Decision Theory

Introduction
 What makes the difference between good and bad decisions?
 Good decisions may be defined as:
 Based on logic,
 Considered all possible decision alternatives,
 Examined all available information about future, and
 Applied decision modeling approach.
 Bad decisions may be defined as:
 Not based on logic,
 Did not use all available information,
 Did not consider all alternatives, and
 Did not employ appropriate decision modeling techniques.
 Decision Analysis

A set of quantitative decision-making

techniques for decision situations where
uncertainty exists
 Decision Theory Elements
 A set of possible future conditions exists that
will have a bearing on the results of the decision
 A list of alternatives (courses of action) for the
manager to choose from
 A known payoff for each alternative under each
possible future condition
 Decision Making

States of nature
 Events that may occur in the future
 Decision maker is uncertain which state of
nature will occur
 Decision maker has no control over the states
of nature
 Decision Theory

Decision Theory represents a general approach to

decision making which is suitable for a wide range
of operations management decisions, including:

capacity product
product and
and
planning service
service design
design

location equipment
planning selection
 Five Steps of Decision Making

1. Clearly define the problem at hand.

2. List all possible decision alternatives.
3. Identify possible future events (states of nature)
4. Identify payoff (usually, profit or cost) for each
combination of alternatives and events.
5. Select one of the decision theory modeling
techniques, apply decision model, and make decision.
 Thompson Lumber Company (1 of 2)
Step 1. Identifies problem as:
whether to expand product line by manufacturing and
marketing new product which is “backyard storage
sheds.”
Step 2. Generate decision alternatives available.
Decision alternative is defined as course of action or
strategy that may be chosen by the decision maker.
Alternatives are to construct:
(1) a large plant to manufacture storage sheds,
(2) a small plant to manufacture storage sheds, or
(3) build no plant at all.
Step 3. Identify possible future events
 Thompson Lumber Company (2 of 2)

Step 4. Express payoff resulting from each possible

combination of alternatives and events.
Objective is to maximize profits.
Step 5. Select decision theory model and apply it to
data to help make decision.
Type of decision model available depends on the
operating environment and the amount of uncertainty
and risk involved.
 Payoff Table
 A method of organizing & illustrating the payoffs from
different decisions given various states of nature

 A payoff is the outcome of the decision

 Payoff Tables
Payoff Tables can be constructed when there is a finite set
of discrete decision alternatives.

In a Payoff Table -
The rows correspond to the possible decision
alternatives.
The columns correspond to the possible future events.
Events (States of Nature) are mutually exclusive
The body of the table contains the payoffs.
 Payoff Table

States of Nature
Decision a b
1 Payoff 1a Payoff 1b
2 Payoff 2a Payoff 2b
Payoff Table:Thompson Lumber Company
 Types Of Decision Making
Environments

Type 1: Decision Making under Certainty

Type 2: Decision Making under Uncertainty
Type 3: Decision Making under Risk.
Types Of Decision Making Environments

 Type 1: Decision Making under Certainty. Decision

maker knows with certainty the consequence of every
decision alternative. (The future state of nature is
assumed to be known.)
Type 2: Decision Making under Uncertainty. Decision
maker has no information about various outcomes.
(There is no knowledge about the probability of the states
of nature occurring)
 Types Of Decision Making Environments
 Type 3: Decision Making under Risk. Decision maker
has some knowledge regarding the probability of
occurrence of each event or state of nature. (There is
some knowledge about the probability of the states of
nature occurring)
Decision Making Under Uncertainty
 Decision Making Under Uncertainty-
Steps of :
• Construct a Payoff Table
• Select a Decision Making Criterion
• Apply the Criterion to the Payoff Table
• Identify the Optimal Solution
 Decision Making Under Uncertainty

The decison criteria are based on the decision

maker’s attitude toward life
These include an individual being pessimistic
or optimistic, conservative or aggressive
 Decision Making Criteria Under Uncertainty
 Criteria for making decisions under
uncertainty.
 Maximax.
 Maximin
 Equally likely.
 Criterion of realism.
 Minimax regret.
 First four criteria calculated directly from
decision payoff table.
 Fifth minimax regret criterion requires use of
opportunity loss table.
 Maximax Criterion (1 of 2)
 Maximax criterion selects the alternative that
maximizes maximum payoff over all alternatives.
 Is based on the best possible scenario.
 First locate maximum payoff for each alternative.
 Select alternative with maximum value.
 Decision criterion locates alternative with highest
possible gain.
 Called optimistic criterion.
 Table shows maximax choice is first alternative:
"construct large plant."
 Maximax Criterion (2 of 2)
Example 1: Thompson Lumber Company
 Maximax criterion selects alternative that maximizes maximum
payoff over all alternatives.
 First alternative, "construct a large plant”, $200,000 payoff is
maximum of maximum payoffs for each decision alternative.
 Maximin Criterion (1 of 2)
 Maximin criterion finds the alternative that maximizes
minimum payoff over all alternatives.
 Is based on the worst-case scenario.
 First locate minimum payoff for each decision alternative
across all states of nature.
 Select the alternative with the maximum value.
 Decision criterion locates the alternative that has the least
possible loss.
 Called pessimistic criterion.
 Maximin choice, "do nothing," is shown in table.
 $0 payoff is maximum of minimum payoffs for each
alternative.
 Maximin Criterion (2 of 2)
Example 1. Thompson Lumber Company
First locate minimum payoff for each alternative, and select the
alternative with maximum number.
 Equally Likely (Laplace) Criterion (1 of 2)
 Equally likely, also called Laplace, criterion finds decision
alternative with highest average payoff (here the
probabilities of each state of nature is assumed to be equal)
 Calculate average payoff for every alternative.
 Pick the alternative with maximum average payoff.
 Assumes all probabilities of occurrence for states of nature
are equal.
 Equally likely choice is the second alternative, "construct a
small plant."
 Strategy shown in table has maximum average payoff
($40,000) over all alternatives.
Equally Likely (Laplace) Criterion (2 of 2)
Example 1. Thompson Lumber Company
 Equally likely criterion finds decision alternative with highest
average payoff.
 Calculate average payoff for every alternative.
 Pick alternative with maximum average payoff.
 Criterion of Realism (Hurwicz)(1 of 3)

 Often called weighted average, the criterion of

realism (or Hurwicz) decision criterion is a
compromise between optimistic and pessimistic
decision.
 Select coefficient of realism, , with value between 0
and 1.
– When  is close to 1, decision maker is optimistic
about future.
– When  is close to 0, decision maker is pessimistic
about future.  
 Criterion of Realism (2 of 3)

Formula for criterion of realism =

(maximum payoff for alternative) +

(1-) (minimum payoff for alternative)

 Assume coefficient of realism  0.80.

 Best decision would be to construct a large plant.

 This alternative has highest weighted average payoff:

$124,000
 Criterion of Realism (3 of 3)
Example 1. Thompson Lumber Company
Coefficient of realism 0.80.
$124,000 = (0.80)($200,000) + (0.20)(- $180,000).
 Minimax Regret Criterion (1 of 5)
 Final decision criterion is based on opportunity loss.
 Develop opportunity loss (regret) table.
 Determine opportunity loss of not choosing the best
alternative for each state of nature (or the regret by failing
to choose the “best” decision)
 Minimax Regret Criterion (2 of 5)
 Opportunity loss, also called regret for any state of
nature, or any column is calculated by subtracting
each outcome in column from best outcome in the
same column.
 The alternative with the minimum of the maximum
regrets for each alternative is selected.
 Minimax Regret Criterion (3 of 5)
Example 1. Thompson Lumber Company
• Best outcome for favorable market is $200,000 as
result of first alternative, "construct a large plant."
• Subtract all payoffs in column from $200,000.
• Best outcome for unfavorable market is $0 that is the
result of third alternative, "do nothing."
• Subtract all payoffs in column from $0.
• Table illustrates computations and shows complete
opportunity loss table.
 Minimax Regret Criterion (4 of 5)
Example 1. Thompson Lumber Company
• Table illustrates computations and shows complete opportunity
loss table.
 Minimax Regret Criterion (5 of 5)
Example 1. Thompson Lumber Company
• Once the opportunity loss table has been constructed, locate the
maximum opportunity loss within each alternative.
• Pick the alternative with minimum value
• Minimax regret choice is second alternative, "construct a small
plant." Regret of $100,000 is minimum of maximum regrets
over all alternatives.
Tom Brown Investment Example for
Decision Making Under Uncertainty
Example 2. Tom Brown Investment Decision

Tom Brown has inherited $1000.

He has decided to invest the money for one year.
A broker has suggested five potential investments.
1. Gold.
2. Junk Bond.
3. Growth Stock.
4. Certificate of Deposit.
5. Stock Option Hedge.
Tom has to decide how much to invest in each investment.
 The Payoff Table
Example 2. Tom Brown Investment Decision
States
StatesofofNature
Nature
Decision
Decision Alternatives
Large
Large Rise
Alternatives RiseSmall
SmallRise
RiseNo
No Change
Change Small
SmallFall
Fall Large
LargeFall
Fall
Gold
Gold -100
-100 100
100 200
200 300
300 00
Bond
Bond 250
250 200
200 150
150 -100
-100 -150
-150
Stock
Stock 500
500 250
250 100
100 -200
-200 -600
-600
C/D
C/DAccount
Account 60
60 60
60 60
60 60
60 60
60
Stock
StockOption
OptionHedge
Hedge 2200
00 150
150 150
150 -200
-200 -150
-150

The Stock Option Alternative is dominated by the

Bond Alternative
 Maximax Criterion
Example 2. Tom Brown Investment Decision Th
eO
pti
ma
The Maximax criterion ld Maximum
Decision Large rise Small rise No changeSmall fall Large ec fall Payoff
isi
Gold -100 100 200 300 0 on 300
Bond 250 200 150 -100 -150 200
Stock 500 250 100 -200 -600 500
C/D 60 60 60 60 60 60
 The Maximin Criterion

Example 2. Tom Brown Investment TDecision he

Op
TheTheMaximin
MaximinCriterion
Criterion tim Minimum
Minimum
a
Decisions
Decisions LargeRrise
LargeRrise Small
SmallRise
Rise No
Nochange
change Small Falll deLarge
SmallFall LargeFall
Fall Payoff
Payoff
Gold -100 100 200 300 cis 0 -100
Gold -100 100 200 300 io0n -100
Bond
Bond 250
250 200
200 150
150 -100
-100 -150
-150 -150
-150
Stock
Stock 500
500 250
250 100
100 -200
-200 -600
-600 -600
-600
C/D
C/Daccount
account 60
60 60
60 60
60 60
60 60
60 60
60
 Minimax Regret Criterion
T e
Example 2. Tom Brown Investment hDecision
Opt
im a
l de
cisi
Regret Table on
Decision Large rise Small rise No changeSmall fall Large fall regret
Gold 600 150 0 0 60 600
Bond 250 50 50 400 210 400
Stock 0 0 100 500 660 660
C/D 440 190 140 240 0 440
Decision Making Under Risk
 Decision Making Under Risk
 Common for decision maker to have some idea about the
probabilities of occurrence of different outcomes or
states of nature.
 Probabilities may be based on decision maker’s personal
opinions about future events, or on data obtained from
market surveys, expert opinions, etc.
 When probability of occurrence of each state of nature
can be assessed, problem environment is called decision
making under risk.
 Expected Monetary Value (1 of 3)
• Given decision table with conditional values (payoffs) and
probability assessments, determine the expected monetary
value (EMV) for each alternative.
• Computed as weighted average of all possible payoffs for
each alternative, where weights are probabilities of
different states of nature: 
EMV (alternative i) =
(payoff of first state of nature) x (probability of first
state of nature) +
(payoff of second state of nature) x (probability of second
state of nature) + . . . +
(payoff of last state of nature) x (probability of last
state of nature)
 Expected Monetary Value (2 of 3)
Example 1. Thompson Lumber Company
• Probability of favorable market is the same as probability of
unfavorable market.
• Each state of nature has a 0.50 probability of occurrence.
 Expected Monetary Value (3 of 3)
The
Opt
Example 2. Tom Brown Problem ima
The Expected Value Criterionl dec Expected
isio fall Value
Decision Large rise Small rise No changeSmall fall Large n
Gold -100 100 200 300 0 100
Bond 250 200 150 -100 -150 130
Stock 500 250 100 -200 -600 125
C/D 60 60 60 60 60 60
0.2
Prior Probability 0.3 0.3 0.1 0.1

(0.2)(250) + (0.3)(200) + (0.3)(150) + (0.1)(-100) + (0.1)(-150) = 130

Expected Value of Perfect Information

Expected value of perfect information: the difference

between the expected payoff under certainty and the
expected payoff under risk

Expected value of Expected payoff Expected payoff

-
perfect information = under certainty under risk
 Expected Value of Perfect Information
• Expected value with perfect information is expected or average
return, if one has perfect information before decision has to be
made.
• Choose best alternative for each state of nature and multiply its
payoff times probability of occurrence of that state of nature:
Expected value with perfect information (EV with PI) =
(best payoff for first state of nature)x
(probability of first state of nature)
+ (best payoff for second state of nature)
x (probability of second state of nature)
+ . . . + (best payoff for last state of nature)
x (probability of last state of nature)
EVPI = EV with PI - maximum EMV
It is also the smallest expected regret of any decision
alternative.
 EV with PI and EVPI
• Best outcome for state of nature "favorable market" is "build a
large plant" with a payoff of $200,000.
• Best outcome for state of nature "unfavorable market" is "do
nothing," with payoff of $0.
• Expected value with perfect information
(EV with PI) = ($200,000)(0.50) + ($0)(0.50)
= $ 100,000.
• If one had perfect information, an average payoff of $100,000
if decision could be repeated many times.
• Maximum EMV or expected value without perfect
information, is $40,000.
• EVPI = EV with PI - maximum EMV
= $100,000 - $40,000 = $60,000.
 Decision Trees
 Any problem presented in decision table can be
graphically illustrated in decision tree.

 A graphical method for analyzing decision situations

that require a sequence of decisions over time
(decision situations that cannot be handled by
decision tables)
 Decision tree consists of
Square nodes - indicating decision points
Circles nodes - indicating states of nature
Arcs - connecting nodes
These nodes are represented using following symbols:
= A decision node
Arcs (lines) originating from decision node denote all
decision alternatives available at that node.
О = A state of nature (or chance) node.
Arcs (lines) originating from a chance node denote all
states of nature that could occur at that node.
 Decision Tree

State 1
Outcome 1
v e 1 1 State 2
na ti Outcome 2
lt er
A
Alte
rna
tive State 1
2 Outcome 3
2 State 2
Outcome 4
Decision
Node
State of Nature Node
 Decision Tree

a t ure 1 Payoff 1
Decision Point Stat e of n
Chance Event eA ’1 Payoff 2
’ Choos
A State
se of
o natur 2
o e2
Ch Choose
A’2 Payoff 3
B
1
s e A ’3 Payoff 4
Ch oo
u re 1
a t
C

o f n 2
ho

State
os

Choose Payoff 5
e

A’4
A
’2

State
o f natu Payoff 6
re 2
 Decision Tree
Thompson Lumber Company
• Tree usually begins with decision node.
• Decision is to determine whether to construct large plant, small
plant, or no plant.
• Once the decision is made, one of two possible states of nature
(favorable or unfavorable market) will occur.
 Folding Back a Decision Tree
Thompson Lumber Company
• In folding back decision tree, use the following two rules:
– At each state of nature (or chance) node, compute expected value
using probabilities of all possible outcomes at that node and
payoffs associated with outcomes.
– At each decision node, select alternative that yields better
expected value or payoff.
 Reduced Decision Tree
Thompson Lumber Company
• Using the rule for decision nodes, select alternative with highest
EMV.
• Corresponds to alternative to build small plant.
• Resulting EMV is $40,000.
Decision Trees for Multi-stage
Decision Making Problems
 Decision Tree With EMVs Shown
Thompson Lumber Company
Decision Making in Southern Textile
 Southern Textile Company
STATES OF NATURE
Good Foreign Poor Foreign
DECISION Competitive Conditions Competitive Conditions

Expand $ 800,000 $ 500,000

Maintain status quo 1,300,000 -150,000
Sell now 320,000 320,000
 Southern Textile Company
STATES OF NATURE
Good Foreign Poor Foreign
DECISION Competitive Conditions Competitive Conditions

Expand $ 800,000 $ 500,000

Maintain status quo 1,300,000 -150,000
Maximax
Sell now
Solution
320,000 320,000
Expand: $800,000
Status quo: 1,300,000  Maximum
Sell: 320,000
Decision: Maintain status quo
 Southern Textile Company
STATES OF NATURE
Good Foreign Poor Foreign
DECISION Competitive Conditions Competitive Conditions

Expand $ 800,000 $ 500,000

Maintain status quo 1,300,000 -150,000
Maximin
Sell now
Solution320,000 320,000
Expand: $500,000  Maximum
Status quo: -150,000
Sell: 320,000
Decision: Expand
 Southern Textile Company

Minimax Regret Solution

STATES OF NATURE
Good Foreign Poor Foreign
GOOD CONDITIONS
DECISION POOR CONDITIONS
Competitive Conditions Competitive Conditions
$1,300,000 - 800,000 = 500,000 $500,000 - 500,000 = 0
1,300,000 - 1,300,000 = 0 $ 800,000
Expand 500,000 - (-150,000)$ =500,000
650,000
1,300,000
Maintain status- quo
320,000 = 980,0001,300,000
500,000 - 320,000 -150,000
= 180,000
Maintain status quo 1,300,000 -150,000
Sell now 320,000 320,000
Expand: $500,000  Minimum
Status quo: 650,000
Sell: 980,000
Decision: Expand
 Southern Textile Company

STATES OF NATURE
Good Foreign Poor Foreign
DECISION Competitive Conditions Competitive Conditions
Hurwicz Criteria
Expand $ 800,000 $ 500,000
 = 0.3
Maintain status quo 1-
1,300,000  = 0.7 -150,000
Sell now 320,000 320,000
Expand: $800,000(0.3) + 500,000(0.7) = $590,000  Maximum
Status quo: 1,300,000(0.3) -150,000(0.7) = 285,000
Sell: 320,000(0.3) + 320,000(0.7) = 320,000

Decision: Expand
 Southern Textile Company
STATES OF NATURE
Equal Likelihood Good
Criteria
Foreign Poor Foreign
DECISION Competitive Conditions Competitive Conditions
Two states of nature each weighted 0.50
Expand $ 800,000 $ 500,000
Expand:
Maintain status quo $800,000(0.5)1,300,000  Maximum
-150,000
+ 500,000(0.5) = $650,000
SellStatus
now 320,000
quo: 1,300,000(0.5) 320,000
-150,000(0.5) = 575,000
Sell: 320,000(0.5) + 320,000(0.5) = 320,000

Decision: Expand
 Southern Textile Company
STATES OF NATURE
Good Foreign Poor Foreign
DECISION Competitive Conditions Competitive Conditions
Expected Value
Expand $ 800,000 $ 500,000
quo = 0.70 1,300,000
p(good)
Maintain status p(poor) = 0.30 -150,000
Sell now 320,000 320,000
EV(expand) $800,000(0.7) + 500,000(0.3) = $710,000
EV(status quo) 1,300,000(0.7) -150,000(0.3) = 865,000  Maximum
EV(sell) 320,000(0.7) + 320,000(0.3) = 320,000

Decision: Status quo

 EVPI Example
Good conditions will exist 70% of the time, choose maintain
status quo with payoff of $1,300,000

Poor conditions will exist 30% of the time, choose expand

with payoff of $500,000

Expected value given perfect information

= $1,300,000 (0.70) + 500,000 (0.30)

= $1,060,000

EVPI= $1,060,000 - 865,000 = $195,000