CHAPTER FIVE

DECISION THEORY
Dear learner, in the previous units dealing with LP, models were formulated
and solved in order to aid the manager in making decision. The solutions to
the models were represented by values for the decision variables. However,
these LP models are formulated under the assumption that certainty
existed. In actual practice, however, many decision making situations occur
under conditions of uncertainty. For example, the demand for a product
may be not 100 units next week, but 50 or 200 units, depending on the
market (which is uncertain).

5.1. Characteristics of Decision Theory

Decision theory problems are characterized by the following:

1. List of alternatives: are a set of mutually exclusive and collectively

exhaustive decisions that are available to the decision maker
(sometimes, 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.
3. 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.
4. 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.

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 5. 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.

5.2. 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 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 below:

States of nature

S1 S2 S3

A1 V11 V12 V13

Alternatives 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.

Decision situations can be categorized in to three classes: Situation of

certainty, Situations where probabilities cannot be assigned to future
occurrences and Situations where probabilities can be assigned to future
occurrences. In this chapter we will discuss each of these classes of decision
situations separately.

5.3. 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 that corresponds to the state of

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nature that will occur. The decision maker then selects the alternative that
would yield the best payoff, given that state of nature.

 EXAMPLE

The following payoff table provides data about profits of the various states of
nature/alternative combination.

S1 S2 S3

4 16 12 A1

5 6 10 A2

-1 4 15 A3

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.

5.4. 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.

A decision making situation includes several components- the decision

themselves and the actual event that may occur future, known as state of
nature. 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.

Decisions made under these circumstances are at the opposite end of the
spectrum from the certainty case just mentioned. Once the decision has
been organized in to a payoff table, several criteria are available making the
actual decision. There are several approaches (criteria) to decision making
under complete uncertainty. Some of these discussed in this section include:
maximax, maximin,minimax regret, Hurwicz, and equal likelihood.

5.4.1. MAXIMAX

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With the maiximax criterion, the decision maker selects the decision that will
result in the maximum of the maximum payoffs ( In fact this is how this
criterion derives its name- maximum of maximum). Tha 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.

For the previous problem:

S1 S2 S3 Row Maximum

4 16 12 16*maxim A1
um
A2
5 6 10 10
A3
-1 4 15 15

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. For the
subsequent decision criteria we encounter, the same logic in the case of
costs can be used.

5.4.2. 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 cannot be less than this amount. It involves selecting best of
the worst. For the previous problem

S1 S2 S3 Row minimum

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 4 16 12 4 A1

5 6 10 5*maxim A2
um
A3
-1 4 15 -1

Decision: A2 will be chosen.

Note: If it were cost, the conservative approach would be to select the

maximum cost for each decision and select the minimum of these costs.

5.4.3. 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,
the maximax strategy ignores the possibility that an alternative with a
slightly smaller payoff might offer a better overall choice. For example,
consider this payoff table:

S1 S2 S3 Row Max.

-5 16 -10 16*max A1

15 15 15 15 A2

15 15 15 15 A3

A similar example could be constructed to demonstrate comparable

weaknesses of the maximin criterion, which is also due to the failure to
consider all payoffs.

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. 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.

EXAMPLE:

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 S1 S2 S3

4 16 12 A1

5 6 10 A2

-1 4 15 A3

Opportunity loss table:

S1 S2 S3

5-4=1 16- 15- A1

16=0 12=3
A2
5-5=0 16- 15-
A3
6=10 10=5

5-(- 16- 15-

1)=6 4=12 15=0

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.

S1 S2 S3 Max. Loss

5-4=1 16- 15- 3*minim A1

16=0 12=3 um
A2
5-5=0 16- 15- 10
A3
6=10 10=5

5-(- 16- 15- 12

1)=6 4=12 15=0

Decision: A1 will be chosen.

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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.

EXAMPLE:

Opportunity loss table

S1 S2 S3 S4 Max. Loss

0 0 0 2 24 A1
4
A2
15 15 15 0 15*mini
A3
mum

15 15 15 0 15*mini
mum

5.4.4. 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 was equally likely,
and it focuses on the average payoff for each row, selecting the alternative
that has the highest row average.

 EXAMPLE

S1 S2 S3 S4 S5 Row Average

28 28 2 2 4 23.2*maxi A1
8 8 mum
A2
5 5 5 5 2 9.6
8

5 5 5 5 2 9.6
8

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 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.

[Link] 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). 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-.

Example: If  = 0.4 for the above example,

A1 = (0.4x16) + (0.6x4) = 8.8

A2 = (0.4x10) + (0.6x5) = 7

A3 = (0.4x15) – (0.6x1) = 5.4

Decision: A1 is selected

A limitation of Hurwicz criterion is the fact that  must be determined by the

decision maker. 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.

5.5. DECISION MAKING UNDER RISK (WITH PROBABILITIES)

Dear learner, the decision making criteria just presented was based on the
assumption that no information regarding the likelihood of the states of the

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nature was available. Thus, no probabilities of occurrence were assigned to
the states of nature, except in the case of the equal likely hood criterion.

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. 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. Some of these are discussed below.

5.5.1. 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:

EMVi = Σ [Link]

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.

EXAMPLE:

Probability 0.20 0.50 0.30

S1 S2 S3 Expected payoff
4 16 12 12.40*maxim A1
um
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5 6 10 7

-1 4 15 6.30
 A2

A3

Decision: A1 will be chosen.

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.

5.5.2. 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.

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).

5.5.3. Expected Value of Perfect Information (EVPI)

It can sometimes 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.

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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.

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.

Note: The expected value approach is particularly useful for decision making
when a number of similar decisions must be made; it is a long-run approach.
For one-shot decisions, especially major ones, other methods (perhaps,
maximax or maximin) may be preferable. In addition, non monetary factors,
although not included in a payoff table, may be of considerable importance.
Unfortunately, there is no convenient way to include them in an expected
value analysis.

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