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Decision Theory

The document discusses decision theory and various decision making criteria including: 1) Maximax criterion which maximizes the maximum payoffs. 2) Maximin criterion which maximizes the minimum payoffs taking a conservative approach. 3) Minimax regret criterion which minimizes the maximum regret or opportunity loss. Examples are provided to illustrate applying these criteria to decision problems involving payoff tables. Expected values and mathematical expectations are also discussed as important tools for characterizing probability distributions in decision making under uncertainty.

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Amzelle Diego Laspiñas
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157 views16 pages

Decision Theory

The document discusses decision theory and various decision making criteria including: 1) Maximax criterion which maximizes the maximum payoffs. 2) Maximin criterion which maximizes the minimum payoffs taking a conservative approach. 3) Minimax regret criterion which minimizes the maximum regret or opportunity loss. Examples are provided to illustrate applying these criteria to decision problems involving payoff tables. Expected values and mathematical expectations are also discussed as important tools for characterizing probability distributions in decision making under uncertainty.

Uploaded by

Amzelle Diego Laspiñas
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PPTX, PDF, TXT or read online on Scribd
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Decision Theory

4/8/2019
Decision Theory
• a methodology for making management
decisions which constitutes a particular
branch of operations research/management
science
• defined as the analysis of decision situations
in which certainty cannot be assumed
• aids the decision maker address the problem
of making complex choices under uncertain
conditions
Steps in Decision Making

1. Clearly define the problem.


2. List all the possible alternative events that may
occur.
3. Determine all possible outcomes.
4. Identify the profit/loss of each combination of
alternatives events and outcomes.
5. Choose one mathematical decision theory
model.
6. Apply the model and make the decision.
Decision Making Criteria
• Maximax Criterion
- also known as optimistic approach
- maximizes the maximum payoffs for the different
decisions starting with the identification of the
maximum payoffs of each alternative decision.
Maximax decision
– that decision which yields the largest maximum
payoffs
Maximax rule
- an extremely optimistic criterion for choosing
alternative decision
• Maximin Criterion
- also known as conservative approach
- simply maximizes the minimum payoffs given
the various decisions that are possible
Steps:
1. Identify the minimum payoff for each decision
2. Select the largest minimum payoff
Maximin rule
- Very conservative one that takes a pessimistic
view on the various states of nature
• Minimax Regret Criterion
- involves the construction of an opportunity loss
or regret matrix prior to applying the minimax
rule
Minimax regret rule
- states to identify the maximum regret
(opportunity loss) for each decision and then
choose that decision with the smallest maximum
regret
Example:
A farmer in Region 2 must decide which crop to plant
next year on his land: corn, wheat, or rice. The return from
each crop will be determined by whether a new trade bill
with Hongkong passes the Senate. The profit the farmer will
realize from each crop given the two possible results on the
trade bill is shown in the following payoff table. Determine
the best crop to plant using the following decision criteria.:
a. Maximax Crop Trade Bill
b. Maximin Pass Fail
c. Minimax regret Corn ₱2,000,000 ₱ 700,00
Wheat 1,100,000 500,000
Rice 1,400,000 1,200,000
Exercise
• Given the following payoff table, what is the
recommended decision under each of the
following criteria: (a) maximin;(b) maximax; (c)
minimax regret?
State of Nature
Decision S1 S2 S3 S4

D1 145 118 180 138


D2 133 131 130 120
D3 295 260 177 127
D4 260 135 115 114
Expected Value/
Mathematical Expectations
• very important in characterizing its probability
distribution
symbol E(x) is used for the expected value
𝛍 = E(x) = E(x) = Ʃ[x • P(x)]
Examples:

1. If a man purchases a raffle ticket, he will win a


first prize of ₱500,000 or a second prize of
₱200,000 with probabilities 0.0001 and
0.0005. What should be a fair price to pay for
the ticket?

E(x) = Ʃ[x • P(x)]


E(x) = (500,000)(0.0001) + (200,000)(0.0005)
E(x) = 50 + 100
E(x) = ₱150
The fair price of the ticket is ₱150.
2. A gambler tosses a die If a 1, 3, or 5 appears, the
gambler will be paid ₱9; if a 2, or a 4 turns up, he
will lose ₱ 9; and if 6 is showing, he will win ₱ 12.
Determine the expectation of the gambler.
Solution:
Let P(A) = probability of 1, 3, or 5 will appear
P(B) = probability of 2 or 4 will appear
P(C) = probability of 6 will appear
Take note that there are six faces of a regular die
which serves as the possible outcome, therefore
the probabilities of A, B, and C are as follows:
P(A) = 3/6 ; P(B) = 2/6 ; P(C) = 1/6
E(x) = Ʃ[x • P(x)]
E(x) = [9 • P(A)] - [9 • P(B)] + [12 • P(C)]
E(x) = 9(3/6) – 9(2/6) + 12(1/6)
E(x) = 4.5 – 3 + 2
E(x) = ₱3.50
Thus, the gambler expects to win ₱3.50 per toss
of a die.
3. A financial analyst suggests that his client select one of two types of investments
in which to invest ₱100,000. Investment A pays a return of 8% and has a failure to
pay rate of 5%. Investment B has a 6% return and a failure to pay rate of 3%. Find
the expected rate of return and decide which investment would be better. (When
the investment fails to pay, the investor loses all the investment.)

Solution:
The return on investment A is ₱100,000(8%) = ₱8,000. The expected return then is
E(x) = ₱8,000(0.95) – ₱100,000(0.05)
E(x) = ₱7,600 – ₱5,000
E(x) = ₱ 2,600

The return on investment B is ₱100,000(6%) = ₱6,000. The expected return then is


E(x) = ₱6,000(0.97) – ₱100,000(0.03)
E(x) = ₱5,820 – ₱3,000
E(x) = ₱ 2,820
Decision Trees
- another useful technique for analyzing a decision
situation
- graphical diagram consisting of nodes and branches
Circles & Squares
- referred as nodes
Squares
- decision nodes
Decision Variable
- a variable whose value represents a potential
decision on the part of the decision maker
For example: see this link…

• https://hbr.org/1964/07/decision-trees-for-de
cision-making
Exercise

• MSS Manufacturing is planning the introduction of a new product.


The cost to set up to manufacture one of the product’s components is
very high, so MSS is considering purchasing that component rather
than manufacturing it. One set up to manufacture the component,
however, MSS’s variable cost per unit would be low in comparison to
the purchase price of the component. MSS’s materials manager has
calculated the net profit in millions of pesos for three different levels
of demand below.
Decision Demand
Low Medium High
Make Component 11 35 55
Buy Component 17 29 46

The states of nature have probabilities P(low) = 0.40, P(medium) = 0.35,


and P(high) = 0.25. Draw a decision tree and use it to decide whether
MSS should make or buy the component.

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