to make sure all possible outcomes are included,
3) Calculate the tree values working from the right side back to the left,
4) Calculate the values of uncertain outcome nodes by multiplying the value
of the outcomes by their probability (i.e., expected values).

On the tree, the value of a node can be calculated when we have the values for all
the nodes following it. The value for a choice node is the largest value of all nodes
immediately following it. The value of a chance node is the expected value of the nodes
following that node, using the probability of the arcs. By rolling the tree backward, from
its branches toward its root, you can compute the value of all nodes including the root of
the tree. Put these numerical results on the decision tree results in a graph like what is
presented following. Determine the best decision for the tree by starting at its root and
going forward. Based on the proceeding decision tree, our decision is as follows:

• Hire the consultant, and then wait for the consultant's report. If the report
predicts either high or medium sales, then go ahead and manufacture the
product. Otherwise, do not manufacture the product.

Check the consultant's efficiency rate by computing the following ratio:

Consultant's Efficiency Rate =

(Expected payoff using consultant dollars amount) / EVPI

Using the decision tree, the expected payoff if we hire the consultant is:

EP = 1000 - 500 = 500,

EVPI = .2(3000) + .5(2000) + .3(0) = 1600.

Therefore, the efficiency of this consultant is: 500/1600 = 31%

 Figure 1
A Typical Decision Tree

the manager wishes to rely solely on the marketing research

firm's recommendations, then we assign flat prior probability (as opposed to (0.2, 0.5,
0.3) used in our numerical example). Clearly the manufacturer is concerned with
measuring the risk of the above decision, based on decision tree. Coefficient of Variation
as Risk Measuring Tool and Decision Procedure: Based on the above decision, and its
decision-tree, one might develop a coefficient of variation (C.V) risk-tree, as depicted
below:
 Figure 2
Coefficient of Variation as a Risk Measuring Tool and Decision Procedure

Notice that the above risk-tree is extracted from the decision tree, with C.V.
numerical value at the nodes relevant to the recommended decision. For example the
consultant fee is already subtracted from the payoffs. From the above risk-tree, we notice
that this consulting

firm is likely (with probability 0.53) to recommend Bp (medium sales), and if you decide
to manufacture the product then the resulting coefficient of variation is very high (403
percent), compared with the other branch of the tree (i.e., 251 percent).

Clearly one must not consider only one consulting firm; rather one must consider
several potential consulting firms during the decision making planning stage. The risk
decision tree then is a necessary tool to construct for each consulting firm in order to
measure and compare to arrive at the final decision for implementation.
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