CHAPTER FOUR

DECISION THEORY/ANALYSIS
•Reading topics:
•CHARACTERISTICS OF DECISION THEORY
•Decision tree

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 CHARACTERISTICS OF DECISION THEORY

Decision theory problems are characterized by the following:

List of alternatives: are a set of mutually exclusive and collectively exhaustive
decisions that are available to the decision maker (some times, not always, one of
these alternatives will be to “do nothing”.)
States of nature: - the set of possible future conditions, or events, beyond the
control of the decision maker, that will be the primary determinants of the eventual
consequence of the decision. The states of nature, like the list of alternatives, must
be mutually exclusive and collectively exhaustive.
Payoffs: - the payoffs might be profits, revenues, costs, or other measures of value.
Usually the measures are financial. Usually payoffs are estimated values. The more
accurate these estimates, the more useful they will be for decision making purposes
and the more likely, it is that the decision maker will choose an appropriate
alternative. The number of payoffs depends on the number of alternative/state of
nature combination.
 
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 CHARACTERISTICS……

Degree of certainty: - the approach often used by a decision maker depends on the
degree of certainty that exists. There can be different degrees of certainty. One
extreme is complete certainty and the other is complete uncertainty. The later exists
when the likelihood of the various states of nature are unknown. Between these two
extremes is risk (probabilities are unknown for the states of nature). Knowledge of
the likelihood of each of the states of nature can play an important role in selecting
a course of active.
Decision criteria: - the decision maker’s attitudes toward the decision as well as the
degree of certainty that surrounds a decision. Example; maximize the expected
payoffs.

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 THE PAYOFF TABLE

 
A payoff table is a device a decision maker can use to
summarize and organize information relevant to a
particular decision. It includes:
 list of alternatives
 states of nature
 payoffs associated with each of the
alternative/state of nature combinations.
The general format of the table is illustrated below:

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 A payoff table

  States of nature

S1 S2 S3

  A1 V11 V12 V13

Alternatives
A2 V21 V22 V23

A3 V31 V32 V33

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 Classification of Decision situations

Decision making situations can be categorized

in to three classes:
 Decision making under complete certainty.
 Decision making under complete
uncertainty (without probabilities).
 Decision making under risk situations
(with probability).
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 DECISION MAKING UNDER CERTAINTY

 The simplest of all circumstances occurs when decision

making takes place in an environment of complete
certainty.
 When a decision is made under conditions of complete
certainty, the attention of the decision maker is focused
on the column in the payoff table corresponds to the state
of nature that will occur.
 The decision maker then selects the alternative that
would yield the best payoff, given that state of nature.

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 Example

The following payoff table provides data about profits of the

various states of nature/alternative combination.
  States of nature
S1 S2 S3
  A1 4 16 12
Alternative A2 5 6 10
s A3 -1 4 15
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. 8
 DECISION MAKING UNDER COMPLETE
UNCERTAINTY (With out probabilities)

Under complete uncertainty, the decision maker either is unable

to estimate the probabilities for the occurrence of the different
state of nature, or else he or she lacks confidence in available
estimates of probabilities, and for that reason, probabilities are
not included in the analysis.

At the time the decision is made, the decision maker is uncertain

which state of nature will occur in the future, and has no control
over them.

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 DECISION …

There are several approaches (criteria) to

decision making under complete uncertainty.
Some of these discussed in this section include:
 Optimism (maximax or minimin) Criterion
 Pessimism (maximin or minimax) criterion
 Laplace (equal likelihood) criterion
 Hurwicz (coefficient of optimism)
 Regret(salvage) criterion

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 A. MAXIMAX
 With the maiximax criterion, the decision maker selects the
decision that will result in the maximum of the maximum
payoffs (for profit ) or minimum of the minimum (for cost).( In
fact this is how this criterion derives its name- maximum of
maximum).
 maximax is very optimistic.
 The decision maker assumes that the most favorable state of
nature for each decision alternative will occur.
 For example, the investor would optimistically assume that
good economic conditions will prevail in the future. The best
payoff for each alternative is identified, and the alternative
with the maximum of these is the designated decision. 11
 Example

  States of nature Row

Maximum
S1 S2 S3

  A1 4 16 12 16*maximum=
Alternatives =4
A2 5 6 10 10=5
Decision: A1 will be chosen.
A3 -1 4 15 15=-1
Note: If the pay off table consists of costs instead of profits,
the opposite selection would be indicated: The minimum of
minimum costs. For the subsequent decision criteria we
encounter, the same logic in the case of costs can be used. 12
 B. MaxiMin or Minimax Criteria

 This approach is the opposite of the previous one, i.e.

it is pessimistic. This strategy is a conservative one.
 It consists of identifying the worst (minimum) payoff
for each alternative, and, then, selecting the
alternative that has the best (maximum) of the worst
payoffs.
 In effect, the decision maker is setting a floor on the
potential payoff by selecting maximum of the
minimum.
 It involves selecting best of the worst.
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 Example

  States of nature Row

S1 S2 S3 Maximum

  A1 4 16 12 4=16
Alternatives A2 5 6 10 5*maximum
Decision: A2 will be chosen based on the maxmin criterion
=10
 Note: If it A3
were cost,-1the conservative
4 15 approach -1=15
would be to
select the maximum cost for each decision and select the
minimum of these costs. 14
 C. MINIMAX REGRET

 Both the maximax and maximin strategies

can be criticized because they focus only on a
single, extreme payoff and exclude the other
payoffs.
 Thus, An approach that does take all payoffs in to
consideration is Minimax regret.
 In order to use this approach, it is necessary to
develop an opportunity loss table.

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 The opportunity loss reflects the difference between
each payoff and the best possible payoff in a column
(i.e., given a state of nature).
 Hence, opportunity loss amounts are found by
identifying the best payoff in a column and, then,
subtracting each of the other values in the column
from that payoff.
 Therefore, this decision avoids the greatest regret by
selecting the decision alternative that minimizes the
maximum regret.
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 Example

  States of nature

S1 S2 S3

  A1 4 16 12
Alternatives
A2 5 6 10

A3 -1 4 15
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 Procedures

Opportunity loss table:

  States of nature

S1 S2 S3

  A1 5-4=1 16-16=0 15-12=3

Alternatives
A2 5-5=0 16-6=10 15-10=5

A3 5-(-1)=6 16-4=12 15-15=0

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 Procedures

Opportunity loss table:

  States of nature

S1 S2 S3

  A1 5-4=1 16- 15- 3

Alternatives 16=0 12=3
A2 5-5=0 16- 15- 10
6=10 10=5
A3 5-(-1)=6 16- 15- 12
4=12 15=0
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 Cont…

 The values in an opportunity loss table can be viewed

as potential “regrets” that might be suffered as the
result of choosing various alternatives.
 A decision maker could select an alternative in such a
way as to minimize the maximum possible regret.
 This requires identifying the maximum opportunity
loss in each row and, then,
 choosing the alternative that would yield the best
(minimum) of those regrets.
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 Cont…
  States of nature Maximum
Loss

S1 S2 S3

  A1 5-4=1 16-16=0 15-12=3 3*minimum

Alternatives

A2 5-5=0 16-6=10 15-10=5 10

A3 5-(-1)=6 16-4=12 15-15=0 12

Decision: A1 will be chosen.

Although this approach makes use of more information than either Maximin or
Maximax, it still ignores some information, and, therefore, can lead to a poor decision.
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 PRINCIPLE OF INSUFFICIENT
REASON/ Equal likelihood/ Laplace

 The Minimax regret criterion’s weakness is the

inability to factor row differences. Hence,
sometimes the minimax regret strategy will lead to a
poor decision because it ignores certain information.
 The principle of insufficient reason offers a method
that incorporates more of the information.
 It treats the states of nature as if each were equally
likely, and it focuses on the average payoff for each
row, selecting the alternative that has the highest row
average.
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 Example
  States of nature     Row
Average
S1 S2 S3 S4 S5

  A1 28 28 28 28 5 23.4*maxi
Alternatives mum

A2 5 5 5 5 28 9.6
A3 5 5 5 5 28 9.6
Decision: A1 is selected
1/5(28+28+28+28+5)=23.4
1/5(5+5+5+5+28)=9.6
1/5(5+5+5+5+28)=9.6
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 The Hurwitz Criterion
 
 The Hurwitz criterion strikes a compromise between the
maximax and maximin criterion.
 The principle underlying this decision criterion is that the
decision maker is neither totally optimistic, nor totally
pessimistic.
 With Hurwitz criterion, the decision payoffs are weighted by a
coefficient of optimism, a measure of a decision maker’s
optimism. The coefficient of optimism, which is defined as ,
is between zero and one (0< <1).

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 The Hurwitz ….
 
 If  = 1, then the decision maker is said to be completely
optimistic, if = 0, then the decision maker is completely
pessimistic. Given this definition, if  is coefficient of
optimism, 1- is coefficient of pessimism.

 The Hurwitz criterion requires that for each alternative, the

maximum payoff is multiplied by  and the minimum
payoff be multiplied by 1-.
 

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 Example : If  = 0.4 for the above example,

  States of nature
S1 S2 S3
  A1 4 16 12
Alternatives
A2 5 6 10
A3 -1 4 15
A1 = (0.4x16) + (0.6x4) = 8.8
A2 = (0.4x10) + (0.6x5)= 7
A3 = (0.4x15) – (0.6x1)= 5.4
Decision: A1 is selected 29
 DECISION MAKING UNDER
RISK (WITH PROBABILITIES)
 It is often possible for the decision maker to know
enough about the future state of nature to assign
probabilities to their occurrences. The term risk is
often used in conjunction with partial uncertainty,
presence of probabilities for the occurrence of
various states of nature. The probabilities may be
subjective estimates from managers or from experts
in a particular field, or they may reflect historical
frequencies.
Given that probabilities can be assigned, several
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 EXPECTED MONETARY
VALUE (EMV)
The 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 EMV. The average or expected payoff of each alternative is
a weighted average:
 
k
EMVi = Σ Pj.Vij
i=1
Where:
EMVi = the EMV for the ith alternative
Pi = the probability of the ith state of nature
Vij = the estimated payoff for alternative i under state of
nature j.
Note: the sum of the probabilities for all states of nature must be 1.
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 Procedures
Probability 0.20 0.50 0.30
S1 S2 S3 Expected payoff

4 16 12 12.40*maximum

A1
5 6 10 7

A2
-1 4 15 6.30

A3

A1=0.2*4+0.5*16+0.3*12=12.4
A2=0.2*5+0.5*6+0.3*10=7
A3=0.2*-1+0.5*4+0.3*15=6.3

Decision: A1 will be chosen. 33

Note that it does not necessarily follow that the decision
maker will receive a payoff equal to the expected
monetary value of a chosen alternative. Similarly, the
expected payoffs for either of the other alternatives do
not equal any payoffs in those rows. What, then, is the
interpretation of the expected payoff? Simply a long-run
average amount; the approximate average amount one
could reasonably anticipate for a large number of
identical situations.
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 Expected Opportunity Loss (EOL)

 The table of opportunity loss is used rather than a table of

payoffs.
 Hence, the opportunity losses for each alternative are weighted
by the probabilities of their respective state of nature to
compute a long run average opportunity loss
 the alternative with the smallest expected loss is selected as the
best choice.
EOL (A1) = 0.20(1) + 0.50(0) + 0.30(3) = 1.10 *minimum
EOL (A2) = 0.20(0) + 0.50(10) + 0.30(5) = 6.50
EOL (A3) = 0.20(6) + 0.50(12) + 0.30(0) = 7.20
 

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 Procedures

Opportunity loss table:

  States of nature

S1=0.2 S2=0.5 S3=0.3

  A1 5-4=1 16-16=0 15-12=3

Alternatives
A2 5-5=0 16-6=10 15-10=5

A3 5-(-1)=6 16-4=12 15-15=0

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 Expected Opportunity Loss (EOL)

EOL (A1) = 0.20(1) + 0.50(0) + 0.30(3) = 1.10 *minimum

EOL (A2) = 0.20(0) + 0.50(10) + 0.30(5) = 6.50
EOL (A3) = 0.20(6) + 0.50(12) + 0.30(0) = 7.20
Decision: A1 will be chosen
 

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