Chapter Four

Decision Theory

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TeBek-AAU-FBE-Mgmt
 7.1. Introduction
• Hundreds of decisions are made every day in the operations
activity.
• Each minor decision determines the company's success or
failure.
• It ranges from simple judgmental to complex analysis which can
also involve judgment (past experience and common sense).
• They involve a way of blending objective and subjective data to
arrive at a choice.
• The success or failure that an individual or organization
experiences, depends to a large extent on the ability of making
appropriate decisions.
• Making of a decision requires an enumeration of feasible and
viable alternatives (courses of action or strategies),

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 Cont’d
 Making appropriate decision is the most vital
aspect in management
 Decision making is the process of identifying
problems and then resolving them
 Decision-making is the process of selecting the
best option from two or more possible
alternatives based on some criteria.
 A decision represents a course of actions
chosen from a number of possible alternatives.
 Cont’d
• Decision are classified in to d/t categories according to the degree of
certainty.
• The scale of certainty can range from complete certainty to complete
uncertainty.
• The region which falls between these two extreme points corresponds to the
decision making under risk (probabilistic problems).
How much certainty exists?

Completely certain Extremely uncertain

Risk Situation

Objective information Subjective Information

.

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 Cont’d

Characteristics of Decision Theory

Irrespective of the type of decision model, there are certain essential
characteristics which are common to all are listed below.
1. Decision alternatives:
There are a finite number of decision alternatives available with the
decision-maker at each point in time when a decision is made. These
alternatives are also called courses of action (actions, acts or
strategies) and are under control and known to the decision-maker.
2. State of Nature: A possible future condition (consequence or
event) resulting from the choice of a decision alternative depends upon
certain factors beyond the control of the decision-maker. These factors
are called states of nature (future).
3. Degree of certainty: - There can be different degrees of certainty.
One extreme is complete certainty and the other is complete
uncertainty. Between these two extremes is risk (probabilities are
unknown for the states of nature).
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 Cont’d
4.Decision criteria: - Example; maximize the expected
payoffs.
5. Payoff: A numerical value (outcome) resulting from
each possible combination of alternatives and states of
nature is called payoff.
6. The Payoff Table: A payoff table is a device a
decision maker can use to summarize and organize
information relevant to a particular decision.
•It includes a list of alternatives, the possible future
states of nature, and the payoffs associated with each of
the alternative/state of nature combinations.

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 Cont’d
Table 7.1. General Form of Payoff Matrix
Courses of Action (Alternatives)
States of Nature S1 S2 … Sn
N1 P11 P12 … P1n
N2 P21 P22 … P2n
. . . .
. . . .
. . . .
Nm Pm1 Pm2 … Pmn

Where: Sn = the nth alternative course of action

Nm = the mth state of nature
Pmn = the value/ payoff that will be realized if alternative n will chosen and event m
occurs 7
 Steps in Decision Theory Approach

The decision-making process involves the following steps:

1. Identify and define the problem
2. Identifying the various possible outcomes, called states of nature,
which can occur in the context of the decision problem.
3. Identification of all the courses of action (alternatives or decision
choices) which are available to the decision-maker.
4. Expressing the payoffs (Pmn) resulting from each pair of course of
action and state of nature. These payoffs are normally expressed in a
monetary value.
5. Apply an appropriate mathematical decision theory model to select
best course of action from the given list on the basis of some criterion
(measure of effectiveness) that results in the optimal (desired) payoff.
6. Choosing the best course of action among the various alternatives on
the basis of some predetermined criterion

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 7.2. Types of Decision Making Environment
There are four types of decision-making environment: certainty,
uncertainty, risk and conflict.
1. Decision Making under Certainty
The simplest of all circumstances occurs when decision making takes place in
an environment of complete certainty.
2. Decision Making under Risk
In this case, the decision-maker has less than completes knowledge with
certainty of the consequence of every decision choice (course of action). For
example, probability of getting head in the toss of a coin is 0.5.
3. Decision Making under Uncertainty
In this case the decision-maker is unable to specify the probabilities with which
the various states of nature (futures) will occur. For example, the probability
that Mr. X will be the prime minister of the country 15 years from now is not
known.
4. Decision Making under Conflict /Competitive Conditions/
Decision making under conflict is made when neither the state of nature completely
known nor completely uncertain. For example, when two competitors are compete for
the same product.
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 1. Decision Making under Certainty
• The most widely used decision rule under the certainty
situation is break-even analysis (cost-profit-
volume analysis), cost-benefit analysis and
mathematical programming.
• In this case, the decision-maker has the complete
knowledge (perfect information) of consequence of
every decision choice (course of action or alternative)
with certainty.
• Obviously, s/he will select an alternative that yields the
largest return (payoff) for the known future (state of
nature).

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 Example

EXAMPLE, The following payoff table provides data about profits of the various states of
nature/alternative combination.
S1 S2 S3
A1 4 16 12
A2 5 6 10
A3 -1 4 15
If we know that S2 will occur, the decision maker then can focus on the first raw of the payoff
table. Because alternative A1 has the largest profit (16), it would be selected. 11
 B. Decision Making Under Uncertainty

In the absence of knowledge about the

probability of any state of nature (future)
occurring, the decision-maker must arrive at a
decision only on the actual conditional payoff
values, together with a policy (attitude). Once
the decision has been organized in to a payoff
table, there are several methods for arriving at
an optimal solution under uncertainty. These are:
a. Maximax or Minimim d. Criterion of realism (Hurwicz).
b. Maximin or Minimax e. Criterion of regret
c. Equally likely (Laplace)
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 Cont’d

A. Criterion of Optimism (Maximax or Minimin)

•In this criterion, the decision-maker ensures that s/he
should not miss the opportunity to achieve the largest
possible profit (maximax) or lowest possible cost (minimin).
•Thus, s/he selects the alternative (decision choice or course
of action) that represents the maximum of the maxima (or
minimum of the minima) payoffs (consequences or
outcomes).
a.Locate the maximum (or minimum) payoff corresponding
to each alternative (or course of action), then
b.Select an alternative with best anticipated payoff value
(maximum for profit and minimum for cost).

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 Cont’d
• The maximax criterion is very optimistic.
• The decision maker assumes that the most favorable
state of nature for each decision alternative will
occur.
• Thus, this criterion is also called an optimistic
decision criterion.

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 Cont’d

For example, consider the following table.

Table 4.2 Payoff table illustrating a maximax decision

Maximum payoff 15
 Cont’d

The decision maker first selects the maximum

payoff for each decision. Of the three maximum
payoffs $50,000, $100,000, and $30,000- the
maximum is $100,000; thus, the corresponding
decision is to purchase the office building.
However if the payoff table consisted of costs, the
opposite selection would be indicated: the minimum of
the minimum costs, or a minimin criterion.

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 Cont’d

b. Criterion of Pessimism (Maximin or Minimax)

•The Maximin or Minimax is based upon the conservative
approach to assume that the worst possible is going to
happen.
•In this criterion the decision-maker ensures that s/he would earn
no less (or pay no more) than some specified amount.
•Thus, s/he selects the alternative that represents the maximum
of the minima (or minimum of the maxima in case of loss) payoff
in case of profits.
1. Locate the minimum (or maximum in case of profit) payoff
value in case of loss (or cost) data corresponding to each
alternative, then
2. Select an alternative with the best anticipated payoff value
(maximum for profit and minimum for loss or cost). i.e select the
alternative that has the best payoff of the worst payoffs. 17
 Cont’d
Since in this criterion the decision-maker is conservative
about the future and always anticipates worst possible
outcome (minimum for profit and maximum for cost or
loss), it is called a pessimistic decision criterion. This
criterion is also known as Wald’s criterion

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 Example:

Table 7.3 Payoff table illustrating a maximin decision

Table 7.3 Payoff table illustrating a maximin decision

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 Cont’d

 The minimum payoffs for our example are

$30,000, -$40,000, and $10,000.
 The maximum of these three payoffs is
$30,000; thus the decision arrived at using the
maximin criterion would be to purchase the
apartment building.
 If Table 7.2 contained costs instead of profits as the
payoffs, the conservative approach would be to select
the maximum cost for each decision.
 Then the decision that resulted in the minimum of
these costs would be selected.
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c. Equally Likely Decision (Laplace) Criterion
Since the probabilities of states of nature are not known, it is assumed
that all states of nature will occur with equal probability, i.e. each state
of nature is assigned an equal probability assuming that the states of
nature are equally likely to occur. As states of nature are mutually
exclusive and collectively exhaustive, so the probability of each of these
must be 1/ (number of states of nature).
a.Assign equal probability value to each state of nature using the
formula:
b.Compute the expected (or average) payoff for each alternative (course
of action) by adding all the payoffs and dividing by the number of
possible states of nature or by applying the formula:
Expected payoff = (Probability of state of nature j) x
(payoff value for the combination of alternative, i and state of
nature j)
( c) Select the best expected payoff value (maximum for profit and
minimum for cost ). 21
 Example,

In above example, since there are two states of nature,

we assign a weight of 0.5 to each one. Next, we
multiply these weights by each payoff for each decision.
 
Decision Values
Apartment building $50,000 (0.5) + 30,000(0.5) = $40,000
Office building $100,000 (0.5) – 40,000(0.5) = $30,000
Warehouse $30,000 (0.5) + 10,000(0.5) = $20,000
Then we select the decision that has the maximum of these
weighted values. Since $40,000 is the highest weighted value,
the investor’s decision would be to purchase the apartment
building.

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 Cont’d

D. Criterion of Realism (Hurwicz Criterion)

•The Hurwitz criterion strikes a compromise between the maximax and
maximin criterion.
•This criterion suggests that a rational decision-maker should be neither
completely optimistic nor pessimistic and, therefore, must display a
mixture of both.
•Hurwicz, who suggested this criterion, introduced the idea of a
coefficient of optimism (denoted by ) to measure the decision-maker’s
degree of optimism.
•With Hurwitz criterion, the decision payoffs are weighted by a
coefficient of optimism, a measure of a decision maker’s optimism. The
coefficient of optimism, which is defined as , is between zero and one
(0< <1).
•If  = 1, then the decision maker is said to be completely optimistic, if
= 0, then the decision maker is completely pessimistic. Given this
definition, if  is coefficient of optimism, 1- is coefficient of pessimism.
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 Cont’d

The Hurwicz approach suggests that the decision maker must

select an alternative that maximizes H (Criterion of realism) =
 (Maximum in row) + (1- ) (Minimum in row)
a. Decide the coefficient of optimism  (alpha) and then
coefficient of pessimism (1- ).
b. For each alternative select the largest and lowest payoff value
and multiply these with  and (1- ) values, respectively. Then,
calculate the weighted average, H by using the above formula.
c. Select an alternative with best anticipated weighted
average payoff value.
The Hurwitz criterion requires that for each alternative, the
maximum payoff is multiplied by  and the minimum payoff be
multiplied by 1-.

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 Cont’d
For example, consider this payoff table:
S1 S2 S3
A1 4 16 12
A2 5 6 10
A3 -1 4 15

If  = 0.4 for the above example,

A1 = (0.4x16) + (0.6x4) = 8.8
A2 = (0.4x10) + (0.6x5) = 7
A3 = (0.4x15) – (0.6x1)= 5.4
Decision: A1 will be selected
A limitation of Hurwicz criterion is the fact that  must be determined by the decision maker.
Regardless of how the decision maker determines, it is still a completely a subjective
measure of the decision maker’s degree of optimism. Therefore, Hurwicz criterion is a
completely subjective decision making criterion. 25
 Cont’d

c. Decision Making Under Risk (With Probabilities)

Decision making under risk is a probabilistic decision
situation, in which more than one state of nature exists and the
decision-maker has sufficient information to assign probability
values to the likely occurrence of each of these states.
Knowing the probability distribution of the sates of nature, the
best decision is to select that course of action which has the
largest expected payoff value. The probabilities may be subjective
estimates from managers or from experts in a particular field, or
they may reflect historical frequencies. If they are reasonably
correct, they provide the decision maker with additional
information that can dramatically improve the decision making
process

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 Cont’d
The most widely used criterion for evaluating various courses of action
(alternatives) under risk are the Expected Monetary Value (EMV) and
Expected Opportunity Loss (EOL)
EXPECTED MONETARY VALUE (EMV)

The expected monetary value (EMV) for a given course of action is the weighted average
payoff, which is the sum of the payoffs for each course of action multiplied by the probabilities
associated with each state of nature. Mathematically EMV is stated as follows:
m
EMV (Course of action, Sj) =  Pij
i 1
Pi

Where m = number of possible states of nature

Pi = probability of occurrence of state of nature i

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Pij = Payoff associated with state of nature Ni and course of action, Sj.
 Cont’d

Steps for calculating EMV:

a. Construct a payoff matrix listing all possible courses of
action and states of nature. Enter the conditional payoff
values associated with each possible combination of
course of action and state of nature along with the
probabilities of the occurrence of each state of nature.
b. Calculate the EMV for each course of action by
multiplying the conditional payoff by the associated
probabilities and add these weighted values for each
course of action.
c. Select the course of action that yields the optimal
EMV.
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 Cont’d
Example. ABC manufacturing firm wants to meet the
excess demand to its products. The firm’s management
is concerning with three alternative courses of action.
a. Arrange for subcontracting
b. Begin overtime production
c. Construct new facilities
The correct choice depends largely on future demand,
which may be low, medium or high. Management ranks
the respective probabilities as 10%, 50% and 40% to
low, medium and high product demand in the future
respectively. A cost analysis reveals the effect on profit
of each alternative under a given state. This is given in
the payoff table below. 29
 Cont’d

Required: Which alternative is the viable choice?

We can use expected monetary value approach and decision tree to answer this question.

Determine the expected payoff of each alternative

and choose the alternative that has the best expected payoff.

EMV (A1) =10,000X0.1+0.5X 50,000+0.4X50, 000

EMV (A2) = -20,000X0.1+60,000X0.5+100,000X0.4

EMV (A3) = 150,000X0.1+20,000X0.5+200,000X0.4

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