Chapter 4: 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 Some decision can be withdrawn with out any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
 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 of 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.
Investmen Economic Conditions
t
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
Investment demand (alternative courses
Economic of action)
Conditions
nature)
Good Stable Poor Maximum of Maximaxi
Or product type D1 D2 payoff of D3
each
Alt
Product
Stocks A 14
$ 5,000 $ 7,000 118
$ 3,000 $7000 66

Product B 13 77 141
Real estate -2,000 10,000 6,000 $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
 Maximin/minima cont…

Investmen Economic Conditions

t
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
Investmen Economic Conditions
t
Good Stable Poor Average payoff of Maxi
Alternative Average
Payoff
Stocks $ 5,000 $ $ 3,000 ($5000+$7000+$3000)/3 $5000
7,000 = $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 = $6,000 -$6,000=0

$7000 0

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

$1000 $5000 $1000=$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 Maxi.

each 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
Real estate -2,000 10,000 6,000 ($10000*0.75+- $7000
D
$2000*0.25)= $7000
1 22-12=10) (22-17=5) (22-22=0) (22- 14=8)
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. Economic Conditions
Investmen
t
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 10,000-270=9730 0.96 9730X 0.96=9341

flight

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- 0.99 9650X
350=9650 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 0.4 2500 3500 5000
demand

medium 0.4 2500 3500 2500

demand

Low 0.2 2500 1500 1000

demand
 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?