Chapter 4

Decision Theory
5.1. INTRODUCTION
The success or failure that an individual or organization experiences, depends to a large extent,
on the ability of making acceptable decisions on time. To arrive at such a decision, a decision-
maker needs to enumerate feasible and viable courses of action (alternatives or strategies), the
projection of consequences associated with each course of action, and a measure of effectiveness
(or an objective) to identify the best course of action.
Decision theory is both descriptive and prescriptive business modeling approach to classify the
degree of knowledge and compare expected outcomes due to several courses of action. The
degree of knowledge is divided into four categories: complete knowledge (i.e. certainty),
ignorance, risk and uncertainty.
5.2. TYPES OF DECISION-MAKING ENVIRONMENTS
To arrive at an optimal decision it is essential to have an exhaustive list of decision-alternatives,
knowledge of decision environment, and use of appropriate quantitative approach for decision-
making. In this section three types of decision-making environments: certainty, uncertainty, and
risk, have been discussed. The knowledge of these environments helps in choosing the
quantitative approach for decision-making.
Type 1 Decision-Making under Certainty
In this decision-making environment, decision-maker has complete knowledge (perfect
information) of outcome due to each decision-alternative (course of action). In such a case he
would select a decision alternative that yields the maximum return (payoff) under known state of
nature.
Type 2 Decision-Making under Risk
In this decision-environment, decision-maker does not have perfect knowledge about possible
outcome of every decision alternative. It may be due to more than one states of nature. In such a
case he makes an assumption of the probability for occurrence of particular state of nature.
Type 3 Decision-Making under Uncertainty
In this decision environment, decision-maker is unable to specify the probability for occurrence
of particular state of nature. However, this is not the case of decision-making under ignorance,
because the possible states of nature are known. Thus, decisions under uncertainty are taken even
with less information than decisions under risk.
4.3. DECISION-MAKING UNDER UNCERTAINTY
When probability of any outcome cannot be quantified, the decision-maker must arrive at a
decision only on the actual conditional payoff values, keeping in view the criterion of

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effectiveness (policy). The following criteria of decision-making under uncertainty have been
discussed in this section.
(i) Optimism (Maximax or Minimin) criterion
(ii) Pessimism (Maximin or Minimax) criterion
(iii) Equal probabilities (Laplace) criterion
(iv) Coefficient of optimism (Hurwiez) criterion
(v) Regret (salvage) criterion
1) Optimism (Maximax or Minimin) Criterion
In this criterion the decision-maker ensures that he should not miss the opportunity to achieve the
largest possible profit (maximax) or the lowest possible cost (minimin). Thus, he selects the
decision alternative that represents the maximum of the maxima (or minimum of the minima)
payoffs (consequences or outcomes). The working method is summarized as follows:
(a) Locate the maximum (or minimum) payoff values corresponding to each decision
alternative.
(b) Select a decision alternative with best payoff value (maximum for profit and minimum
for cost).
Since in this criterion, the decision-maker selects a decision-alternative with largest (or lowest)
possible payoff value, it is also called an optimistic decision criterion.
2) Pessimism (Maximin or Minimax) Criterion
In this criterion the decision-maker ensures that he would earn no less (or pay no more) than
some specified amount. Thus, he selects the decision alternative that represents the maximum of
the minima (or minimum of the minima in case of loss) payoff in case of profits. The working
method is summarized as follows:
(a) Locate the minimum (or maximum in case of profit) payoff value in case of loss (or cost)
data corresponding to each decision alternative.
(b) Select a decision alternative with the best payoff value (maximum for profit and
minimum for loss or cost).
Since in this criterion the decision-maker is conservative about the future and always anticipates
the worst possible outcome (minimum for profit and maximum for cost or loss), it is called a
pessimistic decision criterion. This criterion is also known as Wald’s criterion.
3) Equal Probabilities (Laplace) Criterion
Since the probabilities of states of nature are not known, it is assumed that all states of nature
will occur with equal probability, i.e. each state of nature is assigned an equal probability. As
states of nature are mutually exclusive and collectively exhaustive, so the probability of each of
these must be: 1/(number of states of nature). The working method is summarized as follows:

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 (a) Assign equal probability value to each state of nature by using the formula:
1 ÷ (number of states of nature).
(b) Compute the expected (or average) payoff for each alternative (course of action) by
adding all the payoffs and dividing by the number of possible states of nature, or by
applying the formula:
(Probability of state of nature j ) × (Payoff value for the combination of alternative I and
state of nature j.)
(c) Select the best expected payoff value (maximum for profit and minimum for cost).
This criterion is also known as the criterion of insufficient reason. This is because except in a
few cases, some information of the likelihood of occurrence of states of nature is available.
4) Coefficient of Optimism (Hurwicz) Criterion
This criterion suggests that a decision-maker should be neither completely optimistic nor
pessimistic and, therefore, must display a mixture of both. Hurwicz, who suggested this criterion,
introduced the idea of a coefficient of optimism (denoted by α) to measure the decision-maker’s
degree of optimism. This coefficient lies between 0 and 1, where 0 represents a complete
pessimistic attitude about the future and 1 a complete optimistic attitude about the future. Thus,
if α is the coefficient of optimism, then (1 – α) will represent the coefficient of pessimism.
The Hurwicz approach suggests that the decision-maker must select an alternative that
maximizes:
H (Criterion of realism) = α (Maximum in column) + (1 – α ) (Minimum in column)
The working method is summarized as follows:
(a) Decide the coefficient of optimism α (alpha) and then coefficient of pessimism (1 – α).
(b) For each decision alternative select the largest and lowest payoff value and multiply these
with α and (1 – α) values, respectively. Then calculate the weighted average, H by using
above formula.
(c) Select an alternative with best weighted average payoff value.
5) Regret (Savage) Criterion
This criterion is also known as opportunity loss decision criterion or minimax regret decision
criterion because decision-maker regrets for choosing wrong decision alternative resulting in an
opportunity loss of payoff. Thus, he always intends to minimize this regret. The working method
is summarized as follows:
(a) From the given payoff matrix, develop an opportunity- loss (or regret) matrix as
follows:
(i) Find the best payoff corresponding to each state of nature
(ii) Subtract all other payoff values in that row from this value.

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 (b) For each decision alternative identify the worst (or maximum regret) payoff value.
Record this value in the new row.
(c) Select a decision alternative resulting in a smallest anticipated opportunity- loss value.
Example 1
A food products’ company is contemplating the introduction of a revolutionary new product with
new packaging or replacing the existing product at much higher price (S1). It may even make a
moderate change in the composition of the existing product, with a new packaging at a small
increase in price (S2), or may mall a small change in the composition of the existing product,
backing it with the word ‘New’ and a negligible increase in price (S3). The three possible states
of nature or events are: (i) high increase in sales (N1), (ii) no change in sales (N2) and (iii)
decrease in sales (N3). The marketing department of the company worked out the payoffs in
terms of yearly net profits for each of the strategies of three events (expected sales). This is
represented in the following table:

Which strategy should the concerned executive choose on the basis of

(a) Maximin criterion
(b) Maximax criterion
(c) Minimax regret criterion
(d) Laplace criterion?
Solution
The payoff matrix is rewritten as follows:
(a) Maximin Criterion

The maximum of column minima is 300,000. Hence, the company should adopt strategy S3.

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(b) Maximax Criterion

The maximum of column maxima is 7,00,000. Hence, the company should adopt strategy S1.
(c) Minimax Regret Criterion Opportunity loss table is shown below:

Hence the company should adopt minimum opportunity loss strategy, S1.
(d) Laplace Criterion Assuming that each state of nature has a probability 1/3 of occurrence.
Thus,

Since the largest expected return is from strategy S1, the executive must select strategy S1.

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4.4. DECISION-MAKING UNDER RISK
In this decision-making environment, decision-maker has sufficient information to assign
probability to the likely occurrence of each outcome (state of nature). Knowing the probability
distribution of outcomes (states of nature), the decision-maker needs to select a course of action
resulting a largest expected (average) payoff value. The expected payoff is the sum of all
possible weighted payoffs resulting from choosing a decision alternative.
The widely used criterion for evaluating decision alternatives (courses of action) under risk is the
Expected Monetary Value (EMV) or Expected Utility.
1) Expected Monetary Value (EMV)
The expected monetary value (EMV) for a given course of action is obtained by adding payoff
values multiplied by the probabilities associated with each state of nature. Mathematically, EMV
is stated as follows:

Where m = number of possible states of nature

pi = probability of occurrence of state of nature, Ni
pij = payoff associated with state of nature Ni and course of action, Sj

The Procedure
1) Construct a payoff matrix listing all possible courses of action and states of nature. Enter the
conditional payoff values associated with each possible combination of course of action and
state of nature along with the probabilities of the occurrence of each state of nature.
2) Calculate the EMV for each course of action by multiplying the conditional payoffs by the
associated probabilities and adding these weighted values for each course of action.
3) Select the course of action that yields the optimal EMV.
Example
Mr Abebe flies quite often from Hawassa to Addis Ababa. He can use the airport bus which costs
Birr 25 but if he takes it, there is a 0.08 chance that he will miss the flight. The stay in a hotel
costs Birr 270 with a 0.96 chance of being on time for the flight. For Birr 350 he can use a taxi
which will make 99 per cent chance of being on time for the flight. If Mr Abebe catches the
plane on time, he will conclude a business transaction that will produce a profit of Birr 10,000,
otherwise he will lose it. Which mode of transport should Mr Abebe use? Answer on the basis of
the EMV criterion.
Solution
Computation of EMV associated with various courses of action is shown in the Table below.

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 Courses of Action
State of
Airport Bus Stay in Hotel Taxi
Nature
Expected Expected Expected
Cost Prob. Cost Prob. Cost Prob.
Value Value Value

Catch the 10,000- 10000- 10000-

flight 25 0.92 9177 270 0.96 9340.80 350 0.99 9553.50
= 9975 = 9730 = 9650
M iss the
-25 0.08 -2.0 -270 0.04 -10.80 -350 0.01 -3.50
flight

EMV 9175 9330 9550

Since EMV associated with course of action ‘Taxi’ is largest (= Birr 9,550), it is the logical
alternative.
2) Expected Opportunity Loss (EOL)
Expected opportunity loss (EOL), also called expected value of regret, is an alternative decision
criterion for decision making under risk. The EOL is defined as the difference between the
highest profit (or payoff ) and the actual profit due to choosing a particular course of action in a
particular state of nature. Hence, EOL is the amount of payoff that is lost by not choosing a
course of action resulting to the minimum payoff in a particular state of nature. A course of
action resulting to the minimum EOL is preferred. Mathematically, EOL is stated as follows.

Where lij = opportunity loss due to state of nature, Ni and course of action, Sj
pi = probability of occurrence of state of nature, Ni

The Procedure
1. Prepare a conditional payoff values matrix for each combinatio n of course of action and
state of nature along with the associated probabilities.
2. For each state of nature calculate the conditional opportunity loss (COL) values by
subtracting each payoff from the maximum payoff.
3. Calculate the EOL for each course of action by multiplying the probability of each state
of nature with the COL value and then adding the values.
4. Select a course of action for which the EOL is minimum.

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Example
A company manufactures goods for a market in which the technology of the product is changing
rapidly. The research and development department has produced a new product that appears to
have potential for commercial exploitation. A further Birr 60,000 is required for development
testing.
The company has 100 customers and each customer might purchase, at the most, one unit of the
product. Market research suggests that a selling price of Birr 6,000 for each unit, with total
variable costs of manufacturing and selling estimate as Birr 2,000 for each unit.
From previous experience, it has been possible to derive a probability distribution relating to the
proportion of customers who will buy the product as follows:
Proportion of customers : 0.04 0.08 0.12 0.16 0.20
Probability : 0.10 0.10 0.20 0.40 0.20

Determine the expected opportunity losses, given no other information than that stated above,
and state whether or not the company should develop the product.
Solution
If p is the proportion of customers who purchase the new product, the company’s conditional
profit is: (6,000 – 2,000) × 100 p – 60,000 = Birr (400,000 p – 60,000).
Let Ni (i = 1, 2, …, 5) be the possible states of nature, i.e. proportion of the customers who will
buy the new product and S1 (develop the product) and S2 (do not develop the product) be the two
courses of action.
The conditional profit values (payoffs) for each pair of Nis and Sjs are shown in Table below.
Proportion of Conditional Profit = Birr (4,00,000 p – 60,000)
Customers Course of Action
(State of Nature) S1 S2
(Develop) (Do not Develop)
0.04 -44,000 0
0.08 -28,000 0
0.12 -12,000 0
0.16 4,000 0
0.2 20,000 0

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Opportunity loss values are shown in the following Table.
Proportion of Probability Conditional Profit Opportunity Loss (Birr)
Customers
(State of Nature) S1 S2 S1 S2

0.04 0.1 -44,000 0 44,000 0

0.08 0.1 -28,000 0 28,000 0

0.12 0.2 -12,000 0 12,000 0

0.16 0.4 4,000 0 0 4,000
0.2 0.2 20,000 0 0 20,000

Using the given estimates of probabilities associated with each state of nature, the expected
opportunity loss (EOL) for each course of action is given below:
EOL (S1 ) = 0.1 (44,000) + 0.1 (28,000) + 0.2 (12,000) + 0.4 (0) + 0.2 (0) = Birr 9,600
EOL (S2 ) = 0.1 (0) + 0.1 (0) + 0.2 (0) + 0.4 (4,000) + 0.2 (20,000) = Birr 5,600
Since the company seeks to minimize the expected opportunity loss, the company should select
course of action S2 (do not develop the product) with minimum EOL.

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