The types of decisions people make depend on how much knowledge or information they have about the situation. There are three decision-making environments:

• Decision making under certainty

• Decision making under uncertainty

• Decision making under risk

In the environment of decision making under certainty, decision makers know with certainty the consequence of every alternative or decision choice. Naturally, they will choose the alternative that will maximize their well-being or will result in the best outcome. For example, let’s say that you have $1,000 to invest for a 1-year period. One alternative is to open a savings account paying 4% interest, and another is to invest in a government Treasury bond paying 6% interest. If both investments are secure and guaranteed, there is a certainty that the Treasury bond will pay a higher return. The return after 1 year will be $60 in interest.

In decision making under uncertainty, there are several possible outcomes for each alternative, and the decision maker does not know the probabilities of the various outcomes. As an example, the probability that a Democrat will be president of the United States 25 years from now is not known. Sometimes it is impossible to assess the probability of success of a new undertaking or product. The criteria for decision making under uncertainty are explained in Section 3.4.

In decision making under risk, there are several possible outcomes for each alternative, and the decision maker knows the probability of occurrence of each outcome. We know, for example, that when playing cards using a standard deck, the probability of being dealt a club is 0.25. The probability of rolling a 5 on a die is 1/6. In decision making under risk, the decision maker usually attempts to maximize his or her expected well-being. Decision theory models for business problems in this environment typically employ two equivalent criteria: maximization of expected monetary value and minimization of expected opportunity loss.

In the Thompson Lumber example, John Thompson is faced with decision making under uncertainty. If either a large plant or a small plant is constructed, the actual payoff depends on the state of nature, and probabilities are not known. If probabilities for a favorable market and for an unfavorable market were known, the environment would change from uncertainty to risk. For the third alternative, do nothing, the payoff does not depend on the state of nature and is known with certainty.