Chapter Four

Decision Theory

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 Introduction
• Decision theory represents a generalized
approach to decision making which often
serves as the basis for a wide range of
managerial decision making.
• The decision model includes a list of courses
of action that are available and the possible
consequences of each course of action.
• An important factor in decision making is the
degree of certainty associated with
consequences.
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• The decisions are based on the criteria
decided by the objective of the organization
• Example : Maximization of profit or
Minimization of cost, time, wastage, etc
• Many decision making situations occur under
conditions of uncertainty.
• Example : The demand for a product may not
be 500 units next week, but 450 or 600 units,
depending on the market (which is uncertain).
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 Characteristics of Decision Theory
1. 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’.)
2. 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.
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 Characteristics of Decision Theory
3. Payoffs: the decision maker may have different
payoffs associated with different decision
alternatives and states of nature
• The payoffs might be profits, revenues, costs, or
other measures of value.
• Usually the measures are financial. And, 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 of Decision Theory
4. Degree of certainty: - the approach used by a decision
maker often 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. Complete uncertainty exists when the
likelihood of the various states of nature are unknown.
• Between these two extremes is RISK, the term that implies
probabilities are known 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 action.
• Thus, if the decision maker feels that a particular state of
nature is highly likely, this will mean that the pay offs
associated with the state of nature are also highly likely.
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 Characteristics of Decision Theory
5. Decision Criteria: The process of selecting one
alternative from a list of alternatives is governed by
a decision criterion, which embodies the decision
makers attitude toward the decision as well the
degree of certainty that surrounds a decision.
• Some decision maker may have optimistic
attitude, where as others are pessimistic.
• Some wants to maximize gains, where as others are
more concerned with protecting against losses.

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 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 a list of alternatives, the possible
future states of nature, and the payoffs
associated with each of the alternative/state
of nature combinations.
• If probabilities for the states of nature are
available, these can also be listed.
• The general format of the table is illustrated
in the next slide:
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 Payoff Table
State of Nature
S1 S2 S3
V11 V12 V13
Alternatives A1
V21 V22 V23
A2
V31 V32 V33
A3
where:
Ai = the ith alternative
Sj = the jth states of nature
Vij = the value or payoff that will be realized if
alternative i is chosen and event j occurs.
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 Decision Making Process
1. Identify all possible state of nature i.e events available or affecting
the decision.
2. List out various course of action open to the decision maker. These
finite number of course of action will facilitate the decision maker
to decide under controlled parameters.
3. Identify the payoffs for various strategic solution under all known
events or state of nature . Variation of acts & events will be helpful
to identify the outcomes or pay-off for various combination.
4. Decision to choose from amongst these alternative under given
conditions with identified pay-offs.
 These steps may involve the judgment or any additional information
helping the decision making process.

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 Decision making environment

 Decision are made under four types of environment:

1. Decision making under condition of certainty

2. Decision making under condition of uncertainty
3. Decision making under condition of risk
4. Decision making under condition of conflict

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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
 In this environment , only one state of nature exists for each alternative
i.e., there is complete certainty about the future .
 It is easy to analyze the situation and make good decision.

 Since the decision maker has perfect knowledge about the future

outcomes, he/she simply choose the alternative having optimum

payoff.

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 Example

• The following payoff table provides data about profits of the

various states of nature/alternative combination.
S1 S2 S3

A1 4 16 12

A2 5 6 10
A3 -1 4 15

• If we know that S2 will occur, the decision maker then can

focus on the first row of the payoff table. Because
alternative A1 has the largest profit (16), it would be
selected.
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 Decision making under conditions of uncertainty
 Under complete uncertainty, the decision maker either is
unable to estimate the probabilities for the occurrence of the
different states of nature, or else s/he lacks confidence in
available estimates of probabilities, and for that reason,
probabilities are not included in the analysis.
 More than one states of nature exists but the decision maker
lacks the knowledge about the probabilities of their
circumstances
 we shall consider four approaches to decision making under
complete uncertainty. These are:
1. Maximax
2. Maximin
3. Minimax regret
4. Insufficient reason
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 Maximax (optimistic ) Criteria

• The decision maker selects the

decision that will result in the
maximum of the maximum payoffs.
• The maximax is very optimistic.
• The decision maker assumes that the
most favorable state of nature for
each decision alternative will occur.

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Maximax (optimistic ) Criteria
• 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.
S1 S2 S3 Row Maximum
4 16 12 16*
A1 Maximum
5 6 10 10
A2

A3
-1 4 15 15

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Maximax (optimistic ) Criteria
• Decision: A1 will be chosen.
• Note: If the pay off table consists of costs
instead of profits, the opposite selection
would be indicated: The minimum of
minimum costs (MiniMin).
• For the subsequent decision criteria we
encounter, the same logic in the case of
costs can be used

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 Maximin 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;
the actual payoff can not be less than this amount.
 It involves selecting best of the worst.

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 Maximin Criteria
Example:
S1 S2 S3 Row Minimum
A1 4 16 12 4

A2 5 6 10 5*Maximum
-1 4 15 -1
A3
Decision: A2 will be chosen
Note: If it were cost, the conservative
approach would select the maximum cost for
each decision and select the minimum of
these costs.
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 Minimax Regret
• In order to use this approach, it is necessary to develop an
opportunity loss table.
• 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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 Minimax Regret
Example:

S1 S2 S3
4 16 12
A1
5 6 10
A2
-1 4 15

A3

• opportunity loss table

S1
5-4=1 S2
16-16=0 S3
15-12=3 3*minimum
A1
5-5=0 16-6=10 15-10=5 10
A2

A3
5-(-1)=6 16-4=12 15-15=0 12
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 Minimax Regret
• A decision maker could select an alternative
that 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.
• Decision: A1 will be chosen

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 Laplace (criteria of
rationality)or Baye’s criteria
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

S1 S2 S3 S4 S5 Row average

A1 28 28 28 28 4 23.2*maximum
5 5 5 5 28 9.6
A2
5 5 5 5 28 9.6
A3

Decision: A1 is selected

 The basis for the criterion of insufficient reason is that under complete

uncertainty, the decision maker should not focus on either high or low

payoffs, but should treat all payoffs (actually, all states of nature), as if

they were equally likely.

 Averaging row payoffs accomplishes this.

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 The Hurwitz Criterion (Criterion of
realism)
 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). 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.
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The Hurwitz criterion requires that for each alternative,25
 Example

S1 S2 S3 Max row
4 16 12 16
A1
5 6 10 10
A2
-1 4 15 15
A3

If  = 0.4 for the above example,

A1 = (0.4x16) + (0.6x4) = 8.8
A2 = (0.4x10) + (0.6x5) = 7
A3 = (0.4x15) + (0.6x-1) = 5.6
• Decision: A1 is selected
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 The Hurwitz Criterion (Criterion of
realism)
 A limitation of Hurwicz criterion is the fact that 
must be determined by the decision maker
(subjective).
 Regardless of how the decision maker determines
, it is still a completely a subjective measure of
the decision maker’s degree of optimism.
 Therefore, Hurwicz criterion is a completely
subjective decision making criterion.

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 Decision Making Under Risk
 The decision making criteria just presented previously were
based on the assumption that no information regarding the
likelihood of the states of the nature was available.
 Thus, no probabilities of occurrence were assigned to the
states of nature, except in the case of the equal likelihood
criterion.
 It is often possible for the decision maker to know enough
about the future state of nature to assign probabilities to
their occurrences.

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 Decision Making Under Risk
• 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.
• If they are reasonably correct, they provide the decision
maker with additional information that can dramatically
improve the decision making process.
• Given that probabilities can be assigned, several decision
criteria are available to aid the decision maker.
• Following are different approaches to make decision
under Risk
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 A. 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:

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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 Example

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 6.3
A3

Decision: A1 will be chosen

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 B. 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, and the alternative with the smallest
expected loss is selected as the best choice.

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 Example

S1 S2 S3
4 16 12
A1

A2 5 6 10
A3 -1 4 15

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
Note: The EOL approach resulted in the same alternative
as the EMV approach (Maximizing the payoffs is
equivalent to minimizing the opportunity losses).
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 C. Expected Value of Perfect Information
(EVPI)
• It can some times be useful for a decision
maker to determine the potential benefit of
knowing for certain which state of nature is
going to prevail.
• The EVPI is the measure of the difference
between the certain payoffs that could be
realized under a condition involving risk.
• If the decision maker knows that S1 will
occur, A2 would be chosen with a payoff of
$5. Similarly for S2 $16 (for A1) and for S3,
$15 (with A3) would be chosen.
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 C. Expected Value of Perfect Information
(EVPI)
Hence, the expected payoff under certainty (EPC) would be:
EPC = 0.20(5) + 0.50(16) + 0.30(15) = 13.50
The difference between this figure and the expected payoff under
risk (i.e., the EMV) is the expected value of perfect information.
Thus:
EVPI = EPC - EMV
= 13.50 -12.40 = 1.10
• Note: The EVPI is exactly equal to the EOL. The EOL indicates
the expected opportunity loss due to imperfect information,
which is another way of saying the expected payoff that could be
achieved by having perfect information.

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 Decision Trees
• Decision trees are some times used by decision makers
to obtain visual portrayal of decision alternatives and
their possible consequences.
• The term gets its name from the tree-like appearance of
the diagram.
• It is a graphical representation of the decision process
indicating decision alternatives, state of nature,
probabilities attached to the states of nature and
conditional benefits and loss.

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 Decision tree format

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 Decision Trees
• It consists of a network of nodes and branches and
lines .
1. Decision node –represented by a square
2. State of nature (chance or event) node –
represented by a circle.
3. The lines or branches that emanate from a square
represent alternatives, while the branch that
emanate from a circle represent states of nature.
• The tree is read from right to left
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 Steps in decision tree analysis
1. Identify the decision point and alternative
course of action at each decision point
systematically
2. At each point , determine the probability and
payoff associated with each course of action
3. Commencing from the extreme right end ,
compute the expected payoff(EMV) for each
course of action.
4. Choose the course of action that yield the
best payoff for each of the decision.
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 Steps in decision tree analysis
5. Proceed backwards to the next stage of
decision point.
6. Repeat above steps till the first decision
point is reached
7. Finally identify the course of action to be
adopted from the beginning to the end
under different possible outcomes for the
situation as a whole.

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 Example
• Pay off table for Real Estate investment
State of Nature
Good economic poor
economic
Decision conditions (0.6)
conditions(0.4)
(Purchase)_______________________________

Apartment building 50,000 30,000

Office building 100,000 -40,000
Warehouse 30,000 10,000
Required : Draw the decision tree and determine the best
strategy
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 Example
Good economic
50,0000
conditions (0.6)

Poor economic 30,000

Apartment Building 2 conditions (0.4)

Good economic conditions (0.6)

100,00

1 Office building

3
Poor economic -40,000
conditions (0.4)

Good economic conditions (0.6 ) 30,100

Warehouse

4
Poor economic 10,000
conditions (0.4)

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 Example
 Determining the best decision using a decision tree
involves computing the expected value at each
probability node.
 This is accomplished by starting with the final outcomes
(payoffs) and working backward through the decision
tree toward node 1. First, the expected value of the
payoffs is computed at each probability node.
EMV(node 2) = .60($ 50,000) + .40($ 30,000) = $42,000
EMV(node 3) = .60($100,000) + .40($-40,000) = $44,000
EMV(node 4) = .60($ 30,000) + .40($ 10,000) = $22,000

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 Example
 The maximum benefit accrues when you
invest in office building as it gives you the
greatest expected value in purchase.
 Therefore , the stage of the decision tree
would depend on the level of decision
making .
 If there are series of decisions to be made ,
say the likely profit for 5 years spans, it will
be a multistage decision tree case for spans
of 1,2,3,4 and 5 years decisions.

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 Thank you

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