Decision Theory

Decision Theory represents a general approach to

decision making which is suitable for a wide range of
management decisions, including:

Capacity product and

planning service design

location equipment
planning selection

Product –mix Credit policies

 Problem Formulation
• A decision problem is characterized by decision
alternatives, states of nature, and resulting
payoffs.
• The decision alternatives are the different
possible strategies the decision maker can
employ.
• The states of nature refer to future events, not
under the control of the decision maker, which
will ultimately affect decision results.
• States of nature should be defined so that they
are mutually exclusive and contain all possible
future events that could affect the results of all
potential decisions.
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 Payoff Tables

• The consequence resulting from a specific

combination of a decision alternative and a
state of nature is a payoff.
• A table showing payoffs for all combinations
of decision alternatives and states of nature is
a payoff table.
• Payoffs can be expressed in terms of profit,
cost, time, distance or any other appropriate
measure.

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 Fundamentals of decision theory

Decision States of Payoff

alternatives nature

Courses of An occurrence Quantitative

action or over which measure of
strategies decision maker the outcome
has no control
Three-egg omelette Problem
• You are preparing a three-egg omelette.
Having already broken two good eggs into the
pan, you are suddenly assailed by doubts
about the quality of the third. As yet
unbroken.egg, two things may happen: either
the egg is good or it is rotten.
 Egg omelette problem
Acts (strategies)

Events Probability Break 3rd egg Break 3rd egg Throw away 3rd
into pan into saucer & egg
inspect
Third egg is good 0.9 3-egg omlette 3-egg 2-egg
omelette, one omelette, one
saucer to wash good egg
destroyed
Third egg is rotten 0.1 No egg omlette 2-egg 2-egg omelette
2 good eggs omelette, one
destroyed saucer to wash

Pay-offs
States of
nature
 Decision Environments

• Certainty - Environment in which

relevant parameters have known
values
• Risk - Environment in which
certain future events have
probable outcomes
• Uncertainty - Environment in
which it is impossible to assess
the likelihood of various future
events
 Risk vs. Uncertainty
• Risk
– Must make a decision for which the outcome is not known with
certainty
– Can list all possible outcomes & assign probabilities to the
outcomes
• Uncertainty
– Cannot list all possible outcomes
– Cannot assign probabilities to the outcomes
• Certainty
-is an environment in which future outcomes or state of nature are
known.
• Eg: Investment in Bank FD, there is CERTAINTY regarding
FUTURE PAYMENTS on maturity
• Investment in shares is risky
• Investment in shares FETCHING returns higher than FD in
another 2 years, is uncertain
Criteria of decision making under
uncertainity
0ptimism(Maximax or Minimin)

Pessimism(Maximin or Minimax)

Equal probabilities(Laplace)

Coefficient of optimism(Hurwicz)

Regret(Salvage)
 Optimism (Maximax or Minimin criterion)
• Choose the alternative with the best possible
payoff
• Locate the maximum or minimum payoff
values corresponding to each alternatives
• The maximax is 7000 ,hence the company
should adopt strategy S1
States of nature ROW
Strategies N1 N2 N3 MAXIMUM
S1 7000 3000 1500 7000
S2 5000 4500 0 5000
S3 3000 3000 3000 3000
 Pessimism Maximin or Minimax criterion
• Choose the alternative with the best of the
worst possible payoffs
• Locate the minimum payoff values
corresponding to each alternatives
• The act/decision with higher minimum value
is 3000 ,hence the company should adopt S3
criterion strategyStates
S3 of nature Row Minimum
Strategies N1 N2 N3
S1 7000 3000 1500 3000
S2 5000 4500 0 0
S3 3000 3000 3000 3000
Laplace criterion(Equal probabilities)
• Under this assumption ,all states of nature are
equally likely.

• decision maker can compute the average

payoff for each row (the sum of the possible
consequences of each alternative is divided by
the number of states of nature) and, then,
select the alternative that has the highest row
average
 LAPLACE CRITERION
States of nature ROW
Strategies N1 N2 N3 MAXIMUM

S1 7000 3000 1500 3,833.33

S2 5000 4500 0 3166.66

S3 3000 3000 3000 3000

The largest expected return is from Strategy S1, THE EXECUTIVE MUST
SELECT S1
 Coefficient of optimism(Hurwicz)
• This criterion represents a compromise between the
optimistic and the pessimistic approach to decision
making under uncertainty.
• For each alternative select the largest &lowest
payoff values and multiply these with α and (1- α)
values respectively.
• Then calculate the weighted average using the
formula:
H Coefficient of optimism =
α (maximum in column)+ (1-α)(minimum in column)
• Select the best answer
 Hurwicz Criterion

Strategy Maximum Minimum H

pay-off pay-off
S1 7000 1500 4800
S2 5000 0 3000
S3 3000 3000 3000
Assuming degree of optimisim α = 0.6 and (1- α )=0.4
H Coefficient of optimism = α (maximum in column) +
(1-α)(minimum in column)

The maximum value is 4800, adopt S1

 Regret (Salvage rule)
• This rule represents a pessimistic approach.
• The opportunity loss reflects the difference
between each payoff and the best possible payoff
in a column (it can be defined as the amount of
profit foregone by not choosing the best
alternative for each state of nature).
• For each course of action identify the maximum
regret value, record this no in a row
• Select the course of action with Smallest
anticipated opportunity loss value
 Strategies States of nature
N1 N2 N3
S1 7000 3000 1500
S2 5000 4500 0
S3 3000 3000 3000
Column max 7000 4500
States of nature 3000 Row max
Strategies N1 N2 N3
S1 7000 – 7000 4500-3000= 3000-1500=1500 1500
=0 1500
S2 7000- 5000 4500-4500=0 3000-0=3000 3000
= 2000
S3 7000-3000 = 4500-3000= 3000-3000=0 4000
4000 1500
Col max 7000 4500 3000
The company should adopt minimum opportunity loss strategy S1
 Decision table and tree
States of nature
Strategies State 1 State 2
Strategy 1 Outcome 1 Outcome2
Strategy 2 Outcome 3 Outcome 4

Outcome 1

1
outcome2

Outcome 3
2
outcome 4
 Decision tree
• Decision tree is a network which exhibits
graphically the relationship between the different
parts of the complex decision process.
• It is a graphical model of each combination of
various acts and states of nature along with their
payoffs, probability distribution
• It is extremely useful in multistage situations
which involve a number of decisions ,each
depending on the preceding one.
• A decision tree analysis involves the construction
of a diagram that shows , at a glance, when
decisions are expected to be made- in what
sequence, their possible outcomes, &
corresponding payoffs.
• A DT consists of nodes, branches, probability estimates and
pay-offs
• Three types of “nodes”
– Decision nodes - represented by squares (□) It
represents a point of action where a decision maker
must select one alternative course of action among the
available
– Chance nodes - represented by circles (Ο) It indicates a
point of time where the decision maker will discover the
response to his decision
– Terminal nodes - represented by triangles (optional)
• Solving the tree involves pruning all but the best decisions
at decision nodes, and finding expected values of all
possible states of nature at chance nodes
• Create the tree from left to right
• Solve the tree from right to left
Decision tree example

Stay comfortable and dry

Bear unnecessary trouble of carrying umbrella

Get wet and uncomfortable

Remain dry and comfortable

 Elements of Decision Theory
• States of nature: The states of nature could be
defined as low demand and high demand.
• Alternatives: VGK could decide to build a small,
medium, or large Flour processing mill .
• Payoffs: The profit for each alternative under
each potential state of nature is going to be
determined.

We develop different models for this problem on the

following slides.

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 VGK Flour mill : Payoff Table
THIS IS A PROFIT PAYOFF TABLE

Alternatives States of Nature

Low High
Small 8 8
Medium 5 15
Large -11 22
(Profits in LAKHS of Rs )

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 Decision making under risk
 Each possible state of nature has an assumed
probability pi
 States of nature are mutually exclusive
 Probabilities must sum to 1
 Determine the expected monetary value (EMV) for
each alternative
n
E( X )  Expected
Expected monetary of X   pi X i
value
value
i 1
Where Xi is the ith outcome of a decision, pi is the
probability of the ith outcome, and n is the total
number of possible outcomes
 EMV Example
States of Nature
Favorable Unfavorable
Alternatives Market Market
Construct large plant (A1) $200,000 -$180,000
Construct small plant (A2) $100,000 -$20,000
Do nothing (A3) $0 $0
Probabilities .50 .50

1. EMV(A1) = (.5)($200,000) + (.5)(-$180,000) = $10,000

2. EMV(A2) = (.5)($100,000) + (.5)(-$20,000) = $40,000
3. EMV(A3) = (.5)($0) + (.5)($0) = $0
Best Option
 Expected Opportunity Loss (EOL)
• It is the opposite of EMV
• EOL is defined as the difference between the
highest profit or pay-off and the actual profit due
to choosing a particular course of action in a
particular state of nature
• The conditional opportunity loss (EOL) for a
particular course of action is determined by taking
the difference between the payoff value of the
most favourable course of action and some other
course of action.
Opportunity loss matrix
act Cold weather Warm weather
Sell cold drinks 60-40= 20 90-90 =0
Sell ice cream 60-60 = 0 90-40 =50

EOL for each alternative course of action is computed as below

Sell cold drinks 0.3 x 20 + 0.7 x 0 = 6
Sell ice cream 0.3 x 0 + 0.7 x 50 = 35
Since EOL is minimum in case of selling cold drinks ,this is the best act

Sell cold drinks 0.3 x 40 + 0.7 x 90 = 75

Sell ice cream 0.3 x 60 + 0.7 x 40 = 46
Since EMV is more for selling cold drinks, it is recommended
Expected Value of Perfect Information
Expected value of perfect information: the
difference between the expected payoff under
certainty and the expected payoff under risk
Expected value of = Expected payoff Expected payoff
perfect information under certainty - under risk

EVPI is defined as the maximum amount one would

pay to obtain perfect information about the state of
nature that would occur.