Chapter 20 PowerPoint

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Chapter
Twenty
McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved.

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Chapter Twenty
An Introduction to Decision
Theory
GOALS
When you have completed this chapter, you
will
ONE be able to:
Define the terms: state of nature, event, act, and payoff.
TWO
Organize information into a payoff table or a decision tree.
THREE
Find the expected payoff of a decision alternative.
FOUR
Compute opportunity loss and expected opportunity loss.
FIVE
Assess the expected value of information. Goals
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Classical Statistics Statistical

focuses on estimating a Decision Theory
parameter, such as the (Bayesian statistics) is
population mean,
concerned with
constructing confidence
intervals, or hypothesis determining which
testing. decision, from a set of
possible decisions, is
optimal.
Statistical Decision Theory

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Three components to decision-making situation
The available choices
(alternatives or
acts)
The states of nature,

which are not under the
The payoffs - needed
control of the decision
for each combination of
maker - uncontrollable
decision alternative and
future events
state of nature
Elements of a Decision
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A Payoff Table is a listing of all possible

combinations of decision alternatives and states
of nature.
The Expected Payoff or the

Expected Monetary Value (EMV)
is the expected value for each decision.
Payoff Table and Expected Payoff

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 Let Ai be the ith decision alternative.

 Let P(Sj) be the probability of the jth state of
nature.
 Let V(Ai, Sj) be the value of the payoff for the
combination of decision alternative Ai and state

of nature Sj.
 LetEMV (Ai) be the expected monetary value
for the decision alternative Ai.
EMV ( Ai )  [ P( S j )  V ( Ai , S j )]
Calculating the EMV

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The following payoff table (profit) was developed.

Let P(S1)=.5, P(S2)=.3, and P(S3)=.2. Compute the
EMV for each of the alternatives.
Alternative S1 S2 S3
A1 50 70 100
A2 40 80 90
A3 90 70 60
Example 1
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EMV (A1)=(.5)(50)+(.3)(70)+(.2)(100)=66
EMV (A2) =(.5)(40)+(.3)(80)+(.2)(90)=62
EMV (A3) =(.5)(90)+(.3)(70)+(.2)(60)=78
What
decision
would you
recommend
Choose alternative ?
A3 because it gives
the largest expected
monetary value or
expected payoff.
Example 1 continued
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Opportunity Loss or Regret

is the loss because the exact
state of nature is not known at
the time a decision is made.
The opportunity loss is computed by

taking the difference between the
optimal decision for each state of nature
and the other decision alternatives.
Opportunity Loss
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OPPORTUNITY LOSS TABLE
Alternative S1 S2 S3
A1 40 10 0
A2 50 0 10
A3 0 10 40
Example 1 continued
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 Let Ai be the ith decision alternative.

 Let P(Sj) be the probability of the jth state of nature.
 LetR(Ai,Sj) be the value of the regret for the
combination of decision alternative Ai and state of
nature Sj.
 LetEOL(Ai) be the expected opportunity loss for the
decision alternative Ai.
EOL(Ai) =  [P(Sj)*R(Ai,Sj)]
Expected Opportunity Loss

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EOL(A1) =(.5)(40)+(.3)(10)+(.2)(0)=23
EOL(A2) =(.5)(50)+(.3)(0)+(.2)(10)=27 What decision
EOL(A3) =(.5)(0)+(.3)(10)+(.2)(40)=11 would you make
based on the
lowest expected
opportunity
Choose alternative A3 since it gives loss?
the smallest expected opportunity
loss.
Note: This decision is the same
when using the highest expected
payoff. These two approaches will
always lead to the same decision.
Example 1 continued
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Maximin Strategy
maximizes the minimum
gain (pessimistic strategy)
Maximax Strategy
maximizes the maximum
gain (optimistic strategy)
Minimax Regret Strategy

- minimizes the maximum
opportunity loss
Maximin, Maximax, and
Minimax Regret Strategies
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Under the maximax
Under the maximin strategy, what profit are
strategy, what profit you expecting? From the
are you expecting?
From the initial initial payoff table, the
payoff table, the profit will be $100.
profit will be $60.
Under the minimax regret

strategy, what will be your
strategy? From the
opportunity loss table, the
strategy would be to select A1
or A3 since these minimize the EXAMPLE 1 continued
maximum regret.
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What is the worth of information known
in advance before a strategy
is employed?
Expected Value of Perfect Information

(EVPI) is the difference between the expected
payoff if the state of nature were known and the
optimal decision under the conditions of uncertainty.
From Example 1
EVPI = [(.5)(90)+(.3)(80)+(.2)(100)] - 78 = 11
Value of Perfect Information
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Sensitivity Decision Trees

Analysis are useful for
examines the effects structuring the various
of various alternatives. They
probabilities for the present a picture of the
states of nature on various courses of
the expected values action and the possible
for the decision states of nature.
alternatives.
Sensitivity Analysis and

Decision Trees
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$ 2 ,4 0 0
$ 1 ,8 4 0
$ 1 ,0 0 0
$ 2 ,2 0 0
B u y R im $ 1 ,7 6 0
$ 1 ,1 0 0
$ 1 ,6 0 0
$ 1 ,9 0 0
$ 1 ,1 5 0
Buy Texas payoff of

Example 2
$1600 = .40($1,150) + .60($1,900)
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E x p e c te d V a lu e u n d e r C o n d itio n s o f C e r ta in ty
$ 2 ,4 0 0
$ 2 ,4 0 0
B u y R im $ 2 ,2 0 0
$ 1 ,9 0 0
$ 1 ,0 0 0
B u y R im
$ 1 ,1 0 0
$ 1 ,1 5 0
$ 1 ,1 5 0
Example 2 continued

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McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved.

Classical Statistics Statistical

Statistical Decision Theory

The states of nature,

A Payoff Table is a listing of all possible

The Expected Payoff or the

Payoff Table and Expected Payoff

 Let Ai be the ith decision alternative.

combination of decision alternative Ai and state

Calculating the EMV

The following payoff table (profit) was developed.

Opportunity Loss or Regret

The opportunity loss is computed by

OPPORTUNITY LOSS TABLE

 Let Ai be the ith decision alternative.

Expected Opportunity Loss

Minimax Regret Strategy

Under the minimax regret

Expected Value of Perfect Information

Sensitivity Decision Trees

Sensitivity Analysis and

Buy Texas payoff of

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