UNIT FIVE: DECISION THEORY/ANALYSIS
4.1. Characteristics of Decision Theory
• List of alternatives: are a set of mutually exclusive and collectively
exhaustive decisions that are available to the decision maker
• 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.
• Payoffs: - the payoffs might be profits, revenues, costs, or other
measures of value.
• Degree of certainty: - the approach often used by a decision
maker depends on the degree of certainty that exists.
• 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.
4.2. THE 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:
Cont’d
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.
Cont’d
• Decision situations can be categorized in to
three classes:
1. Situation of certainty,
2. Situations where probabilities can not be
assigned to future occurrences
3. Situations where probabilities can be assigned to
future occurrences.
4.3. DECISION MAKING UNDER CERTAINTY
• The simplest of all circumstances occurs when
decision making
• 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
5 6 10
A1
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.
4.4. DECISION MAKING UNDER COMPLETE UNCERTAINTY (Without 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 in 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.
Cont’d
• 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.
4.4.1. MAXIMAX
• With the maiximax criterion, the decision
maker selects the decision that will result in
the maximum of the maximum payoffs
• That maximax is very optimistic.
• The best payoff for each alternative is
identified, and the alternative with the
maximum of these is the designated decision.
Cont’d
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.
4.4.2. 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 can not be less than this amount.
• It involves selecting best of the worst.
Cont’d
• 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.
4.4.3. 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.
• 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.
• For example, consider this payoff table:
Cont’d
S1 S2 S3 Row Max
A1
-5 16 -10 16*max
A2 15 15 15 15
A3 15 15 15 15
Cont’d
• 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.
EXAMPLE:
S1 S2 S3
A1
4 16 12
5 6 10
A2
-1 4 15
A3
Cont’d
• Opportunity loss table:
S1 S2 S3
5-4=1 16-16=0 15-12=3
A1
5-5=0 16-6=10 15-10=5
A2
5-(-1)=6 16-4=12 15-15=0
A3
Cont’d
• 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.
Cont’d
S1 S2 S3 Max. Loss
A1 5-4=1 16-16=0 15-12=3 3*minimum
A2 5-5=0 16-6=10 15-10=5 10
A3 5-(-1)=6 16-4=12 15-15=0 12
Decision: A1 will be chosen.
PRINCIPLE OF INSUFFICIENT REASON/ Equal likelihood/ Laplace
• 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.
Cont’d
S1 S2 S3 S4 S5 Row Average
A1 28 28 28 28 4 23.2*maximu
m
5 5 5 5 28 9.6
A2
5 5 5 5 28 9.6
A3
Decision: A1 is selected
4.4.5. The 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.
Cont’d
• The Hurwitz criterion requires that for each alternative, the
maximum payoff is multiplied by and the minimum payoff
be multiplied by 1-, then select the maximum one.
• 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
Cont’d
• 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.
4.5. DECISION MAKING UNDER RISK (WITH PROBABILITIES)
• The decision making criteria just presented
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 likelyhood criterion.
Cont’d
• 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.
• 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:
EXAMPLE:
Probability 0.20 0.50 0.30
S1 S2 S3 Expected payoff
A1 4 16 12 12.40*maximum
A2 5 6 10 7
A3 -1 4 15 6.30
Decision: A1 will be chosen.
Note: the sum of the probabilities for all states of
nature must be 1
4.5.2. 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
Cont’d
• Note: The EOL approach resulted in
the same alternative as the EMV
approach
• i.e., Maximizing the payoffs is
equivalent to minimizing the
opportunity losses
4.5.3. 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.
4
S1(0.2) 16
S2 (0.5) 12
S3 (0.3)
5 6 10
A1
-1 4 15
A2
A3
• 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, $15 (with A3) would be chosen.
• Hence, the expected payoff under certainty (EPC) would be:
EPC = 0.20(5) + 0.50(16) + 0.30(15) = 13.50
Cont’d
• The difference between this figure and the
expected payoff under risk (i.e., the EMV) is
the expected value of perfect information.
Thus:
EVPI = EPC – EMV
= 13.50 – 12.40 = 1.10
4.6. DECISION TREES
• Decision trees some times are used by
decision makers to obtain a visual portrayal of
decision alternatives and their possible
consequences.
• The term gets its name from the tree-like
appearance of the diagram.
Decision tree format
.
Cont’d
• Decision tree, like probablity tree is composed
of squares, circles, and lines:
The squares indicate decision points
Circles represent chance of events ( circles and
squares are called nodes)
The lines (branches) emanating from squares
represent alternatives.
• The tree is read from right to left.
Example
Pay off table for Real Estate investment
State of Nature
Good economic Poor economic
Decision conditions conditions
(Purchase) 0.6 0.4
Apartment building 50,000 30,000
Office building 100,000 -40,000
Warehouse 30,000 10,000
• The decision tree for the above example will be:
Decision [Link]
Cont’d
• Determining the best decision using a decision tree
involves computing the expected value at each
probability node. This is accomplished by starting
with the final outcomes (payoffs) and working
backward through the decision tree toward node 1.
• First, the expected value of the payoffs is computed
at each probability node.
EV(node 2) = .60($ 50,000) + .40($ 30,000) = $42,000
EV(node 3) = .60($100,000) + .40($-40,000) = $44,000
EV(node 4) = .60($ 30,000) + .40($ 10,000) = $22,000
Cont’d
• These values are now shown as the expected payoffs from
each of the three branches emanating from node 1 in figure
below.
• Each of these three expected values at nodes 2, 3, and 4 is the
outcome of a possible decision that can occur at node 1.
• Moving toward node 1, we select the branch that comes from
the probability node with the highest expected
payoff.
• In figure below, the branch corresponding to the highest
payoff, $44,000 is from node 1 to node 3.
• This branch represents the decision to purchase the office
building. The decision to purchase the office building, with an
expected payoff of $44,000,
• decision [Link]
4.6.1. Sequential Decision Trees
• In order to demonstrate the use of a decision
tree for a sequence of decisions, we will alter
our real estate investment example to
encompass a ten-year period during which
several decisions must be made.
Cont’d
• In this new example, the first decision facing the investor is
whether to purchase an apartment building or land. If the
investor purchases the apartment building, two states of nature
are possible. Either the population of the town will grow (with a
probability of 0.60), or the population will not grow (with a
probability of 0.40). Either state of nature will result in a payoff.
On the other hand, if the investor chooses to purchase land,
three years in the future another decision will have to be made
regarding the development of the land.
• The decision tree for this example, shown in figure below,
contains all the pertinent data, including decisions, states of
nature, probabilities, and payoffs.
• Decision [Link]
Cont’d
• At decision node 1 in figure, the decision choices are to
purchase an apartment building and to purchase land. Notice
that the cost of each venture ($800,000 and $200,000,
respectively) is shown in parentheses. If the apartment
building is purchased, two states of nature are possible at
probability node 2. The town may exhibit population growth,
with a probability of .60, or there may be no population
growth or a decline, with a probability of .40. If the population
grows, the investor will achieve a payoff of $2,000,000 over a
ten-year period. (Note that this whole decision situation
encompasses a ten-year time span.) However, if no population
growth occurs, a payoff of only $225,000 will result.
Cont’d
• If the decision is to purchase land, two states of nature are possible at
probability node 3. These two states of nature and their probabilities
are identical to those at node 2; however, the payoffs are different. If
population growth occurs for a three-year period, no payoff will occur,
but the investor will make another decision at node 4 regarding
development of the land. At that point either apartment will be built at
a cost of $800,000 or the land will be sold with a payoff of $450,000.
Notice that the decision situation at node 4 can occur only if population
growth occurs first. If no population growth occurs at node 3, there is
no payoff and another decision situation becomes necessary at node 5:
the land can be developed commercially at a cost of $600,000 or the
land can be sold for $210,000. (Notice that the sale of the land results in
less profit if there is no population growth than if there is population
growth.)
Cont’d
• If the decision at decision node 4 is to build apartments,
two states of nature are possible. The population may
grow, with a conditional probability of .80, or there may
be no population growth, with a conditional probability
of .20. The probability of population growth is higher
(and the probability of no growth is lower) than before
because there has already been population growth for
the first three years, as shown by the branch from node
3 to node 4. The payoffs for these two states of nature
at the end of the ten-year period are $3,000,000 and
$700,000, respectively, as shown in figure below.
Cont’d
• If the investor decides to develop the land
commercially at node 0. 5, then two states of
nature can occur. Population growth can occur,
with a probability of .30 and an eventual payoff of
$2,300,000, or no population growth can occur,
with a probability of .70 and a payoff of
$1,000,000. The probability of population growth
is low (i.e., .30) because there has already been no
population growth, as shown by the branch from
node 3 to node 5.
Cont’d
• This decision situation encompasses several
sequential decisions that can be analyzed using the
decision tree approach outlined in our earlier
(simpler) example.
• As before, we start at the end of the decision tree
and work backward toward a decision at node 1.
• First we must compute the expected values at
nodes 6 and 7.
EV (node 6) = .80($3,000,000) + .20($ 700,000) = $2,540,000
EV (node 7) = .30($2,300,000) + .70($1,000,000) = $1,390,000
Cont’d
• Both of these expected values (as well as all other nodal
values) are shown in boxes in Decision tree [Link]
• At node 4 we have a choice between two values:
$1,740,000, the value derived by subtracting the cost of
building an apartment building ($800,000) from the
expected payoff of $2,540,000, or $450,000, the
expected value of selling the land computed with a
probability of 1.0.
• The decision is to build the apartment building, and the
value at node 4 is $1,740,000.
Cont’d
• This same process is repeated at node 5. The
decisions at node 5 result in payoffs of
$790,000 (i.e., $1,390,000 - 600,000 =
$790,000) and $210,000.
• Since the value $790,000 is higher, the
decision is to develop the land commercially.
Cont’d
EV (node 2) = .60($2,000,000) + .40($225,000) = $1,290,000
EV (node 3) = .60($1,740,000) + .40($790,000) = $1,360,000
• (Note that the expected value for node 3 is computed from the
decision values previously determined at nodes 4 and 5.)
• Now we must make the final decision for node 1. As before, we
select the decision with the greatest expected value after the cost
of each decision is subtracted .
Apartment building: $1,290,000 - 800,000 = $ 490,000
Land: $1,360,000 - 200,000 = $1,160,000
• Since the highest net expected value is $1,160,000, the decision is
to purchase land and the payoff of the decision is $1,160,000.
Thanks!