Unit Four

Decision Theory

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Chapter Objectives
• At the end of this chapter students will be able to:
– Discuss Types of Decision Making Environment
– Explain Decision making under
• Uncertainty
• Risk
• Certainty
• with Utilities.

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[Link]
• Decision analysis allows us to select a decision from
a set of possible decision alternatives when
uncertainties regarding the future exist.
• The goal is to optimize the resulting payoff in terms
of a decision criterion.
• The decision model includes a list of courses of
action available and the possible consequences of
each course of action.
• An important factor in making a decision is the
degree of certainty associated with consequences.

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Characteristics of Decision Theory Problems
• Decision theory problems are characterized by the
following:
– A list of alternatives: a set of mutually exclusive and
collectively exhaustive options available to the
decision maker.
• Eg. construct new plant, expand the present
plant or subcontract)
– A list of possible future states of nature: a set of
possible future conditions or events, beyond the
control of the decision maker that determine the
decision’s consequence.
• (Eg. High demand, moderate, low demand)
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Cont`d….
– Payoff Values (Conditional gains)
– monetary values for the various decision–outcome
combinations.
– the payoffs might be profits, revenues, costs, or other
measures of value.
– Usually the measures are financial.
– Degree of certainty
– These include complete certainty, risk and complete
certainty.
– A decision criterion
– an approach which embodies the decision maker’s
attitudes toward the decision situation.
– Some are more optimistic, others are more pessimistic;
and some may want to maximize gains, whereas others
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may want to minimize losses. 5
Steps in Decision Theory Approach
• The decision theory approach generally involves five
steps.
• These are:
1. List all the viable alternatives /strategies/ course
actions
2. Identify the states of nature /expected future
events.
3. Construct a payoff table/decision tree
4. Select optimum decision criterion
5. Choose an alternative (decision)

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4.2. Decision Making Environments
• Decisions are made under three types of environments:
1. Under conditions of certainty
– Only one certainly known state of nature exists for
each alternative.
– The decision maker has perfect knowledge about the
future outcomes, and selects the one with highest
payoff.
2. Under conditions of uncertainty
– more than one states of nature, and they are known.
– but the decision maker lacks the knowledge about
the probabilities of their occurrence.

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Cont`d….
• Examples:
– Manufacturer introducing a new product in the
marketplace.
– Government contractor bidding on a new contract.
– Oil company deciding to drill for oil in a particular
location
3. Decision making under conditions of risk
– Here also, more than one known states of nature
exist
– but the decision maker has sufficient knowledge to
allow him/her to assign probabilities to the various
states of nature.
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I. The Payoff Table
• A payoff table is a device used to summarize and
organize information relevant to a particular
decision.
• It includes:
– a list of alternatives,
– possible future states of nature,
– Payoff values, and
– probabilities [if available].
• Positive payoff values correspond to rewards (gains),
and negative values correspond to costs (losses).
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Cont`d….
• Payoff table analysis can be applied when:
– There is a finite set of discrete decision
alternatives.
– The outcome of a decision is a function of a single
future event.
General Format:

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• Example: Tabor Ceramic Manufacturing Company decides
to increase its production to meet the increasing market
demand of ceramic products. After careful consideration,
the company has ruled out “do nothing” and left with the
list of acceptable alternatives which include: expand the
present plant, construct a new plant, and subcontract
production for extra demand. The company came to know
that the greatest uncertainty to go through is the extent of
product demand in the upcoming years of operation.
Hence, the future states of nature related to the demand
are given to be high demand, moderate demand, low
demand, and no demand. The payoff table for Tabor’s
expansion decision stated above is constructed as shown
below incorporating the payoff values associated with
each alternative-state of nature combination
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Cont`d….
• Payoff table for Tabor’s expansion decision

• Under conditions of complete certainty, the decision maker simply picks

up the best payoff in that state of nature and chooses the associated
alternative. For instance, if Tabor knew that product demand would be
high, it would choose the alternative ‘construct a new plant’ to get the
highest payoff Birr 70,000; but, if the company knew that the demand
would be low, it would choose alternative ‘subcontract’ to keep the
losses lowest to Birr 1,000.
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[Link] making under Uncertainty
• We shall consider five decision criteria to decision making
under complete uncertainty.
• These are:
A. Maxi-min (Pessimism)
B. Maxi-max (Optimism)
C. Mini-max Regret
D. Principle of Insufficient Reason (Laplace) , and
E. Hurwitz Criterion (Realism)

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A. Maxi-min Criterion
• It is the pessimistic or conservative approach.
• It consists of identifying the worst payoff for each
alternative, and, then selecting the alternative that
has the best of the worst payoffs.
Example
• The following payoff table provides data about
profits of the various states of nature/alternative
combination.

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Cont`d….

• 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.

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Cont`d….
Example 2
• Indicate the optimal decision for the Tabor’s problem
using Maxi-min

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B. Maxi-max Criterion
• It is an optimistic approach, and associated with
choosing the alternative that could result in the best
payoff.
• Consists of identifying the best payoff for each
alternative and selecting the alternative that has the
best of the best payoffs.
• Example: For the previous problem:

• Decision: A1 will be chosen

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Cont`d…..
• Note
– If the payoff 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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Cont`d…..
Example 2
• Indicate the optimal decision for the Tabor’s
problem using Maxi-max.

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C. Mini-max regret Criterion
• It is based on a regret the decision maker may experience after the
decision has been made.
ith regret = (best payoff – ith payoff) for the jth event
• The objective is to minimize regret before making decision.
• Then, identify the maximum regret for each alternative and
selecting the one with the smallest of of the max. regrets.
• 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
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Cont`d…..
• Example 1:

• opportunity loss table:

– 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.
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Cont`d…..

• Decision: A1 will be chosen.

– Although this approach makes use of more
information than either Maxi-min or Maxi-max, it
still ignores some information, and, therefore, can
lead to a poor decision.
• Example: Opportunity Loss Table

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Cont`d…..
Example 2
• Indicate the optimal decision for the Tabor’s problem
using Mini-max regret.

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D. Principle of Insufficient Reason (Laplace/Equal likelihood
• It is based on the point that there is not enough information to
conclude that occurrences of each state of nature will be different.
• Therefore, equal weights should be assigned to all events of each
alternative, and the one with the best average payoff will be
selected.
• 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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Cont`d…
• 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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Cont`d…
Example 2
• Indicate the optimal decision for the Tabor’s problem
using Laplace.

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E. The Hurwitz Criterion (Realism)
• It is a compromise between the maxi-max (optimistic)
and maxi-min (pessimistic) decision criteria.
• This criterion is based Hurwitz's concept of coefficient of
optimism (α) and coefficient of pessimism (1- α).
• This concept allows the decision maker assign weights to
payoffs based on his/her degree of optimism (or
pessimism)

• The alternative which has the best sum of these

weighted payoffs is then selected.
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Cont`d…
Example
• Indicate the optimal decision for the Tabor’s problem
using The Hurwitz Criterion, given α=0.8.
• Solution

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Cont`d…
– A limitation of Hurwitz 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, Hurwitz criterion is a completely
subjective decision making criterion.

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4.4. Decision making Under Risk
– Under the conditions of risk, probabilities will be assigned
for the occurrence of the various states of nature.
– 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.
– If probabilities are reasonably correct, they provide the
decision maker with additional information that can
dramatically improve the decision making process.
– Several decision criteria are available to aid the decision
maker.
– Some of these are discussed below.
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A. Expected Monetary Value(EMV)
• This 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 expected monetary value.
– The average or expected payoff of each
alternative is a weighted average using
probabilities of events.
• Thus,

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Example: 1
– Tabor Ceramic Manufacturing Company might estimate that
probability of high demand at 0.25, the probability of moderate
demand at 0.40, the probability of low demand at 0.20 and the
probability of no demand at 0.15. Find the optimal decision for the
Tabor’s problem using the EMV approach.
• Solution

Decision: Subcontract

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Cont`d…
• Example 2
• Solution

• 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.
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B. Expected Opportunity Loss (EOL)
• In this case, a table of opportunity losses will be used
rather than a table of payoffs.
• Hence, the opportunity losses for each alternative
are weighted by the probabilities of their respective
event to compute a long run average opportunity loss.
• The alternative with the smallest expected loss will
be selected.
• The EOL will always result in the same choice as the
EMV.
• It is because they are equivalent ways of combining
the values;
– maximizing payoffs is equivalent to minimizing the
opportunity losses.
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Cont`d…
– 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.
– Example: Consider the above example 2
• 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
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opportunity losses). 35
Cont`d….
Example: 2
• Find the optimal decision for the Tabor’s problem
using the EOL approach.
• Solution

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3. Expected Value of Perfect Information
• 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.
• It is a measure of the difference between payoff that
could be realized under condition of certainty (EPC)
and the expected payoff under a condition involving
risk (EMV).

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Cont`d…..

• 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.
• 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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Cont`d….
 Example:
• The EVPI for Tabor’s decision problem can be
computed as:
• EPC
= 0.25 (70,000) + 0.4(30,000) – 0.2(1,000) – 0.15(10,000)
= 17,500 + 12,000 – 200 – 1,500 = Birr 27,800
 EMV = 11, 800 (computed earlier)
EVPI = EPC – EMV
EVPI = 27,800 – 11,800 = Birr 16,000

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Cont`d…..
• Note that the EVPI is exactly equal to EOL (In fact,
these two quantities will always be equal).
• The EOL indicates the expected opportunity losses
due to imperfect information, OR
– the expected payoff that could be achieved by
having perfect information.
• The EVPI represents an upper bounded on the
amount of money the company would spend to
obtain perfect information.
• Thus, the company would be justified in spending up
to Birr 16,000 to know for certain which state of
nature will prevail.
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II. Decision Tree
• The Payoff Table approach is useful for a non-
sequential or single stage decision situations.
• Many real-world decision problems consists of a
sequence of dependent decisions.
• Decision Trees are useful in analyzing multi-stage
decision processes.
• A Decision Tree is a chronological representation of
the decision process.
• The decision tree is composed of nodes (squares and
circles) and branches (lines).

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Cont`d…. • Typical Decision
• The tree format:
squares indicate
decision points
• Circles represent chance
events (circles and squares
are called nodes)
• The lines emanating from
squares represent
alternatives.
• The lines from circles
represent states of nature
• The tree is read from right
to left.
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Example
• Given the following Pay off table for Real Estate investment:
a. Draw up a decision tree.
b. Determine which decision maximizes the Real Estate
investor’s expected payoff?
c. How much will be the optimal expected payoff for the
investment

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Solution
a) The decision tree is develops as follows.

6) $50,000
(0.
Good

nt 2 $30,000
e
a r tm g Poor (0.4)
A p i l d in
Purchase bu Good (0.6) $100,000
1 Office building 3
Poor (0.4 -$40,000
Wa )
re ho Good (0.6)
u se $30,000
4
Poor
(0 .4)
$10,000

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Cont`d….
b) Determining the optimum strategy
– The expected value of the payoffs is computed at each
probability node.
– Start with the final outcomes (payoffs) and work
backward through the decision tree toward node 1.
EV (node 2) = 0.60($ 50,000) + 0.40($ 30,000) = $42,000
EV (node 3) = 0.60($100,000) + 0.40($-40,000) = $44,000
EV (node 4) = 0.60($ 30,000) + 0.40($ 10,000) = $22,000

– Each of these three expected values at nodes 2, 3, and 4

are the outcomes of a possible decision that can occur at
node 1.
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• Now we will be following the folding-back procedure.
 Folding-Back Procedure
• Starting from the right of the decision tree and working back to the
left:
1. At each probability node, calculate an EMV—a sum of products of
monetary values and probabilities.
2. At each decision node, take a maximum of EMVs to identify the
optimal decision.
• Moving toward node 1, we select the branch that comes from the
probability node with the highest expected payoff.
• The branch corresponding to the highest payoff ($44,000) will be
considered. This branch represents the decision to purchase the office
building.
Decision: The optimal strategy is to purchase office building

C. The optimal expected payoff for the investment is $44, 000.

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 Cont`d…..
• Decision tree showing the optimal strategy and the
associated expected payoff value.
$50,000
o d (0.6)
G o

t $30,000
m en 2
t Poor (0.4)
p ar n g
A ildi
Purchase bu Good (0.6) $100,000
1 Office building 3
Poor (0.4 -$40,000
Wa )
re ho Good (0.6)
u se $30,000
4
Poor
(0 .4)
$10,000

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[Link] making Under Certainty
• The manager has complete knowledge and perfect
information of outcome due to each alternatives
• He would select a decision alternatives that will yield the
maximum profit
– Example : a company produces three types of
products. It wants to decide which of the three types
of product it should produce the profit of the
products are dependent on sales season

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Cont`d…..
• If the factory wishes to produce only one product,
Decide which product which should the factory
produce if the manager knows with certainty that the
sales season?
• solution
– At all sales season, product 1 should be produced.
Hence the company can get maximum profit.

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4.6. Decision Making with Utilities
– In some cases the decision alternative with the best
expected monetary value may not be the most
desirable decision.
– If expected monetary value does not lead to the most
preferred decision alternative, expressing the value
of the outcome in terms of its utility will permit the
use of expected utility to identify the most desirable
decision.
– Utility is the measure of total worth of particular
outcome
• it reflects decision maker’s attitude towards
collection of factors such as a profit, loss and risks
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 Cont`d…..
– Decision utility describes the usefulness that we
perceive and use to make a decision, while
experienced utility describes the lived
consequences of the decision in reality.
– These different types of utility have driven new
understandings of utility and its role in decision-
making.

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Cont`d….
• Example

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Cont`d…..
• Solution : Using expected monetary value
– EMVA1= 30000(0.3) + 20,000 (0.5) + -50,000(0.2) = 9,000
– EMVA2= 50,000(0.3) + -20,000(0.5) + -30,000(0.2) = -1,000
– EMVA3= 0(0.3) + 0(0.5) + 0(0.2) =0
– This implies A1 is the best alterative with a long run
average payoff of 9,000.
– Using Expected monetary value, the decision maker selects
A1.
– However, due to uncertainty in the state of nature
probabilities, we do not know which of the three states of
nature will take place.
– If the third state of nature takes place the company suffers
a loss of -50,000, which is the most severe loss from all the
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others. 53
Cont`d…..
– Therefore, a risk aversive company may not be willing to
take such an alternative for fear of the third state of
nature that may result in such a huge loss.
– We need to determine utility for the various monetary
outcomes.
– Where utility of any outcome is total worth of that
outcome, taking in to account the risks and payoffs
involved.
– We need to determine utility for the various monetary
outcomes.
– Where utility of any outcome is total worth of that
outcome, taking in to account the risks and payoffs
involved.
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Developing utilities for payoffs
– To assign utility values for all the payoffs in the
payoff table, assign utility value for the best and
worst payoffs in the decision situation.
– Any value can work as long as the value assigned
to the worst is less than that assigned to the best
payoff
• Developing utility table
– given point of indifference for all the payoff
values in the table, we can calculate utility for all
the values using:
– U (Pij) = (Pij) [U (50,000)] + (1-P) [U (-50,000)]

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Cont`d…..
• Point of indifference is given as follows for the
remaining payoff values.
– P (30,000) = 0.95
– P (20,000) = 0.9
– P (0) = 0.75
– P (-20,000) = 0.55
– P (-30,000) = 0.4
• Developing utility table
– Let assume the utility of the largest payoff
(50,000) to be 10 and Utility of the smallest payoff
(-50,000) to be 0.
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Cont`d…..

– Utility of all the remaining payoffs can be

calculated as:-
– U (30,000) = .95(10) + (0.05) (0) = 9.5
– U (20,000) = 0.9(10) = 9
– U (0) = (0.75) (10) = 7.5
– U (-20,000) =0.55(10) =5.5
– U (-30,000) = 0.4(10) = 4

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Cont`d…..

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 THE END!!!

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