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.
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:
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States of nature
S1 S2 S3
A1 V11 V12 V13
Alternatives A2 V21 V22 V23
A3 V31 V32 V33
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
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.
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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
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*maximum A1
5 6 10 10 A2
-1 4 15 15 A3
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.
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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
4 16 12 4 A1
5 6 10 5*maximum A2
-1 4 15 -1 A3
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
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decision avoids the greatest regret by selecting the decision alternative that minimizes the
maximum regret.
EXAMPLE:
S1 S2 S3
4 16 12 A1
5 6 10 A2
-1 4 15 A3
Opportunity loss table:
S1 S2 S3
5-4=1 16-16=0 15- A1
12=3
A2
5-5=0 16-6=10 15-
A3
10=5
5-(-1)=6 16-4=12 15-
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 16-16=0 15- 3*minimum A1
12=3
A2
5-5=0 16-6=10 15- 10
A3
10=5
5-(-1)=6 16-4=12 15- 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 24 24 A1
15 15 15 0 15*minimum A2
15 15 15 0 15*minimum A3
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 28 28 4 23.2*maximum A1
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.
[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
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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 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:
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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*maximum A1
5 6 10 7 A2
-1 4 15 6.30 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
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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.
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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