An Introduction to Decision

Theory
Chapter 20

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Learning Objectives
LO20-1 Identify and apply the three components of a
decision
LO20-2 Analyze a decision using expected monetary
value
LO20-3 Analyze a decision using opportunity loss
LO20-4 Apply maximin, maximax, and minimax regret
strategies to make a decision
LO20-5 Compute and explain the expected value of
perfect information
LO20-6 Apply sensitivity analysis to evaluate a decision
subject to uncertainty
LO20-7 Use a decision tree to illustrate and analyze
decision making under uncertainty
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Statistical Decision Theory
 Statistical decision theory is concerned with making decisions
from a set of alternatives
 Examples
 Ford Motor Company must decide whether to purchase
assembled door locks for the 2017 F-150 or to manufacture the
locks themselves
 If sales increase – it’s more profitable to make
 If sales level off or decline – it’s more profitable to buy
 GE is considering three options regarding the prices of their
refrigerators next year, raise the prices 5%, 2.5%, or leave the
prices as they are
 The decision will be based on sales estimates and what the
other refrigerator producers might do
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Elements of a Decision
 The choices available
 The various courses of action are called the acts or
alternatives
 The states of nature
 The uncontrollable future events are called the states of
nature
 The payoffs
 The consequence of a particular decision alternative and
state of nature is the payoff
 We can make better decisions if we establish probabilities
for the states of nature

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Decision Making under Uncertainty

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Payoff Table

Bob Hill, a small investor, has $1,100 to invest. He has studied several common
stocks and narrowed his choices to three: Kayser Chemicals, Rim Homes, and
Texas Electronics. He estimates that if stock prices increase drastically (a bull
market), his investment in Kayser stock would more than double. However, if
stock prices decrease (a bear market), the value of the Kayser stock could drop to
$1000. His predictions for the three stocks are shown in the Payoff Table below.

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Expected Payoff

EMV(A1) = [P(S1)· V(A1, S1)] + [P(S2)· V(A1, S2)] In the expected

= .60($2,400) + .40($1,000) monetary value (EMV)
= $1,840 criterion, the expected
value for each decision
alternative is
computed, and the
optimal one is selected

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Opportunity Loss
 The difference between the optimal decision and any other
decision is the opportunity loss or regret due to making a
decision other than the optimum
 An opportunity loss table can be developed
 An opportunity loss table is constructed by taking the
difference between the optimal decision for each state of
nature and the other decision alternatives
 The expected opportunity loss (EOL) is similar to the
expected monetary value
 The opportunity loss is combined with the probabilities of
the various states of nature for each decision alternative to
determine the expected opportunity loss
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Opportunity Loss Table
Suppose Bob Hill had purchased Rim Homes stock and then a bull market
developed. The value of the Rim Homes stock did increase from $1,100 to $2,200 as
expected. But had Bob bought Kayser Chemicals stock and market values increased,
the value of his stock purchase would be $2,400; so he missed making an extra $200.
The $200 is the opportunity loss for not knowing the future state of the market.

Notice, that Kayser Chemicals stock would be a good investment choice in a rising
(bull) market, Texas Electronics stock would be the best buy in a declining (bear)
market, and Rim Homes stock is a compromise.

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Expected Opportunity Loss

EOL(A2) = [P(S1)· R(A2, S1)] + [P(S2)· R(A2, S2)]

= .60($200) + .40($50)
= $140 The two approaches,
lowest expected
opportunity loss and
highest expected payoff,
will always lead to the
same decision.

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Maximin, Maximax, and Minimax Regret
Strategies
 Maximin
 The strategy of maximizing the minimum gain
 Investment advisors may urge the investor to be conservative
and buy Texas Electronics stock
 The investor is assured of at least $1,150
 Maximax
 The strategy of maximizing the maximum gain
 Under this strategy, the investor would buy Kayser stock
 There’s a possibility of selling the stock later for $2,400
 Minimax regret
 The strategy that minimizes the maximum regret
 Buy Kayser, there’s a maximum opportunity loss of $150
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Value of Perfect Information
VALUE OF PERFECT INFORMATION The difference between the
maximum expected payoff under conditions of certainty and the
maximum expected payoff under uncertainty.

If Bob knew precisely what the market would do, he could maximize profit by
always buying the correct stock. What if someone could supply him with
information about when the market will rise or decline? What would this
information be worth?

EVPI = Expected value under certainty – Expected value under uncertainty

= $1,900 - $1,840 = $60
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Sensitivity Analysis
 Sensitivity analysis examines the effects of various
probabilities for the states of nature on the expected values
 The rankings of the decision alternatives are frequently
not highly sensitive to changes within a plausible range

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Decision Trees
 Decision trees are useful for structuring the various
alternatives
 They present a picture of the various courses of action and
the possible states of nature

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