Chapter
Chapter Five
Five
Decision Theory Model
Decision
Decision theory
theory
The decision making refers to the selection of an act
from amongst various alternatives, the one which is
judged to be the best under given circumstances.
Decision theory is used to determine the best
alternative under incomplete and uncertain future
conditions.
To analyze a set of complex situations with many
alternatives and many different possible consequence
Decision
Decision Theory
Theory Process
Process
a) Identify possible future conditions called states of
nature
b) Develop a list of possible alternatives, one of which
may be to do nothing
c) Determine the payoff associated with each alternative
for every future condition
d) If possible, determine the likelihood of each possible
future condition
e) Evaluate alternatives according to some decision
criterion and select the best alternative
State
State of
of nature
nature
Are actual event that may occur in the future and
which are beyond the control of the decision maker
State of nature are factors which influence a choice of
alternatives but their occurrences are knowing during
decision making
Example
• Demand level of a product
• Market condition
• Whether condition etc
Pay
Pay off
off table
table
• A payoff table is a tool that provides information about
consequences associated with each
alternative/state of nature combination usually
related to potential profit or loss.
Decision
Decision making
making environment/
environment/
Degree
Degree of
of certainty
certainty
1. Decision-making under certainty
•There is complete certainty about the future
•The decision-maker knows with certainty the consequences of
every alternative and Wich state of nature will happen
2. Decision-making under uncertainty
•The decision-maker does not know the probabilities of the
various outcomes and which state of nature will happen
3. Decision-making under risk (with probability)
•The decision-maker does know the probabilities of the various
outcomes and state of nature
Decision
Decision criteria
criteria
Criteria under complete uncertainty
1. Maximin
2. Maximax
3. Minimax regret
4. Hurwicz
5. Equal likelihood
Criteria under probability
1. Expected monitory value(EMV)
2. Expected opportunity Loss(EOL)
Criteria..
Criteria..
Maximin: The maximin 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 for the potential
payoff; the actual payoff cannot be less than this amount.
Maximax
The maximax approach is the opposite of the previous one: The best
payoff for each alternative is identified, and the alternative with the
maximum of these is the designated decision.
Minimax Regret
An approach that takes all payoffs into account. To use this
approach, it is necessary to develop an opportunity loss table that
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
The
The Hurwicz
Hurwicz (Realism)
(Realism) Criterion
Criterion (Weighted
(Weighted
Average
Average or
or Realism
Realism Criterion)
Criterion)
• The approach offers the decision maker a compromise
between the maximax and the maximin criteria.
– Requires the decision maker to specify a degree of
optimism, in the form of a coefficient of optimism α, with
possible values of α ranging from 0 to 1.00.
– The closer the selected value of α is to 1.00, the more
optimistic the decision maker is, and the closer the value
of α is to 0, the more pessimistic the decision maker is.
Shortly
Shortly
• Maximin - Choose the alternative with the best of the
worst possible payoffs
• Maximax - Choose the alternative with the best possible
payoff
• Laplace - Choose the alternative with the best average
payoff of any of the alternatives
• Minimax Regret - Choose the alternative that has the
least of the worst regrets
Approaches
Approaches to
to Incorporating
Incorporating Probabilities
Probabilities in
in the
the
Decision
Decision Making
Making Process
Process
• Expected Monetary Value (EMV) approach
– Provides the decision maker with a value that
represents an average payoff for each alternative.
• Expected Opportunity Loss (EOL)
– The opportunity losses for each alternative are
weighted by the probabilities of their respective states
of nature to compute a long-run average opportunity
loss, and the alternative with the smallest expected loss
is selected as the best choice.
• Expected Value of Perfect Information (EVPI)
– Expected value of perfect information: the difference
between the expected payoff under certainty and the
expected payoff under risk
Example
Example 11
Suppose that an investor wants to construct one of the
following facilities (small, medium, or large facility). The
profit from each facility depends on the future market
demand, which could be low, moderate, or high. His
estimated profit for each alternative under each state of
nature is shown in the table.
A decision is being made concerning which size facility should be
constructed
Expected
Expectedopportunity
opportunityloss(EOL)
loss(EOL)
Example
Example 22
• A farmer wants to decide which of the three crops he should
plant on his 100-acre farm. The profit from each is
dependent on the rainfall during the growing season. The
farmer has categorized the amount of rainfall as high,
medium, and low. His estimated profit for each is shown in
the table. Alternative State of nature
s High Medium Low
Crop A 8000 3500 5000
Crop B 4500 4500 5000
Crop C 2000 5000 4000
If the farmer wishes to plant only crop, decide which should be his
best crop under each criteria?
Example
Example 33
Suppose that a real estate developer must decide on a
plan for developing a certain piece of property. After
careful consideration, the developer has identified the
following list of acceptable alternatives:
[Link] building
[Link] building
[Link] building
Suppose that the developer identified the following state
of nature
1. Low demand
2. Moderate demand
3. High demand
Payoff
Payoff Table
Tablefor
forReal
RealEstate
EstateDeveloper
Developer
(( Profit
Profit per
per year
year in
in Birr)
Birr)
State Of Nature( Demand Level)
Alternatives
(Types of building) High Moderate Low
Apartment 500 320 200
Office 750 300 100
Commercial 400 100 -125
