“ The one word that makes a good
manager – decisiveness.”
DECISION THEORY
What is Decision Theory?
“ A process of best selection from a set of alternative
courses of action, that course Of action which is
supposed to meet objectives up to satisfaction of the
decision maker “
Courses of Action: A set of predermined rule
Without a clear direction we slow down, uncertain of where to head.
Decision theory provides direction with clarity that allows for focused effort and speed.
The Decision Maker refers to ‘Individual’ or a ‘group
of individual’ responsible for making the choice of an
appropriate course of action amongst the available
course of action.
Decision Alternatives
There is a finite number of
decision alternatives available to the
decision maker at each point in time
When a decision is made.
These alternatives are also
called Courses of action ( Actions,
acts, or Strategies ) and are not only
under control but are also known to
the decision maker.
States of Nature
These are the future conditions (also called
consequences, events or scenarios) that are not
under the control of decision maker.
A state of nature can be a state of economy (e.g.
inflation) , a weather condition, a political
development, etc. These are the result of an ’act
of God’ or result of many situations pushing in
various directions.
States of Nature
The states of Nature are mutually
exclusive and collectively exhaustive
(total) With respect to any decision
problem.
The states of nature may be described
numerically such as , demand of 100 units of
an item or non – numerically such as
employees strike, etc.
Pay off
A numerical value (Out Come) resulting from
each possible combination of alternatives
and states of nature is called payoff . A
tabular arrangement of these values is
known as payoff matrix.
Courses of Action
States of
Nature A1 A2 …. An
N1 a11 a12 … a1n
N2 a21 a22 … a2n
N3 a31 a22 …. a3n
. . . … .
. . . … .
Nm am1 am2 … a mn
Pay off matrix
example.
States of
Nature
Weather
Price
Dry(E1) Moderate(E2) Damp(E3) Rs.Per Kg
paddy (A1) 500 1700 4500 1.25
Yield in kg per hectare
Ground Nut
(A2) 800 1200 1000 4.00
Courses Tobacco(A3) 100 300 200 15.00
of action
Regret or Opportunity
loss
Opportunity loss is incurred due to
failure of not adopting most favourable
course of action or strategy.
The difference between the highest
possible profit for a state of nature and
the actual profit obtained for the
particular action taken is known as
opportunity loss.
Types of DECISION-MAKING
Environments
1. Decision under certainty
2. Decision Under Uncertainty
(W/0 probability)
3. Decision under Risk
(With probability)
1. Decision under
certainty
In this case the decision maker
has the complete knowledge of
consequence of every decision choice
with certainty.
Example.
Break even point analysis, wherein
precise information about the cost and
sales revenue is known, and linear
programming , wherein the required
resource , available resources, and the
costs/profits associated with it are known.
2. Decision Under
Uncertainty
(With out Probability)
The decision situations where there
is no way in which the decision maker can
assess the probabilities of the various states of
nature are called decisions under uncertainty.
Examples.
A new product is introduced in the market.
A new plant is set up.
3. Decision under Risk
(With probability)
In this case decision maker
Supposed to believe Authentic
information, knowledge, past
experience or happenings to enable
him to assign probability values to the
likelihood of occurrence of each state of
nature.
Decision Making Under
Uncertainty
The five commonly used criteria for decision
making under uncertainty are:
1. The optimistic approach (Maxi-max)
2. The conservative approach (Maxi-min)
3. The minimax regret approach (Mini-max
regret)
4. Equally likely (Laplace criterion)
5. Criterion of realism with (Hurwicz criterion)
1. Optimistic
Approach
The optimistic approach would be
used by an optimistic decision
maker.
The decision with the largest
possible payoff is chosen.
If the payoff table was in terms of
costs, the decision with the lowest
cost would be chosen
Example: CAL
Condominium Complex
A developer must decide how large
a luxury condominium complex to
build – small, medium, or large. The
profitability of this complex depends
upon the future level of demand for
the complex’s condominiums.
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CAL Condos: Elements of
Decision Theory
States of nature: The states of
nature could be defined as low demand
and high demand.
Alternatives: CAL could decide to
build a small, medium, or large
condominium complex.
Payoffs: The profit for each
alternative under each potential state
of nature is going to be determined.
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CAL Condos: Payoff
Table
THIS IS A PROFIT PAYOFF TABLE
States of Nature
Alternatives Low High
Small 8 8
Medium 5 15
Large -11 22
(payoffs in millions of dollars)
CAL Condos: Optimistic
Decision (Maxi- max )
If the optimistic approach is selected:
STATES OF NATURE
BEST
Alternatives Low High
PROFIT
Maxima
Small 8 8 8
x payoff
Medium 5 15 15
Maxima Large -11 22 22
x
decision
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2. Conservative
Approach
The conservative approach would be used by a
conservative decision maker.
For each decision the minimum payoff is listed
and then the decision corresponding to the
maximum of these minimum payoffs is selected.
(Hence, the minimum possible payoff is
maximized.)
If the payoff was in terms of costs, the
maximum costs would be determined for each
decision and then the decision corresponding to
the minimum of these maximum costs is
selected. (Hence, the maximum possible cost is
minimized.)
CAL Condos:
Conservative Decision
( Max-min)
If the conservative approach is selected:
STATES OF NATURE
Maxi- WORST Maxi-min
min Alternatives Low High PROFIT
payoff
decision
Small 8 8 8
Medium 5 15 5
Large -11 22 -11
The decision with the best profit from the column of worst profits is selected.
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3. Mini-max Regret
Approach
The minimax regret approach requires the
construction of a regret table or an opportunity
loss table.
This is done by calculating for each state of
nature the difference between each payoff and
the largest payoff for that state of nature.
Then, using this regret table, the maximum
regret for each possible decision is listed.
The decision chosen is the one corresponding to
the minimum of the maximum regrets.
CAL Condos: Payoff
Table
THIS IS A PROFIT PAYOFF TABLE
States of Nature
Alternatives Low High
Small 8 8
Medium 5 15
Large -11 22
(payoffs in millions of dollars)
Loss table
States of Nature
Low High Max
Los
s
Small 8-8= 0 22-8=14 14
Mediu 8-5= 3 22-15=7 7
m
Large 8-(-11)=19 22-22= 19
0
4.Laplace Criterion:
- Assume equal amount of probabilities
- Computation of expected value for each decision choice
CAL Condos: Payoff
Table
THIS IS A PROFIT PAYOFF TABLE
States of Nature
Alternatives Low High
Small 8 8
Medium 5 15
Large -11 22
(payoffs in millions of dollars)
5. Hurwicz Criterion:
First, select coefficient of realism, a,
with a value between 0 and 1. When a is
close to 1, decision maker is optimistic
about future, and when a is close to 0,
decision maker is pessimistic about future.
Payoff = a x (maximum payoff) + (1-a) x (minimum
payoff)
Decision under Risk
(With probability)
1. Expected monetary value ( EMV)
2. Expected opportunity Loss ( EOL)
3. Expected value of Perfect
information ( EVPI)
Expected monetary
value
( EMV)
The expected monetary value (EMV)
for a given course of action is the
weighted sum of possible payoffs for
each alternative. The expected value is
the long run average value that would
result if the decision were repeated a
large number of times.
Steps for calculating
EMV:
1. Construct a payoff matrix listing all
possible course of action and states of
nature and enter the conditional payoff
values.
2. Calculate the EMV for each course of
action by multiplying the conditional
payoffs by the associated probabilities
and adding these weighted values for
each course of action.
3. Select the course of action that yields
Expected Opportunity
Loss.
An alternative approach to maximizing
expected monetary value ( EMV) is to
minimize opportunity loss( EOL) , also
called expected value of regret.
It is defined as the difference between the
highest profit of a state of nature and
actual profit obtained by the particular
course of action.
Steps for EOL.
1. Prepare a conditional profit table for each
course of action and state of nature
combination along with the associated
probabilities.
2. For each state of nature calculate the
conditional opportunity loss values by
subtracting each payoff from the maximum
payoff for that outcome.
3. Calculate the EOL for each course of action
by multiplying the probability of each state of
nature with the COL value and then adding
Expected value of Perfect
information ( EVPI)
It represents the maximum amount of
money the decision maker has to pay in
order to get this additional information
about the occurrence of various states of
nature, before a decision has to be made.
EVPI= (Expected profit with perfect information)-
( Expected profit without perfect
information)
Decision Tree analysis
Definition: It consists of nodes, branches,
probability estimates, and payoffs. There are
two types of nodes: Decision nodes( also called
act node) and chance node( also called event
node) .
Decision node: It is represented by a square
and indicates places where a decision maker
must select one alternative course of action.
Chance node: The chance node is
represented by a circle and indicates a point
A news paper boy has the probabilities of selling a
magazine as shown in the table. The cost of a copy sold
is Rs.30 and the sale price of the magazine is Rs. 40 . The
unsold copies fetch a salvage value of Rs.5 in the second
sale market . How many copies should be ordered
according to EMV, EOL and EVPI criterion.
No. of 9 10 11 12 13 14
copies
sold
Probability 0.05 0.1 0.15 0.3 0.25 0.15
A retailer purchases cherries every morning at Rs.50 per
case and sells them for Rs.80 a case. Any case that
remains unsold at the end of the day can be disposed off the
next day at a salvage value of Rs. 20 per case ( there after
they have no value) . The past sale have ranged from 15 to
18 cases per day. The following is the record of sales for
the past 120 days. Find out how many cases should the
retailer purchase per day in order to maximize his profit.
Apply EMV,EOL,EVPI
Cases 15 16 17 18
sold
No. of 12 24 48 36
