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CHAPTER FIVE

DECISION THEORY
 Introduction
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 The decision theory (decision analysis) is used

to determine optimal strategies where a
decision maker is faced with several decision
alternatives and an uncertain, or risky, pattern
of future events.
 All decision making situations are
characterized by the fact that two or more
alternative course of action are available to
the decision maker to choose from.
 2.1. Basic Concepts in Decision Making
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 The decision making process involves the following

steps:
1.Identification of the various possible outcomes
(state of natures, events).
 The events are beyond the control of the decision
maker.
2. Identification of all the courses of action (strategies)
available to the decision maker.
 The decision maker has control over choice of these.
 Cont...
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3. Determination of the pay off function which describes

the consequences resulting from different combination of
events and acts.
4. Choose among the various alternatives on the base of
some criteria.
 Pay-off Table
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 Depicts the economics of the given problem.

 Pay- Off is a conditional value (a conditional profit, loss
or cost).
 A pay-off table thus represents the matrix of the
conditional values associated with all the possible
combinations of the acts and the events.
 While constructing a pay-off matrix, the alternative
course of action and the possible outcomes must be
clearly determined. In any given situation, the listing of
events and actions must be distinct and mutually
exclusive.
 Cont...
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 After setting up the pay off table we proceed to

take the decision.
 There are several rules or criteria on the base of
which decision may be taken. The selection depends
on factors like:
 Nature of the decision situation
 Attitude of the decision maker and other factors.

 We will discuss the decision rules for taking decision

under different conditions.
 Degree of Certainty
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 The approach used by the decision maker often

depends on the degree of certainty that exists.
 There can be different degrees of certainty.
1. Decision making Under Complete Certainty

2. Decision making Under Complete Uncertainty

3. Decision making Under Risk

 1. Decision Making under Certainty
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 It is the simplest of all circumstances occurs when the

decision making takes place in an environment of
complete certainty.

 The main characteristics of this decision making is that

the decision maker know, with certainty, which event
will occur. He has perfect information about the
outcomes.

 He need only consider one event and the method of

solution is obvious. (He can look at the outcome for
each alternative, and choose the best outcome.)
 Example
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 Cont…
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 If we know that S2 will occur, the decision maker

then can focus on the first raw of the payoff table.
Because alternative A1 has the largest profit (16), it
would be selected.
 2. Decision Making Under Complete Uncertainty
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 The decision situation where there is no way in which

the decision maker can assess the probabilities of
the various states of nature.
 In such situations, the decision maker has no idea at
all as to which of the possible states of nature
would occur nor has a reason to believe why a given
state is more, or less likely to occur as another.
 Cont...
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 With probabilities of the various outcomes unknown

the actual decisions are based on specific criteria.
 There are several decision criteria to recommend a
solution for this kind of problems.
1. Maximax

2. Maximin

3. Minimax regret
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1. Maximax (Minimin) Decision

The maximax principle is optimists’ principle of
choice.
This optimist criterion attempts to describe the
decision-making behavior of people who are
perfectly optimistic in their expectations.

An optimistic decision maker is attracted by large

rewards and is willing to risk high losses in order to
obtain them.
 Steps in Maximax
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 Maximax" is shorthand for "Maximum of the (row)

maxima."
1. For each action alternative (matrix row) determine
the maximum payoff possible.
2. From these maxima, select the maximum payoff. The
action alternative leading to this payoff is the chosen
decision.
 Cont...
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 It is possible to model the optimist profile with the

MAXIMAX decision rule (when the payoffs are
positive-flow rewards) such as profits or revenue.
 When payoffs are given as negative-flow rewards,
(such as costs) the optimist decision rule is MINIMIN.
Note that negative-flow rewards are expressed with
positive numbers.)
 Cont...
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 The decision is shown by circling the maximax value,
thus indicating the row of the chosen action alternative:
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 2. Maximin (Minimax) Decision
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 This principle is adopted by pessimistic decision

makers who are conservative in their approach.
 They assume that the worst outcome will occur. Then it
chooses the alternative that gives the best of these
worst outcomes.

 It is possible to model the pessimist profile with the

MAXIMIN decision rule (when the payoffs are
positive-flow rewards, such as profits or income.

 When payoffs are given as negative-flow rewards,

the pessimist decision rule is MINIMAX.)
 Rule
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1. For each action alternative (matrix row)

determine the minimum payoff possible. This
represents the worst possible outcome if that
strategy were chosen.
2. From these minima, select the maximum
payoff. The action alternative leading to this
payoff is the chosen decision
 Using our matrix defined previously:
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 3. Minimax Regret Decision
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 Sometimes we are judged not by how well we

actually do, but how well we could possibly have
done.
 In such cases there is a regret- the difference
between the actual outcome and best possible
outcome.
 It is the decision criterion that we discussed by
basing the opportunity cost of the alternatives
(savage Min iMax Regret).
 Cont…
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 The Minimax Regret criterion focuses on avoiding the

worst possible consequences that could result when
making a decision

 Regret is defined as the opportunity loss to the

decision maker if action alternative Ai is chosen and
state of nature Sj happens to occur.

 It is an approach that does take all payoffs into

account.
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 In order to use this approach, it is necessary to

develop an opportunity loss table.

 Opportunity loss (OL) is the payoff difference

between the best possible outcome under Sj and the
actual outcome resulting from choosing Ai given that
Sj occurs.
 Minimax Regret Rule
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1.For each event find the best possible outcome (the

best entry in each column)
2. Find the regret for every entry in the column (the
difference between the best and the entry).
It is the amount of payoff the decision maker would
miss by not having chosen the alternative that would
have yielded the best payoff if that state of nature
occurs.
3. Put the regrets found in step 2 in to regret matrix.
There is at least one zero in each column and regret
are always positive.
 Cont...
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4. For each alternative find the highest regret.

5. Choose the alternative with the lowest value of
these highest regrets.
 Let's analyze our previous problem using
opportunity losses instead of the monetary payoffs.
First it must derive the Opportunity Lose matrix from
the payoff matrix R.
 Cont...
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where the star denotes "best payoff under state of nature Sj ".
 Cont…
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 The OL matrix can now be obtained by

subtracting each entry Rij from its column's
best payoff.
 The minimax rule is then applied to the OL

(regret) matrix:
 Opportunity Loss matrix
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A S

H M W

L 15-15=0 4-3=1 1- -6=7

JR 15-9= 6 4-4=0 1- -2= 3

S 15-3 =12 4-2=2 1 - 1= 0

 Cont...
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 3. Decision Making Under Risk
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 The difference between decision making under

uncertainty and risk is the presence of probabilities
for the occurrence of the various states of nature
under decision making under risk.
 The probabilities may be:
 Subjective estimates from managers
 Subjective estimates from experts in the field

 Historical frequencies
 Cont...
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 If they are reasonably correct, they provide the

decision maker with additional information that can
dramatically improve the decision making process.
 The sum of the probabilities for all states of nature
must be 1.00.
 Three approaches are used:
 Expected Monetary Value (EMV)
 Expected Opportunity Loss
 Expected Value of Perfect Information
 1. Criteria of Expected Monetary Value (EMV)
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 EMV approach provides the decision maker with a value which

represents an average payoff for each alternative.
 The best alternative is, then, the one that has the highest
expected monetary value.
 The average or expected payoff of each alternative is
weighted average; the state of nature probabilities are used to
weight the respective payoffs.
 Thus the expected monetary value is:
 EMV (Ai ) = E (Ai ) = Σj pj ( Rij )

 And using the probability distribution estimated by the

managers of the company, we obtain:
 Cont...
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 2. Criteria of Expected Opportunity Loss
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 Using Expected Opportunity Loss (EOL) is an

alternate method for incorporating probabilities in
to a decision making process.
 The approach is nearly the same to the EMV
approach, except that a table of opportunity losses
is used rather than a table of payoff.
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 The opportunity losses for each alternative are

weighted by the probabilities of their respective
states of nature, and the alternative with the
smallest expected loss is selected as the best.
 EOL (Ai ) = E (Ai ) = Σj pj ( OLij )
 Cont...
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 3. Expected Value of Perfect Information
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 Sometimes the decision maker might opt to delay a

decision until it is evident which state of nature is
going to materialize (be certain).
 Such delays will involve a cost of some sort.
 Hence, the question is whether the cost of waiting
outweighs the potential benefits that could be
realized.
 Cont...
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 If it would be worth the cost to refine or eliminate

probabilities of states of natures.
 The EVPI is thus, the measure of the difference
between the certain payoff that could be realized
under a condition of certainty and expected payoff
under condition involving risk.
 Cont...
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 The probabilities of the original state of nature can

be used to weight the payoff, one of which will
occur under certainty. This is called the expected
payoff under certainty (EPC).
 EVPI = Σj pj (Rij*)
Where; Rij* is the best payoff under state Sj
 Cont...
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 Cont...
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 EPC = 0.1(15) + .6(4) + .3(1) = 4.2

 The difference between this figure and the expected payoff
under risk (EMV) is the expected value of perfect information.
EVPI=EPC-EMV
EVPI= 4.2 - 2.7 =1.5
 Perfect information would increase ACME's expected
payoff by $1.5 million, so that is what the perfect
information is worth.
 Cont...
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 The expected opportunity loss due to imperfect

information is equal to the expected payoff that
could be achieved by having perfect information.
 Therefore EVPI is always equal to EOL
EVPI=EOL
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Thank You!