Chapter Two: Decision Theory

Introduction
 Making appropriate decision is the most vital aspects in
management. In fact, certain authors have defined
management as decision making.
 Decision making is an action. Every action has a reaction.
Some decision initiates a set of activities; some put an
end a certain activities.
 Some decision can be withdrawn with out any
consequential actions and losses, but majority of the
decisions are not.
 Therefore, the success or failure of an individual or
organization experiences, depends to large extent on the
ability of making appropriate decisions
 Introduction cont…
• Making an appropriate decision requires:
• an enumeration of feasible and viable alternatives
(courses of actions or strategies),
• the projection of consequence associated with different
alternatives and
• A measure of effectiveness (or an objectives) by which
the most preferred alternative is identified.
• Decision theory provides an analytical and systematic
approach to the study of decision making.
• Decision models useful in helping decision makers to
make the best possible decisions are classified according
to the degree of certainty.
 Common Terms in Decision Making

•Decision alternatives: these are act, action, option, or

strategies available for decision maker before any decision is
made. Decision alternatives are under the control and known
to decision maker.
•State of nature: a possible future condition (consequence or
event) resulting from the choices of a decision alternatives
depends up on certain factors beyond the control of decision
maker. These factors are depends on the environment.
•Payoff: a numerical value resulting from each possible
combination of alternatives and state of nature is payoff. The
payoff might be profits, revenues, costs, or other measures of
values. The payoff values are always conditional values
because of unknown state of nature.
 Common Terms in Decision Making cont…
• Degree of certainty. There can be different degree of
certainty. One extreme is complete certainty and the
other is complete uncertainty.
• The latter exists when the likely hood of the various state
of are unknown. Between theses two extremes is risk, a
term that implies that probabilities are known for the
state of nature.
• A tabular arrangement of these conditional outcome
(payoff) values is known as payoff matrix (or decision
table or payoff table).
• Rows represent the state of nature and columns
represent decision alternatives to be considered.
 Steps in Decision Making Theory

Step1. Identify and define the problem

 Step2. List all possible future events (state of nature)
which are beyond the control of the decision maker.
 Step3. Identify all courses of actions (alternatives) which
are under the control of the decision maker.
 Step4. Express the payoff resulting from each pair of
course of action and state of nature. Normally payoffs are
expressed in a monetary value.
 Step5. Apply appropriate decision theory model to select
the best courses of action.
 The Payoff Table

•A tabular arrangement conditional outcome (payoff)

values is known as payoff matrix (or decision table or
payoff table).
• It includes a list of the alternatives, the possible
state of nature, and the payoff associated with each
of the alternatives-statue of nature combinations.
•Conventionally, rows represent the state of nature
and columns represent decision alternatives to be
considered. Note that pay off can be profits, revenues
,costs, or other measures of values.
 Illustration 1
• An investor is considering investing in stock, real estate,
or bonds under uncertain economic conditions. The
payoff table of returns for the investor’s decision
situation is shown below.
Investment Economic Conditions
Good Stable Poor

Stocks $ 5,000 $ 7,000 $ 3,000

Real estate -2,000 10,000 6,000

Bond 4,000 5000 1000

 Decision making environment

•Knowledge of the likely hood of each of the state of nature

can play an important role in selecting a course of action.
Generally there are three decision making environments:
certainty, uncertainty and risk.
•Decision under certainty
•Decision under certainty is the case where the decision
maker has a perfect knowledge (information) about the state
of nature. This situation does not need any techniques or
managerial tool for the manager to take his decision. In this
case, the decision maker will simply select an alternative that
yields the largest return (payoff) for the known future (state of
nature). However, in practice, decision under certainty is very
rare.
 Decision making under uncertainty

This is a situation in which decision maker has neither

previous knowledge of the outcomes of his decisions, nor
is in a position to attribute a probability of occurrence of
such outcomes.
Still various options are opened to you to make decision
in the absence of perfect knowledge which depends on a
variety of criteria.
 Decision making under uncertainty cont…
In this section we will introduce you only four
approaches for decision making under uncertainty.
maximaxi or minimini(criteria of optimism)
In this section, the decision maker ensures that he
should not miss the opportunity to achieve the largest
possible profit (maximaxi) or lowest possible cost
(minimini).
Thus, he selects the alternatives that represent the
maximum of the maxima (or minimum of the minima)
payoffs (outcomes).
 Decision making under uncertainty cont…
• The working method is summarized as follows:
• Locate the maximum (or minimum) payoff values
corresponding to each alternative. Then, Select an
alternative with best anticipated payoff value(maximum
for profit and minimum for cost)
• Illustration 2
• To illustrate the maximaxi criteria, let as refer the
example given under illustration1.
• Required: based on illustration1, which strategy (decision
alternative) should the manufacturing company adopt?
 Maximaxi
• Solution :In order to determine the strategy (alternative
action) first determine the maximum value for each
column. Then, the column with the largest value is
considered as the best strategy.
(State of nature)
Investment demand (alternative
Economiccourses of action)
Conditions
Good Stable Poor Maximum of Maximaxi
Or product type D1 D2 D3
payoff of each Alt

Stocks
Product A $ 5,000
14 $ 7,000 $ 3,000
118 $7000
66

Product B
Real estate 13
-2,000 10,000 77
6,000 141
$10000 $10000

1 73 145
Product C
Bond 4,000 5000 1000 $5000
Column maximum 14 118 145
 Maximaxi cont…
Maximaxi: The maximum of column maxima is $10000.
Hence the investor should invest on real state(ROI is in
Real state).
Maximin or minimaxi(criteria of pessimism).
In this criterion, the decision makers ensures that he
would earn no less or (pay no more) than some specified
amount.
Thus he selects the alternative that represents the
maximum of the minima (in case of profit) and the
minimum of the maximum (in case of loss). The
application is simple.
First select the minimum from each column and select
the largest values from the minimum column rows
 Maximin/minima cont…

Investment Economic Conditions

Good Stable Poor Minimum Payoff Maximin

of each Alternative

Stocks $ 5,000 $ 7,000 $ 3,000 $3000

$3000

Real estate -2,000 10,000 6,000 -$2000

Bond 4,000 5000 1000 $1000

 Maximin cont…
 According to maximin approach, it is recommendable for
an investor to invest on Stocks because investing in stock
will allow the investor to gain maximum of minimum
ROI when compared with other alternatives.
 C. Laplace criteria/equaly likely
Since the probabilities of state of nature are not known, it
is assumed that all state of nature will occur with equal
probability, i.e. each state of nature is assigned an equal
probability.
• The working method is summarized as follows:
• compute the expected(average) value payoff for each
alternative by adding all the pay offs and dividing by the
number of possible states of nature
• Select the best expected payoff value (maximum for
profit or minimum for cost).
 C. Laplace Maximaxi
criteria/equaly likely
Investment Economic Conditions

Good Stable Poor Average payoff of Alternative Maxi

Average
Payoff
Stocks $ 5,000 $ 7,000 $ 3,000 ($5000+$7000+$3000)/3 = $5000
$5000

Real estate -2,000 10,000 6,000 (-$2000+$10000+$6000)/3

= $4667

Bond 4,000 5000 1000 ($4000+$5000+$1000)/3

= $3333
 minimax regret
• This criteria also called opportunity loss decision criteria
or savage criterion because decision makers feels regret
after adopting a wrong course of action (alternative)
resulting an opportunity loss of payoff. Thus, the decision
maker always intends to minimize this regret. The work
method is as follows:
• from the given pay off matrix, develop an opportunity
loss(or regret)matrix as follows:
• Find the best payoff corresponding to each state of
nature, and Subtract all other entries (payoff values) in
that row from this value.
• For each course of action(alternative) identify the worst
(maximum regret value)
 Cont.
Select the course of action with the smallest anticipated
opportunity loss value. For better understanding of the
concept let as see the following
Illustration
Given the following payoff tables, determine which
alternatives would be chosen using each of these decision
criteria.
i. maximaxi, ii)maximin iii) minimax regret iv) laplace
criterion
 minimax regret
Investment Economic Conditions

Good Stable Poor

Stocks $ 5,000 -5000= $0 $10000-$ 7,000= $6000-$ 3,000

$3000 =$3000

Real estate 5000-(-2,000)= $10000-$10,000 = 0 $6,000 -$6,000=0

$7000

Bond 5000-4,000= $1000 $10000-$5000= $6000-$1000=$5000

$5000
 minimax regret
Economic Conditions

Investment Good Stable Poor Maximum Minimax

regret payoff regret value

Stocks $0 $3000 $3000 $3000 $3000

Real estate $7000 $0 $0 $7000

Bond $1000 $5000 $5000 $5000

 minimax regretCont.
According to Minimax regret criteria, the investor should
adopt investing Stocks because investing on Stocks
results in minimum regret value relative to other
investment alternatives.
 Hurwicz Criterion
The Hurwicz criterion is an approach somewhere
between the maximax and the maximin approaches. The
Hurwicz criterion approach selects the maximum and the
minimum payoff from each decision alternative. A value
called alpha (not the same as the probability of a Type I
error), which is between 0 and 1, is selected as a weight of
optimism. The nearer alpha is to 1, the more optimistic is
the decision maker.
The nearer alpha is to 1, the more optimistic is the
decision maker. The use of alpha values near 0 implies a
more pessimistic approach.
 Hurwicz Criterion cont’

The maximum payoff under each decision alternative

is multiplied by alpha and the minimum payoff
(pessimistic view) under each decision alternative is
multiplied by 1 (weight of pessimism). These weighted
products are summed for each decision alternative,
resulting in a weighted value for each decision
alternative.
The maximum weighted value is selected, and the
corresponding decision alternative.
Assuming Alpha level = 0.75, determine the best
alternative to be selected.
 Hurwicz Criterion
Investment Economic Conditions

Good Stable Poor Weighted payoff for each Maxi.

alternative Weighted
payoff

Stocks $ 5,000 $ 7,000 $ 3,000 ($7000*0.75+

$3000*0.25) = $6000

Strategy/ Alternative course of actions/

A B C D
Real estate -2,000 10,000 6,000 ($10000*0.75+- $7000
1 22-12=10) (22-17=5) (22-22=0) $7000 (22- 14=8)
$2000*0.25)=

2 18-18=0) (18-10=8) (18-16=2) (18-14=4)

3 (15-15=0) (15-14=1) (15-10=5) (15-14)=1)

Bond 4,000 5000 1000 ($5000*0.75+
$1000*0.25)= $4000
 Hurwicz Criterion cont’

As per Hurwicz Criterion, the investor should

select investing on real state because investing on
real state will enable the investor to generate
maximum ROI averagely when compared with other
investment opportunities.
 Decision making under risk

In this case also the decision maker has to make

decision when outcomes are not certain.
However, unlike the previous case, he has sufficient
information to assign probability values to the likely
occurrence of each of the states.
Knowing the probability distribution of the state of
nature, the best decision is to select that course of action
(decision alternatives) which has the largest expected
payoff value.
 Decision making under risk

• The most widely used criterion for evaluating various

courses of action (alternatives) under risk includes:
expected monetary value (EMV), expected opportunity
loss (EOL), expected value of perfect information (EVPI).
• Now let us see each with illustrations expected monetary
value
• Expected monetary value is the sum of the payoffs for
each course of action multiplied by the probabilities
associated with each state of nature.
 Steps for calculating EMV

• Construct a payoff matrix listing all possible courses of

action and state of nature. Enter the conditional payoff
values associated with each possible combination of
courses of action and state of nature along with the
probabilities of the occurrences of each state of nature.
• Calculate the EMV for each course of action by
multiplying the conditional payoffs by the associated
probabilities and add these weighted values for each
course of action.
• Select the course of action that yields the optimal values.
 Illustration 1
• Assuming the probability of the three states of natures
are 0.35, 0.45 and 0.2 respectively, determine which
alternative the investor should choose using EMV.
Investment Economic Conditions

Good Stable Poor

Stocks $ 5,000 $ 7,000 $ 3,000 = ($5000*0.35+$7000*0.45+

$3000*0.2)= $5500

Real estate -2,000 10,000 6,000 = (-$2000*0.35+$10000*0.45+

$6000*0.2)= $5000

Bond 4,000 5000 1000 = ($4000*0.35+$5000*0.45+

$1000*0.2)= $3850
 EMV Criteria
According to EMV criteria, investor should invest on
Stocks because investing on Stock will result in
Maximum EMV compared to other investment
alternatives.
 Example 2
• Mr. Bilisuma quite often flies from Finfinnee to Beijing.
He can use the air port bus but it costs him birr 25 and
there is a 0.08 chance that he will miss the bus. He can
also stay in hotel but it costs him birr 270 with a
0.96cahnces of being on time for the flight. Still he can
use Taxi which costs him birr 350 with a 0.99 chance of
being on time for flight. If Mr. Bilisuma catches the
plane, he will conclude a business transaction which will
produce a profit of birr 10,000 otherwise, he will lose it.
• Required: using EMV method, which mode of
transportation should Mr.Bilisuma use?
 Decision Under Risk(EMV) cont…
Solution: Computations of EMV for the three courses of
action are shown below.
States of Nature
Course of action
Bus
Cost probability Expected Value

Catch flight Birr 10,000- 1-0.08=0.92 9975X 0.92=9177

25=9975

Miss the flight -25 0.08 -25X0.08=-2

EMV 9177 -2 = birr 9175

 EMV calculation cont…
States of Alternatives(Stay in Hotel)
nature

Cost Probability Expected value

Catch the flight 10,000-270=9730 0.96 9730X 0.96=9341

Miss the flight -270 1-0.96=0.04 -270X0.04= -11

EMV 9341 -11 = birr 9330

 EMV calculation cont…
States of Nature course of action(taking Taxi)

Cost probability Expected Value

Catch the flight 10,000-350=9650 0.99 9650X 0.99=9553.50

Miss the flight -350 1-0.99=0.01 -350X0.01= -3.50

EMV 9553 -3.50 = birr 9550

Thus, comparing the EMV of the three courses of action, the alternative with the highest
EMV is the third alternative i.e. using Taxi.

So Mr. Bilisuma must use taxi to maximize his expected monetary value.
 Expected Opportunity Loss(EOL)
For the states of nature S1, S2,…Sn let p(S1),p(S2),…
p(Sn) be the respective prior probabilities then EOL to
acts A1,A2,…An will be:
A1=(M1-p11)p(S1)+(M2-p12) p(S2)+…(Mn-p1n)P(Sn)
A2=(M1-p21)(p(S1)+(M2-p22)p(S2)+…(Mn-p2n)p(Sn)
Where mi is maximum profits(pay off) corresponding to si
and p11,p12,p13…p1n be the outcome of act A1, similarly
for act A2 and so on.
 EOL Criteria Cont’
Economic Conditions

Investment Good Stable Poor EOL of each minimum EOL

alternative

Stocks $0 $3000 $3000 ($3000*0.45+ $1,950

$3000*0.2) =
$1,950

Real estate $7000 $0 $0 ($7000*0.35)=

$2,450

Bond $1000 $5000 $5000 ($1000*0.35)+

($5000*0.45)+
($5000*0.2)=
$3,600
 EOL Criteria Cont’
Based on EOL criteria, It is recommendable for an
investor invest on Stocks because investing on Stocks
will result in minimum EOL relative to the other
investment opportunities.
 Expected value of perfect information
This is the expected(average) return in the long run,
provided there is perfect information before decision is
taken.
At 1st we are expected to calculate expected payoff with
perfect information(EPPI) which is as follows:
 EPPI= (Max. payoff in the 1st states of
nature )×(probability of the same states of nature)+
(max. payoff in the 2nd states of nature) ×( prob. of the 2nd
states of nature )+ …up to the last states of nature.
 Now EVPI= EPPI-EMV.
 EVPI cont’
Investment Economic Conditions

Good Stable Poor

Stocks $ 5,000 $ 7,000 $ 3,000

Real estate -2,000 10,000 6,000

Bond 4,000 5000 1000

 EVPI cont’
EPPI= ($5000*0.35)+($10000*0.45)+($6000*0.2)=
$7,450
EVPI= EPPI-EMV= $7,450-$5500= $1950
Thus, the investor should pay for perfect information
up to$1950. That means it is not viable for an investor
to pay more than $1950
 Class Activity
States of Courses of action/Strategies
nature

Probability don’t expand Expand 200 units expand 400

units
High demand 0.4 2500 3500 5000

medium 0.4 2500 3500 2500

demand

Low demand 0.2 2500 1500 1000

 Given the above payoff matrix:
 What should be the decision if we use:
 Maximaxi criterion?
 Maximin criterion ?
 Minimax regret criterion?
 Laplace criterion?
 EMV criterion?
 EOL Criterion?
 EVPI?