Decision & Game Theory

Chapter 1: Problem Formulation

Sonia REBAI
Tunis Business School
University of Tunis
The first step in the decision analysis process is the problem formulation. We
begin with a verbal statement of the problem. We then identify the following
elements:

• the objective to optimize,

• the decision alternatives,

• the uncertain future events, referred to as chance events or state of

nature

• the consequences associated with each decision alternative and each

chance event outcome, referred to the outcome (gain or loss) function
Setting objectives
An objective is a specific goal that a decision-maker attempts to reach.
Setting the right objectives is vital for a decision problem.

• It should be measurable to evaluate the alternatives leading to different

levels of the objective.
• Knowing the right objectives helps identifying the adequate alternatives
to consider.
• It also dictates the way to measure the results and the type of
uncertainty inherited in the problem. 3
• Some objectives may be related; others may serve for more important

ones. The DM should distinguish between what is important for an

objective and what is the ultimate objective.

• It is possible to have a hierarchy of objectives. For example; by having a

university degree, one may get a good job that can generate a high

salary which can improve the quality of life of the DM. Hence,

improving the quality of life is the ultimate objective in this hierarchy.

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• It is sometimes difficult to understand the objective itself. For

instance, business firms seek “success” or “excellence”.

ü How to measure it accurately?

ü Would profit maximization, cost reduction, or operating according to

international standards be good indicators to track progress towards

such an objective?
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Identifying alternatives
Once the decision situation is clearly identified and the objectives are
adequately set, one may attempt to discover and create alternatives.

• Some of the alternatives may arise in a straightforward way: e.g.,

accept/reject, select among a list. Others may be obtained only after
some careful consideration and analysis of the problem.

• The DM should make sure that the identified actions would serve the
final objective(s) either directly or indirectly.
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• Among possible actions to consider:

ü Wait & see: in order to gain more information before acting.

ü Do nothing: in order to not to get worse than the current situation.

ü Pay for safety or insurance: in order to get rid of risk.

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• In complex situations, some alternatives are less obvious to identify. It is
the case where alternatives are of technical nature: legal procedures,
financial solutions, reforms, engineering methods, medical procedures.
These would be obtained by consulting the right experts.

• Other alternatives may be less technical yet require deep thinking. These
may be identified by calling for meetings, to take more time to think, to
employ competencies & know-how. Among scientific tools used are
creativity, checklists, brainstorming.
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Environment of the decision problem
The decision problem environment can be identified through the level of
knowledge of the states of nature. Three levels can be distinguished.

More information

Uncertainty Risk Certainty

Less information

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ü Uncertainty
It reflects the extreme case where situations are out of the control of the decision-
maker without knowledge on the likelihood of their occurrence
ü Risk
The available information is used to assess a probability distribution of the
occurrences of the situations that are out of the control of the DM
ü Certainty
Another extreme case where all outcomes of the decision problem are
known beforehand.

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In general, it is not necessary that the problem falls in one of the three
cases above. However, the modeling approach would dictate the
environment as a choice such as investigating the uncertainty or totally
neglecting it.

Uncertain Environment
Risky Environment
Deterministic
Environment

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Example 1
A company manufacturing electronic components realizes that the computer market
grow rapidly. It has reached the maximum of its production for the moment and can no
longer meet any additional demand.
The managers, whose policy is to satisfy the demand, are considering the opportunity of
purchasing a machine from two preselected ones or or move towards subcontracting.
The possible results in million TD are estimated as follows:

Additional Additional Additional Weak No Additional

High Demand Medium Demand Demand Demand
Machine 1 0.7 0.3 -0.1 -0.3
Machine 2 0.5 0.4 0.1 -0.2
Subcontracting 0.3 0.2 0.3 0 12
Alternatives
• A1 : Buying machine 1
• A2: Buying machine 2
• A3: Subtracting
States of Nature
• E1: High Additional Demand
• E2: Medium Additional Demand
• E3: Weak Additional Demand
• E4: Null Additional Demand
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Payoff Table and Decision Tree

• The consequence resulting from a specific combination of a decision

alternative and a state of nature is a payoff.

• A table showing payoffs for all combinations of decision alternatives and

states of nature is a payoff table.

• Payoffs can be expressed in terms of profit, cost, time, distance or any

other appropriate measure.
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 E1 E2 E3 E4
A1 0,7 0.3 -0,1 -0,3
A2 0,5 0.4 0,1 -0,2
A3 0,3 0,2 0,3 0

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Ø To structure the decision problem, a graph called a decision tree can
be used.

Ø The decision tree is a graphical representation that structures in a

chronological order the decision alternatives and the states of nature.
Ø It consists on representing nodes connected to each other by arcs.
Nodes are of two types:

• Decision nodes represented by squares and

• Probability nodes represented by circles.
Ø the different results are indicated at the extremities of the tree.
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 E1
0.7
A1 E2 0.3
E3
-0.1
A2 E4
-0.3
E1 0.5
E2 0.4
A3

E3 0.1
E4 -0.2
E1 0.3
E2 0.2
E3 0.3
E4 0 17
 Solving the Decision Problem
• Solving the decision problem by identifying the optimal set of actions to
take is usually obtained through backward iterations
• Calculations are usually simple and mostly performed through software
packages such as:
ü Expert Choice
ü Logical Decisions
ü Decision Tools
ü Tree Plan
ü Supertree 18
Sensitivity Analysis
• Once the problem is solved, sensitivity analysis is performed to answer
“What if” questions
• One should find out if a minor change in the problem inputs would make
significant change in the solution
• In such a case, one should carefully re-evaluate sensitive parameters (for
which a small change may result in a change in the solution)
• Sensitivity analysis may help the DM feel the need to redefine objectives
or to reconsider alternatives leading to a more structured model
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• After several iterations of revising the decision model, the DM may reach
a more adequate structure or more pertinent solution

• With the tedious iterative process of conducting sensitivity analysis, the

perception of the problem may change, some better understanding of
uncertainty may be obtained and the views on the various alternatives
may be modified.
• The DM will reach higher maturity in considering the problem with the
deep thinking involved

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