Chapter no 7

MODELLING
UNCERTAINTY
Modeling uncertainty
Manager takes a decision
There is some uncertainty
Is it worth taking or not
Should he go for alternative course
or not
If yes, Analyze by means of Odds OR
Probability
Odds are difficult to manipulate
mathematically, therefore probability
is used
Modeling uncertainty
Managers assessment of probability of
an event occurring is derived either from:
Frequency of past occurrences
(relative frequency method)
Managers subjective estimate
(subjective probability)
Laws of manipulating probability allows
us to combine Probability estimates in the
light of further information

Modeling uncertainty
useful method is decision matrix
List of decision options on one dimension
List of states of nature on other dimension
Result Consequences
Each consequence is examined by using
Decision rules
Optimistic decision rule
Pessimistic decision rule
Regret decision rule
Expected value decision rule


Disadvantage of decision matrix
Cannot describe sequential decisions conveniently


Modeling uncertainty
Decision trees are used
Represent each decision and each state of nature in
branch formation
First set of branches shows options available in first
decision
Second set of branches shows states of nature for
each option
Third set of branches indicate subsequent decisions
and so on
Decision tree can be analyzed to indicate
Option in the first decision
which will result in most favorable pay off
Certainty , uncertainty, risk
Stochastic deterministic dimension
Reflects the fact that we can choose to
model decisions as having a particular
degree of uncertainty
When managers take a decision
They may be reasonable confidant of
the precise nature of the consequence
should they choose one particular
option
Certainty , uncertainty, risk
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
Under conditions of total uncertainty
We cannot predict the consequences of a decision
We will be little confident in our view of
What states of nature are possible
In the likelihood of their occurrence
Our understanding of the structure of decision will be poor
Our information will be extremely limited or ambiguous

Incorporating uncertainty
There are three possible ways
Take single point estimate
make best possible guess with the help of available data
Evaluate as if there is no uncertainty
Proceed as above
Keep an allowance of estimates being optimistic
Incorporate uncertainty in modeling
Uncertainty can be incorporated by:
Examining how to quantify uncertainty
Describing three types of models which have been used to aid decision
under conditions of uncertainty :-
Decision matrix
Decision trees
Risk simulation


Quantifying uncertainty
Likelihood of something happening is
usually quantified by
Probability figure
Set of odds
Odds express chance of an occurrence as
a measure relative to its non occurrence
Probability expresses chance relative to
total span of possibilities

Types of probabilities
Classical approach
Probability based on equal chances of events happening
One card is likely to deal as another
A six is as likely as five in the game
Probabilities are derived from fair nature of game
Relative frequency approach
If the event is easily repeatable or occurs frequently
The likelihood is deduced from its occurrence history
Frequency of an event is counted and expressed as a
proportion of total number of times it could have occurred

Types of probabilities
When a manager says Product has
70% chances of success. He is
expressing personal belief instead of
an objective assessment
If a decision to Launch a product or
not has to be made Some
assessment of its success must be
made
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