DECISION THEORY

Decision theory problems are characterized by the following:

1. List of alternatives: - must be a set of mutually exclusive and collectively
exhaustive decisions that are available to the decision maker (some times, 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.
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 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 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 if 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
A1 4 16 12
A2 5 6 10
A3 -1 4 15
if we know that S2 will occur, the decision maker then can focus on the first column
of the payoff table. Because alternative A1 has the largest profit (16), it would be
selected.
DECISION MAKING UNDER COMPLETE UNCERTAINTY
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.
Decisions made under these circumstances are at the opposite end of the spectrum
from the certainty case just mentioned. There are four approaches to decision making
under complete uncertainty. They are:
1. MAXIMIN
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; the actual payoff can not be less than this amount.
For the previous problem:

S1 S2 S3 Row minimum
A1 4 16 12 4
A2 5 6 10 5*maximum
A3 -1 4 15 -1
A2 will be chosen.
2. MAXIMAX
This approach is the opposite of the previous one: 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
A1 4 16 12 16*maximum
A2 5 6 10 10
A3 -1 4 15 15
A1 will be chosen.
 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.
A1 -5 16 -10 16*max
A2 15 15 15 15
A3 15 15 15 15
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.
EXAMPLE
S1 S2 S3
A1 4 16 12
A2 5 6 10
A3 -1 4 15
opportunity loss table:
S1 S2 S3
A1 5-4=1 16-16=0 15-12=3
A2 5-5=0 16-6=10 15-10=5
A3 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
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

A1 will be chosen.
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
A1 0 0 0 24 24
A2 15 15 15 0 15*minimum
A3 15 15 15 0 15*minimum
4. PRINCIPLE OF INSUFFICIENT REASON
The Minimax regret criterion 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 were 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
A1 28 28 28 28 4 23.2*maximum
A2 5 5 5 5 28 9.6
A3 5 5 5 5 28 9.6
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.
DECISION MAKING UNDER RISK
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.
*the sum of the probabilities for all states of nature must be 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 = k
Σ Pj.Vij
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.
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
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.
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 that the EOL approach resulted in the same alternative as the EMV approach
(Maximizing the payoffs is equivalent to minimizing the opportunity losses).

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.
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 that 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.
COMMENT
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.
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:

A tree is composed of squares, circles, and lines:

- The squares indicate decision points
- Circles represent chance events
- The lines from squares represent alternatives
- The lines from circles represent states of nature
- The tree is read from right to left.
It should be noted that although decision trees represent an alternative approach to payoff
tables, they are not commonly used for problems that involve a single decision. Rather,
their greatest benefit lies in portraying sequential decisions (i.e., a series of chronological
decisions). In the case of a single decision, constructing a decision tree can be
cumbersome and time consuming.