Chapter Four

Decision Theory
Types of Decision Making Environments

• Type 1: Decision Making under Certainty. Decision

maker know for sure (that is, with certainty) outcome or
consequence of every decision alternative.
• Type 2: Decision Making under Uncertainty. Decision
maker has no information at all about various outcomes
or states of nature.
• Type 3: Decision Making under Risk.
• Decision maker has some knowledge regarding
probability of occurrence of each outcome or state of
nature.
 2.1. Condition of Certainty
 In this type of decision making environment, there is only one
type of event that can take place.
 The decision maker has full and needed information to make
decision.
 The manager knows exactly what the outcome will be as he/she
has enough clarity about the situation, knows the resources, time
available for decision making.
 The nature of the problem itself, possible alternatives to solve the
problem, and undoubtedly clarify with certainty result of
alternatives.
 Condition of Certainty …cont’d

In most situations the solutions are already available from the past
experience or incidents and appropriate for the problem at hand. For
example: The decision to restock food supply, when the stock falls below a
determined level.

In decision making under certainty, the situation can be mapped

as a table with one payoff column (One state of nature).

Therefore, in making a decision, all one has to do is to compare

all the entries in the payoff column and select the alternative with
the highest profit or lowest cost.
 Condition of Certainty …cont’d
In executing such a comparison, one distinguishes between two
cases:
 When the number of alternatives is small, an approach known
as complete enumeration is used.
 When the number of alternatives is large, or even infinite, it is
important to search for the best solutions with the aid of
mathematical models.
  Complete Enumeration
Complete enumeration means examining every payoff, one at a time,
comparing the payoffs to each other and discarding inferior solutions. The
process continues until all payoffs are examined.

Decision making under certainty involves the following steps:

 Determine the alternative courses of action;

 Calculate (assess) the payoffs, one for each course of action;

 Select the one with the best payoff (largest profit or smallest cost)
either by complete enumeration or by the use of mathematical
model.
 Example: Assignment of employees to machines: A maintenance crew of three
mechanists is to be assigned to the repair of three machines on one- to- one basis
in a manner that minimizes repair time. Based on historical data, the supervisor
knows the exact time, which varies with each person-machine match as shown
below in the table.

Machine
A B C
Machinist

4
Jack 3 7
Repair
Time
Gelu 4 6 6

Melat 3 8 5
By comparing the total repair time for all possibilities, it is found that
alternative a6 is the best since the total repair time is the smallest
as shown below.
Alternatives Total payoff
(Total repair time)
a1: Jack-A, Gelu-B, Melat- C 3+6+5= 14
a2: Jack A, Gelu-C, Melat- B 3+6+8 = 18
a3: Jack-B, Gelu-A Melat-C 7 +4+5 =16
a3: Jack-B, Gelu-C, Melat-A 7+6+3 = 16
a5: Jack-C, Gelu-A, Melat-B 4+4+8 = 16
a6: Jack-C, Gelu-B, Melat-A 4+6+3 = 13
2.2. Decision Making Under Condition of Uncertainty
 Decision maker has no information at all about various outcomes
or states of nature.
 No estimates of the probabilities for the occurrence of the
different states of nature are available. Hence, probabilities can
not be used at the choice of the best alternative.
 The decision maker lacks confidence in the state of nature to
make decision.
 Most of the rules for decision making under uncertainty express a
different degree of decision maker´s optimism.
 Condition of Uncertainty …con’d

If the decision maker does not know with certainty which state of nature
will occur, then he/she is said to be making decision under uncertainty.

The five commonly used criteria for decision making under uncertainty
are:

1. The optimistic approach (maximax)

2. The conservative approach (maximin)

3. The minimax regret approach (minimax regret)

4. Equally likely (laplace criterion)

5. Criterion of realism with  (hurwicz criterion)

 Optimistic Approach

• The optimistic approach would be used by an

optimistic decision maker.
• The decision with the largest possible payoff is
chosen.
• If the payoff table was in terms of costs, the
decision with the lowest cost would be chosen.
 Example: Marketing Strategy

Consider the following problem with two decision alternatives (d 1

& d2) and two states of nature S1 (Market Receptive) and S2
(Market Unfavorable) with the following payoff table
representing profits ( $1000):

States of Nature
s1 s3

d1 20 6
Decisions
d2 25 3
 Optimist choice

An optimistic decision maker would use the optimistic

approach. All we really need to do is to choose the decision
that has the largest single value in the payoff table. This
largest value is 25, and hence the optimal decision is d2.
Maximum
Decision Payoff
d1 20
choose d2 d2 25 maximum
 Conservative Approach
• The conservative approach would be used by a conservative
decision maker.
• For each decision the minimum payoff is listed and then the
decision corresponding to the maximum of these minimum payoffs
is selected. (Hence, the minimum possible payoff is maximized.)
• If the payoff was in terms of costs, the maximum costs would be
determined for each decision and then the decision corresponding
to the minimum of these maximum costs is selected. (Hence, the
maximum possible cost is minimized.)
 Example: Marketing Strategy
Consider the following problem with two decision alternatives (d 1
& d2) and two states of nature S1 (Market Receptive) and S2
(Market Unfavorable) with the following payoff table
representing profits ( $1000):

States of Nature
s1 s3

d1 20 6
Decisions
d2 25 3
 Example: Conservatism choice

A conservative decision maker would use the conservative

approach. List the minimum payoff for each decision. Choose
the decision with the maximum of these minimum payoffs.
Minimum
Decision Payoff

choose d1 d1 6 maximum
d2 3
 Minimax Regret Approach

• The minimax regret approach requires the construction of a

regret table or an opportunity loss table.
• This is done by calculating for each state of nature the
difference between each payoff and the largest payoff for that
state of nature.
• Then, using this regret table, the maximum regret for each
possible decision is listed.
• The decision chosen is the one corresponding to the minimum
of the maximum regrets.
 Example: Marketing Strategy
Consider the following problem with two decision alternatives (d 1
& d2) and two states of nature S1 (Market Receptive) and S2
(Market Unfavorable) with the following payoff table
representing profits ( $1000):

States of Nature
s1 s3

d1 20 6
Decisions
d2 25 3
 Example: Minimax Regret choice
For the minimax regret approach, first compute a regret
table by subtracting each payoff in a column from the
largest payoff in that column. The resulting regret table is:
s1 s2 Maximum

d1 5 0 5
d2 0 3 3 minimum

Then, select the decision with minimum regret.

 Equally Likely (Laplace) Criterion

Equally likely, also called Laplace, criterion finds decision

alternative with highest average payoff.
• First calculate average payoff for every alternative.

• Then pick alternative with maximum average payoff.

Average for d1 = (20 + 6)/2 = 13

Average for d2 = (25 + 3)/2 = 14 Thus, d2 is selected

 Criterion of Realism (Hurwicz)
Often called weighted average, the criterion of realism (or Hurwicz)
decision criterion is a compromise between optimistic and a pessimistic
decision.
 First, select coefficient of realism, a, with a value between 0 and
1. When a is close to 1, decision maker is optimistic about
future, and when a is close to 0, decision maker is pessimistic
about future.

 Payoff = a x (maximum payoff) + (1-a) x (minimum payoff)

In our example let  = 0.8

Payoff for d1 = 0.8*20+0.2*6=17.2

Payoff for d2 = 0.8*25+0.2*3=20.6 Thus, select d2

2.3. Decision Making Under Condition of Risk

• In this case, the decision maker doesn´t know which state of

nature will occur but can estimate the probability of occurrence
for each state.
• The probabilities may be subjective (they usually represent
estimates from experts in a particular field), or they may reflect
historical frequencies.
• A widely used approach to decision making under risk is
expected monetary value criterion. There are also other
techniques that can be used to make decision under this
condition.
 2.3.1. Expected Monetary Value Criterion

• The Expected Monetary Value (EMV) of an alternative is

calculated by multiplying each payoff that the alternative can
yield by the probability for the relevant state of nature and
summing the products.
• The value is computed for each alternative, and the one with the
highest EMV is selected.
• Suppose that the grocer can assign probabilities of low,
moderate and high demand on the basis of his experience with
sale of pastry.
• The estimates of these probabilities are 0.3, 0.5, 0.2,
respectively.
• We will recall the payoff table for the considered problem.
 Payoff table:

Demand Low Moderate High

Order

Small 50 50 50

Medium 42 52 52

Large 34 44 54
• The EMV for various sizes of the order are as follows:

 EMV (small) = 0.3*50 + 0.5*50 + 0.2*50 = 50

 EMV (medium) = 0.3*42 + 0.5*52 + 0.2*52 = 49
 EMV (large) = 0.3*34 + 0.5*44 + 0.2*54 = 43
• Therefore, in accordance with the EMV criterion, the small
order should be chosen.
• Note that the EMV of $50 will not be the profit on any one day.
It represents an expected or average profit.
• If the decision were repeated for many days (with the same
probabilities), the grocer would make an average of $50 per day
by ordering the small amount of pastry.
• Even if the decision were not repeated, the action with the
highest EMV is the best alternative that the decision maker has
available.
• The EMV criterion remains as the most useful of all the
decision criteria for decision making under risk.
• For risky decisions, a sensible approach is first to calculate the
EMV, and then to make a subjective adjustment for the risk in
making the choice.
 Exercise:
• If you need to make a decision for investment using the
expected monetary value criterion (EMV), which alternative
do you select ? Recall the following data. (Assume that the
probabilities are 0.5, 0.3 and 0.2 for good economic, medium
economic and poor economic conditions respectively).
State of nature
Alternatives
Good economic Medium condition Poor economic
condition condition
Apartment building $50,000 $45,000 $30,000

Office building $100,000 $70,000 - $40,000

Warehouse building $30,000 $20,000 $10,000

2.3.2. The Expected Opportunity Loss (ELO)
Criterion
• The expected opportunity loss (EOL) is nearly identical to the
EMV approach, except that a table (or matrix) of opportunity
losses (or regrets) is used.

• The opportunity losses for each alternative are weighted by the

probabilities of their respective states of nature and these
products are summed.

• The alternative with the smallest expected loss is selected as the

best choice.
We will use ELO procedure in the regret matrix shown above
Regret table:
Demand Low Moderate High
Order

Small 50 50 50

Medium 42 52 52

Large 34 44 54

Demand Low Moderate High

Order
Small 0 2 4
Medium 8 0 2
Large 16 8 0
• Supposing that the probabilities of various sizes of the demand
are 0.3, 0.5, 0.2, we can determine the EOL for each size of the
order as follows:
 EOL (small) = 0.3*0 + 0.5*2 + 0.2*4 = 1.8
 EOL (medium) = 0.3*8 + 0.5*0 + 0.2*2 = 2.8
 EOL (large) = 0.3*16 + 0.5*8 + 0.2*0 = 8.8
• Since the small order is connected with the smallest EOL, it is
the best alternative.

• The EOL approach resulted in the same alternative as the EMV

approach.

• The two methods always result in the same choice, because

maximizing the payoffs is equivalent to minimizing the
opportunity losses.
 Exercise:
• Make a decision for selection of a type of investment to be made
using EOL criterion by recalling the following data ( Assume
probabilities of 0.3, 0.5 and 0.2 for good, medium and poor
economic conditions respectively).
State of nature
Alternatives
Good economic Medium condition Poor economic
condition condition
Apartment building $50,000 $45,000 $30,000
Office building $100,000 $70,000 - $40,000
Warehouse building $30,000 $20,000 $10,000
 2.3.3. Decision Tree Analysis
• Decision tree is a graphical diagram consisting of nodes and
branches.
• In a decision tree, the user computes the expected value of each
outcome and makes a decision based on these expected values.
• The primary benefit of a decision tree is that it provides an
illustration (picture) of the decision making process which makes
the decision making process easier.
• A decision tree is composed of nodes and branches (arcs).

• The terminology of nodes and arcs comes from network models which
have a similar pictorial representation.
• A decision tree has three types of nodes: decision nodes, chance event
nodes, and terminating nodes.
 Decision nodes: are denoted by squares.

 Each decision node has one or more arcs beginning at the node
and extending to the right.

 Each of those arcs represents a possible decision alternative at

that decision point
Chance event nodes: are denoted by circles.
Each chance event node has one or more arcs beginning at the node
and extending to the right.

Each of those arcs represents a possible event at that chance event

point. The decision maker has no control over these chance events.

The events associated with branches from any chance event node
must be mutually exclusive and all events included.

The probability of each event is conditional on all of the decision

alternatives and chance events that precede it on the decision tree.

The probabilities for all of the arcs beginning at a chance event node
must sum to 1.
 A terminating node: represents the end of the sequence of
decisions and chance events.

 No arcs extend to the right from a terminating node.

 Terminating nodes are the starting points for the

computations needed to analyze the decision tree.
Format of a decision tree
 Analysis of Decision Trees
 After the tree has been drawn, it is analyzed from right to left.

 The aim of this analysis is to determine the best strategy of the

decision maker, that means an optimal sequence of the decisions.
 To analyze a decision tree, we must know a decision criterion,
probabilities that are assigned to each event, and revenues and
costs for the decision alternatives and the chance events that
occur.
 Analyzing a decision tree, we begin at the end of the tree and
work backwards.
 We carry out two kinds of calculations:
i. For chance event nodes, we calculate the events emanating
from these nodes.

Under the assumption that the decision maker has a neutral

attitude toward risk, certainty equivalent of uncertain
outcomes can be replaced by their expected value.

i. At decision nodes, the alternative with the best expected

value of the decision criterion is selected.
 The analysis of a decision tree is illustrated by the following
example.

 A firm is deciding between two alternatives: to introduce a new

product or to keep the existing product. Introducing a new product
has uncertain outcomes in dependence on the demand. If the demand
is high, the resulting profit of the firm will be 140. The low demand
will be result in the profit will be 80. The firm estimates the
probabilities of a high and low demand 0.7 and 0.3, respectively. If
the firm keeps the existing product, its profit will be 110.
 The decision tree for the above decision problem can be shown
as follows: (If the alternative not to be chooses, (// ) will be
used.
 Example1:

 The estimated profit is written at the end of the chance branches.

 The probabilities of a high and a low demand for the new product are
written below the branches leaving the chance node.
 The nodes are numbered.
 For the chance node 2, we calculate the expected value of the
profit (0.7*140 + 0.3*80 = 122) and write this value over the node
2.
 At the decision node 1, we select the decision alternative with the
higher expected profit. Because max (122;110) = 122, introducing
the new product is profitable.
 We write the maximum expected profit over the node 1 and draw
double lines (//) through the branch representing the inferior
(worse) decision alternative.
Exercise :
 Formulate the tree that represents a decision tree for the order
planning problem given in the following table with the
probabilities of 0.3, 0.5 and 0.2 for low, moderate and high
demand respectively. Them make a decision.
 The decision tree for order planning:
 The use of a decision table in comparison with the use of a
decision tree may seem easier and simpler when the decision
problem becomes simple.
 As the decision problem becomes more complex, the decision
tree becomes more valuable in organizing the information
needed to make the decision.
 This is especially true if the decision maker must make a
sequence of decisions, rather than a single decision, as the next
example illustrates.