Decision Theory PK
Decision Theory PK
location equipment
planning selection
5
Fundamentals of decision theory
Decision States of Payoff
alternatives nature
Events Probability Break 3rd egg Break 3rd egg Throw away 3rd
into pan into saucer & egg
inspect
Third egg is good 0.9 3-egg omlette 3-egg 2-egg
omelette, one omelette, one
saucer to wash good egg
destroyed
Third egg is rotten 0.1 No egg omlette 2-egg 2-egg omelette
2 good eggs omelette, one
destroyed saucer to wash
Pay-offs
States of
nature
• Certainty - Environment in which
relevant parameters have known
values
• Risk - Environment in which
certain future events have
probable outcomes
• Uncertainty - Environment in
which it is impossible to assess
the likelihood of various future
events
Risk vs. Uncertainty
• Risk
– Must make a decision for which the outcome is not known with
certainty
– Can list all possible outcomes & assign probabilities to the
outcomes
• Uncertainty
– Cannot list all possible outcomes
– Cannot assign probabilities to the outcomes
• Certainty
-is an environment in which future outcomes or state of nature are
known.
• Eg: Investment in Bank FD, there is CERTAINTY
regarding FUTURE PAYMENTS on maturity
• Investment in shares is risky
• Investment in shares FETCHING returns higher than
FD in another 2 years, is uncertain
Criteria of decision making under
uncertainity
0ptimism(Maximax or Minimin)
Pessimism(Maximin or Minimax)
Equal probabilities(Laplace)
Coefficient of
optimism(Hurwicz)
Regret(Salvage)
Decision tree
• A decision tree is a network that exhibits
graphically the relationship between the different
parts of the complex decision process.
Outcome 1
1
outcome2
Outcome 3
2
outcome 4
Decision tree example
25
Expected Opportunity Loss (EOL)
• It is the opposite of EMV
• EOL is defined as the difference between the
highest profit or pay-off and the actual profit due
to choosing a particular course of action in a
particular state of nature
• The conditional opportunity loss (EOL) for a
particular course of action is determined by taking
the difference between the payoff value of the
most favourable course of action and some other
course of action.