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Chapter Four: Decision Theory

The document discusses decision theory and decision making. [1] It defines decision making as selecting a course of action from alternatives to solve problems. [2] The key elements of decision making are the decision maker, available acts or alternatives, possible outcomes, and payoff tables representing costs and benefits. [3] Different types of decision making situations include decisions under certainty, uncertainty, risk, and conflict.

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Ebsa Abdi
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62 views19 pages

Chapter Four: Decision Theory

The document discusses decision theory and decision making. [1] It defines decision making as selecting a course of action from alternatives to solve problems. [2] The key elements of decision making are the decision maker, available acts or alternatives, possible outcomes, and payoff tables representing costs and benefits. [3] Different types of decision making situations include decisions under certainty, uncertainty, risk, and conflict.

Uploaded by

Ebsa Abdi
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PPTX, PDF, TXT or read online on Scribd
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Chapter Four

Decision theory
Chapter Objectives

After carefully studying this section you will be able to:

• Define decision making

• Describe elements of decision making

• Explain the elements of decision theory model

• Pinpoint and explain the different types of decision making situation


Introduction

Operational research is:

• decision rules,

• evaluating alternative decisions,

• optimizing decisions,

• predicting the outcome of decisions,

• helping to cope with uncertainty and risk, etc.


Decision making
• Decision Making: is the process of selecting a feasible course of
action from a set of alternative, so as to solve problems.

“The life of manager is a perpetual decision making activities”.


Peter Ferdinand Drucker
Elements of decision making
1. The decision maker

• The decision maker is charged with responsibility of making the decision.

2. The acts

• The acts are the alternative courses of action of strategies that are available to the decision
maker.

3. Event or states of nature or outcomes.

• Are an actual events that may occur in the future

4. Payoff table

• A pay off table represents the economics of a problem, i.e. revenue and costs associated with any
action with a particular outcome. It’s a means of organizing a decision situation
5. Opportunity loss table
Types of Decision Making Situations

• Decision making under certainty

• Decision making under uncertainty

• Decision making under risk

• Decision making under conflict


Decision making under certainty

• In a situation involving certainty, people are reasonably sure about what


will happen when they make a decision.
• The information is available and is considered to he reliable, and the cause
and effect relationships are known.
Decision making under uncertainty

• The following choices are available before the decision maker in situations of

uncertainty.

• Maxi-max Criterion (optimist)

• Mini-max Criterion (pessimist)

• Maxi-min Criterion (conservative)

• Hurwicz Alpha Criterion ( Criterion of Realism)

• Laplace Criterion ( criterion of equally likelihood)


A. maximax decision criterion (criterion of optimism)
• The term ‘ maxi-max’ is an abbreviation of the phrase maximum of maximums,

• The decision maker may choose to take the action that would result in the
maximum payoff table.

• Very optimistic

• The decision maker assumes that the most favorable state of nature for each
alternative will occur.

• For example, an investor would optimistically assume that good economic


condition will prevail in the future .
B. maximin decision criterion ( criterion of pessimism)

• Unlike the maxi-max criterion, this criterion is pessimistic.

• The decision maker select the decision that will reflect the maximum of the
minimum payoffs.

• Of these minimum payoffs, the maximum is selected.


C. mini-max regret decision criterion

• Minimax is just the opposite of maxi-max.

• Decision maker is conservative but not pessimist.

• The decision maker attempts to avoid regret or loss by selecting the decision alternative that
minimizes the maximum regret.
• The mini-max regret criterion minimizes the maximum regret.

• Regret is the difference between the payoff from the best decision and all other decision
payoffs.

• To use the mini-max regret criterion, a decision maker first selects the maximum payoff under
each state of nature then subtracted from these amounts
D. Hurwicz alpha criterion

• This method is a combination of maxi-max criterion and maxi-min criterion.

• The decision maker is neither totally optimistic nor totally pessimistic.

• In this method, the decision maker’s degree of optimism is represented by α, the


coefficient of optimism.

• α varies between 0 and 1. When α =0 , there is total pessimism and when α=1
there is total optimism.
Hurwicz alpha criterion

• We find D1, D2, D3 etc. Connected with all strategies where D1= αMi +(1- α)mi

Where Miis the maximum payoff, mi the minimum payoff of ‘i’ the strategy.

• The strategies with highest of D1, D2…, is chosen.

• The Hurwicz criterion multiplies the best payoff by α, the coefficient of optimism,
and the worst payoff by 1 - α, for each decision, and the best result is selected.
E. Laplace criterion (equally likelihood)

• The equal likelihood, or LaPlace, criterion weights each state of nature equally,
thus assuming that the states of nature are equally likely to occur.

• The equal likelihood criterion multiplies the decision payoff for each state of
nature by an equal weight.
Decision Making Under Risk

• In this situation the decision maker has to face several states of nature.
• But he has some knowledge or experience which will enable him to assign
probabilities to the occurrence of each state of nature.
• The objective is to optimize the expected profit or to minimize the opportunity
loss.
• Methods to make decision under risk
 EMV (Expected monetary value) criterion,
 EOL ( expected Opportunity loss) criterion or
 EVPI ( expected value of perfect information)
a. Expected Monetary Value (EMV)
• The decision maker must first estimate the probability of occurrence of each
state of nature.

• Then, the expected value is computed by multiplying each outcome (of a


decision) by probability of its occurrence.

• Max EMV will be selected


b. Expected Opportunity Loss (EOL)

• The difference between the greater payoff and actual payoff is known as

opportunity loss.

• Under this criterion the strategy which has minimum expected opportunity loss

(EOL) is chosen.

• The calculation of EOL is similar to that of EMV.

• It is the expected value of the regret for each decision.


c. Expected Value of Perfect Information (EVPI)

• It is the maximum amount a decision maker would pay for additional


information.

• In order to calculate EVPI, we choose the best alternative with the probability of
their state of nature.

• The expected value of perfect information minus the outcome with max EMV.

• Therefore, EVPI= Expected value with perfect information –Max EMV


Thank you!

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