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Decision Theory

The document discusses decision theory, outlining various decision-making methods under conditions of certainty, risk, and uncertainty. It details techniques such as the Maximin, Maximax, Minimax Regret, and Expected Monetary Value methods, along with the use of decision trees for evaluating alternatives. Additionally, it explains the concept of the Value of Perfect Information and its significance in decision-making processes.

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2 views6 pages

Decision Theory

The document discusses decision theory, outlining various decision-making methods under conditions of certainty, risk, and uncertainty. It details techniques such as the Maximin, Maximax, Minimax Regret, and Expected Monetary Value methods, along with the use of decision trees for evaluating alternatives. Additionally, it explains the concept of the Value of Perfect Information and its significance in decision-making processes.

Uploaded by

johnonzerelubanga
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We take content rights seriously. If you suspect this is your content, claim it here.
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STUDY TEXT * 241 g CHAPTER 6 itroduction. [ee [Decision trees and sub sequential di Mixed strategies ..... Dominance INTRODUCTION Decision theory is a body of knowledge and related analytical techniques of different degrees of {rmality designed to help a decision maker choose among a set of alternatives in light of their lc consequences, Decision theory can apply to conditions of certainty, risk, or uncertai ty. In Ic helps operations mangers with decisions on process, capacity, location and inventory, because such decisions are about an uncertain future. Types of decisions There are many types of decision making 1. Decision making under uncertainty Decision under certainty means that each alternative leads to one and only one consequence and a alternatives is equivalent to a choice among consequences. choice amo 2. Decision maki Whenever there exists on under certainty ‘one outcome for a decision we are dealing with this category e.g. linear transportation assignment and sequencing e.t<. programmit 3. De naking using prior data i: cocurs whenever it is possible to use past experience (prior data) to develop probabilities for the occurrence of each data 4. Decision making without prior data No pst eaperience exists that eun be used to derive axteome probabitities in this ease the decision maker uses hisher subjective estimates of probabilities for various outcomes , hn ee RS ANALYSIS STUDY TEXT 242 ‘ DECISION MAKING UNDER UNCERTAINTY Several methods are used to make decision in circumstances where only the pay off are known and the likelihood of each state of nature are known a) MAXIMIN METHOD This criteria is based on the “conservative approach’ to assume that the worst possible is goin happen. The decision maker considers each strategy and locates the minimum pay off for ene | then selects that alternative which maximizes the minimum payof! wo illustration Rank the products A B and C applying the Maximin rule using the following payoff table showing, potential profits and losses which are expected to arise from launching these three products in three market conditions i (see table | below) ay off table in £0 Steady state’ "| Mini profits row ninima : [Product A Product rodu is Yable t "i Ranking the MAXIMIN rule Y b) MAXIMAX METHOD This method is based on ‘extreme optimism’ the decision maker selects that particular st Which corresponds to the maximum of the maximum pay off for each strategy Mlusteation Using the above example Ranking using the MAXIMAX method = CBA, ©) MINIMAX REGRET METHOD “This method assumes that the decision maker will experience ‘regret’ afer he has made the decision and the events have oeeurred. The decision maker selects the alternative whieh minimizes the maximum possibte regret Regret table in £000%s Boom condition | Steady sate Predera Product 3 QUANTITATIVE ANALYSIS STUDY TEXT 243 \ regret table (table 2) is constructed based on the pay off table, trom taking one decision given that a cen boom steady state or r he rank he regret is the ‘opportunity, loss? ‘ain contingency occurs in our example whether there is sing MINIMAX regret method = BAC () THE EXPECTED MONETARY VALUE METHOD lhe expected pay off (profit) associated with a given combination of a anultiplyi tiv t and event is obtained by hc pay of? for that act and event combination by the probability of occurrence of the ‘event. The expected monetary value (EMV) of an aet is the sum of all expected conditional + profits associated with that act Musteation AA manager has a choice between ') A risky contract promising shs 7 million with probability 0.6 and shs 4 million with probability 0.4 and ji) A diversified portfolio consisting of two cantr Shs 3.5 million with probability 0.6 and shs 2 1 Can you aivive at the decision using EMV method? 1s with independent outcomes each promising ion with probability 0.4 Solution - The conditional payorf table for the problem may be constructed as below. ‘Shillings in millions) _ Conditional pay offs ‘xpected pay off decision deci Event Ei_| Probability ( | Portfolio Gx + Using the EMV method the manager must go in for the risky contract which will yield him a higher expected monetary value of shs 5.8 million ¢)_ EXPECTED OPPORTUNITY LOSS (EOL) METHOD. ‘This method is aimed at minimizing the expected opportunity loss (OEL). The decision maker chooses the strategy with the minimum expected opportunity toss THE HURWIZ METHOD This method was the concept of evefficient of optimism (or pessimism) introduced by L.. Hurwiez. ‘The decision maker takes into account both the maximum and minimum pay off for each alternative and assigns them weights according to his degree of optimism (or pessimism). The alternative which manimizes the sum of these weighted payoffs is then selected g) THE LAPLACK METHOD - This method uses all the information by assigning equal probabilities to the possible payols for each getion and then selecting that altemmative which corresponds to the maximum expected pay off ILLUSTRATION A company is con QUANTITATIVE ANALYSIS | opportunities _ A Bo Determine the best investment opportunity wsing the following eriteria i) Maximin ii) Maximax iii) Minimax iv) Hunwiez (Alpha = 0.3 SOLUTION [ivesimenc | opportunitie ee Minimum | Maximum | £ = [3000 | 7000 i) Using the Maximin rule Highest niinimum = £ 4000 Choose investment C £10000 ii) Using the Maximax rule Highest maximum = Choose investment B iii) Minimax Regret rule [3 [Maximum regret] 3000 3000 | 7000 Choose the minimum of the maximum regret i.e, £3000 Choose investment A iv) Hunwiez rule: expected values For A (7000 x 0,3) + (3000 x 0.7) = 2100 + 2100 = For B (10000 x 0,3) + (-2000 x 0.7) = 3000- 140 For C (4000 x 0.3) + (4000 x 0.7) = 1200 +2800 Best outcome is £4200 choose investment A 4200 £1600 4000 Value of perfect information 4 Itrelates to the amount that we would pay for an item of information that would enable us to foreetst the exact conditions of the market and act accordingly. The Value of perfect information is the amount by which the expected payotf will improve if the manager knows which event will occur

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