CHAPTER 4

DECISION THEORY/ANALYSIS
 Introduction
• Decision theory represents a generalized approach to
decision making, which often serves as the basis for a wide
range of managerial decision making.

• An important factor in making a decision is the degree of

certainty associated with the consequences.
• This can range anywhere from complete certainty to
complete uncertainty and it generally affects the way a
decision is reached
• This unit presents two commonly used decision theory
approaches: a payoff table and a decision tree
 4.1. CHARACTERISTICS OF DECISION THEORY

List of alternatives:
• A finite number of decision alternatives are available to the
decision maker at the time of making a decision
• These alternatives are also called courses of actions, acts
or strategies and are under control and known to you
i.e. you will determine what courses of action are possible.
• Decision alternatives must be mutually exclusive (clearly
distinct among themselves)
• Determining a realistic set of action alternatives demands
creativity and experience on the nature of the problem under
consideration.
• Managerial intuition is extremely valuable at this stage of the
analysis.
 Cont’d
States of nature
 is the set of possible future conditions, or events, beyond
the control of the decision maker, that will be the primary
determinants of the eventual consequence of the decision.
 The states of nature, like the list of alternatives, must be mutually
exclusive and collectively exhaustive

Payoffs
 A payoff is a quantitative measure of the result of taking a
particular course of action combined with the occurrence of a
particular state of nature
• It is the net gain or loss obtained as the outcome of the decision
that accrues from a given combination of decision alternatives
and events.
 Cont’d
Degree of certainty
• There can be different degrees of certainty. One extreme is
complete certainty and the other is complete uncertainty. The
later exists when the likelihood of the various states of nature are
unknown.
• Between these two extremes is risk (manager is able to estimate
likely hood(probabilities) for the states of nature.
• Knowledge of the likelihood of each of the states of nature can
play an important role in selecting a course of active

Decision criteria
The decision maker‘s attitudes toward the decision as well as the
degree of certainty that surrounds a decision. Example;
maximize the expected payoffs
 4.2. THE PAYOFF TABLE
• 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
• The general format of the table is illustrated below:

State of nature
Altern S1 S2 S3
ative A1 V11 V12 V13
A2 V21 V22 V23
A3 V31 V32 V33

where: Ai = the ith alternative Sj = the jth states of nature Vij = the value or
payoff that will be realized if alternative i is chosen and event j occurs.
 4.3. DECISION MAKING UNDER CERTAINTY
• When a decision is made under conditions of complete
certainty, the attention of the decision maker is focused on
the column in the payoff table that corresponds to the
state of nature that will occur

• The decision maker then selects the alternative that would

yield the best payoff, given that state of nature
 EXAMPLE1

Doctor Thomas has been thinking of opening his own private clinic. The
problem is how large the clinic size should be under various economic
• .
scenarios.
After a careful analysis, Dr.Thomas has developed the following profit (in
thousands) table.

Alternatives Market Conditions

(Clinic Size) (States of nature)
Poor(S1) Fair(S2) Good(S3)

Small(A1) 4 16 12
Medium(A2) 5 6 10
Large(S3) -1 4 15

Therefore, if we know that Fair market condition (S2) will occur, the
decision maker then can focus on the first row of the payoff table.
Because alternative A1 has the largest profit (16), it would be selected.
 4.4. DECISION MAKING UNDER COMPLETE UNCERTAINTY

 There are several approaches (criteria) to

decision making under complete uncertainty.

 Some of these discussed in this section include:

• maximax,
• maximin,
• minimax regret,
• Hurwicz, and
• equal likelihood
 4.4.1. MAXIMAX CRITERIA

• Tha maximax is very optimistic. The decision maker

assumes that the most favorable state of nature for
each decision alternative will occur
• With the maiximax criterion, the decision maker
selects the decision that will result in the maximum
of the maximum payoffs
 Example 2

For the previous problem which alternative should

be selected under maximax criteria?

State of nature
Alternative S1 S2 S3 Row maximum
A1 4 16 12 16* column maximum
A2 5 6 10 10
A3 -1 4 15 15

Decision: alternative “A1” will be chosen

NB: If the pay off table consists of costs instead of profits, the opposite
selection would be indicated: The minimum of minimum costs. For the
subsequent decision criteria we encounter, the same logic in the case of
costs can be used.
 4.4.2. MAXIMIN CRITERIA

• This approach is the opposite of the previous one,

i.e. it is pessimistic.
• This strategy is a conservative one; it consists of
identifying the worst (minimum) payoff for each
alternative, and, then, selecting the alternative that
has the best (maximum) of the worst payoffs
 Example 3

• For the previous problem which alternative should be

selected under maximin criteria?

State of nature
Alternative S1 S2 S3 Row minimum
A1 4 16 12 4
A2 5 6 10 5* column maximium
A3 -1 4 15 -1

Decision: alternative “A2” will be chosen

NB : If it were cost, the conservative approach would be to select the
maximum cost for each decision and select the minimum of these costs.
 4.4.3. MINIMAX REGRET
• Both the maximax and maximin strategies can be criticized
because they focus only on a single, extreme payoff and
exclude the other payoffs
• An approach that does take all payoffs in to consideration is
Minimax regret.
• In order to use this approach, it is necessary to develop an
opportunity loss table
• The opportunity loss reflects the difference between each
payoff and the best possible payoff in a column (i.e., given a
state of nature).
• Hence, opportunity loss amounts are found by identifying the
best payoff in a column and, then, subtracting each of the
other values in the column from that payoff.
• Therefore, this decision avoids the greatest regret by selecting
the decision alternative that minimizes the maximum regret .
 Example 4
For the previous problem which alternative should be selected
under minimax regret criteria?.

State of nature
Altern S1 S2 S3
ative A1 5-4 =1 16-16 =0 15-12 =3
A2 5-5 =0 16-6 =10 15-10 =5
A3 5-(-1)=6 16-4 =12 15-15 =0
Column 5 16 15
Maximum
 Cont’d
Construct opportunity loss table
• The values in an opportunity loss table can be viewed as potential
―regrets‖ that might be suffered as the result of choosing various
alternatives. A decision maker could select an alternative in such a way
as to minimize the maximum possible regret. This requires identifying
the maximum opportunity loss in each row and, then, choosing the
alternative that would yield the best (minimum) of those regrets.

State of nature
Alternative S1 S2 S3 Maximum loss(row)
A1 1 0 3 3*(column minimum)
A2 0 10 5 10
A3 6 12 0 12

Decision: alternative “A1” will be chosen

 4.4.4. PRINCIPLE OF INSUFFICIENT REASON/ EQUAL
LIKELIHOOD/ LAPLACE CRTERIA

• It treats the states of nature as if each were equally likely,

and it focuses on the average payoff for each row, selecting
the alternative that has the highest row average.

• The basis for the criterion of insufficient reason is that under

complete uncertainty, the decision maker should not focus
on either high or low payoffs, but should treat all payoffs
(actually, all states of nature), as if they were equally likely.

• Averaging row payoffs accomplishes this.

 Example 4
• For the previous problem which alternative should be
selected under principle of insufficient reason criteria?

State of nature
Alternative S1 S2 S3 Row Average
A1 4 16 12 10.67* maximum
A2 5 6 10 7
A3 -1 4 15 6

Decision: alternative “A1” will be chosen

 4.4.5. THE HURWITZ CRITERION

• The Hurwitz criterion strikes a compromise between the

maximax and maximin criterion. The principle underlying
this decision criterion is that the decision maker is neither
totally optimistic, nor totally pessimistic.
• Instead of assuming total optimism or pessimism, Hurwicz
incorporates a measure of both by assigning a certain
percentage weight to optimism and the balance to
pessimism.
• A weighted average can be computed for every action
alternative with an alpha-weight α, called the coefficient of
realism or coefficient of optimism
• Note that 0 ≤ α ≤ 1, where an α = 1 implies absolute
optimism (maximax) while an α = 0 implies absolute
pessimism (maximin).
 Cont’d
• Selecting a value for α simultaneously produces a coefficient
of pessimism 1 -α , which reflects the decision maker's
aversion to risk. A Hurwicz weighted average H can now be
computed for every action alternative Ai in A as follows:
 H (Ai ) = α (column maximum) + ( 1 - α ) (column minimum)
for positive-flow payoffs (profits, income)

 H (Ai ) = α (column minimum) + ( 1 - α ) (column maximum)

for negative-flow payoffs (costs, losses)

NB: The Hurwitz criterion requires that for each alternative, the
maximum payoff is multiplied by α and the minimum payoff
be multiplied by 1- α.
 Example 5

• For the previous problem which alternative should be

selected under principle of insufficient reason criteria ;
if α= 0.4.

• A1 (0.4X 16) +(0.6X4) =8.8 (is the maximum)

• A2 (0.4X10)+(0.6X5) =7

• A3 (0.4X15)+(0.6 X-1) =5.4

• Decision: Alternative A1 will be chosen

 4.5. DECISION MAKING UNDER RISK (WITH
PROBABILITIES)
 The term risk is often used in conjunction with partial
uncertainty, presence of probabilities for the occurrence of
various states of nature.
 Given that probabilities can be assigned, several decision
criteria are available to aid the decision maker.
 Some of these are discussed below

 EXPECTED MONETARY VALUE (EMV)

 EXPECTED OPPORTUNITY LOSS (EOL)
 EXPECTED VALUE OF PERFECT INFORMATION (EVPI)
 4.5.1. EXPECTED MONETARY VALUE (EMV)
(under risk)

• The EMV approach provides the decision maker with a

value which represents an average payoff for each
alternative.
• The best alternative is, then, the one that has the highest
EMV. The average or expected payoff of each alternative is
a weighted average
 Example 6

• For the previous problem which alternative should be

selected under EMV criteria if probabilities of 20%, 50% &
30% were assigned to S1,S2 & S3 respectively ?

State of nature
Alt S1(0.2) S2(0.5) S3(0.3) Expected pay off
er A1 4 X.2 16X.5 12X.3 12.4* maximum
na A2 5X.2 6X.5 10X.3 7.8
tiv
A3 -1X.2 4X.5 15X.3 6.7
e

Decision: alternative “A1” will be chosen

 4.5.2. EXPECTED OPPORTUNITY LOSS (EOL)

Steps for calculating EOL:

• a) Prepare a payoff matrix for each course of action and
state of nature combination along with the associated
probabilities.
• b) For each state of nature, calculate the opportunity loss
values by subtracting each payoff from the maximum payoff
for that outcome.

• c) Calculate EOL for each course of action by multiplying

the probability of each state of nature with the opportunity
loss value and then adding the values.

• d) Select a course of action for which the EOL value is

minimum
 Example 7
• For the previous problem which alternative should be
selected under EOL criteria and if probabilities of 20%, 50%
& 30% were assigned to S1,S2 & S3 respectively ?
• The opportunity loss table is summarized below

State of nature
Alternative S1 S2 S3
A1 1 0 3
A2 0 10 5
A3 6 12 0
EOL (A1)= (1x.2)+(0x.5)+(3x.3) = 1.1 the minimum
EOL (A2)= (0x.2)+(10x.5)+(5x.3)= 6.5
EOL (A3)= (6x.2)+(12x.5)+(0x.3)= 7.2
Decision: alternative “A1” will be chosen

Note: The EOL approach resulted in the same alternative as the EMV approach
(Maximizing the payoffs is equivalent to minimizing the opportunity losses).
4.5.3. EXPECTED VALUE OF PERFECT INFORMATION
(EVPI)
• It can sometimes be useful for a decision maker to
determine the potential benefit of knowing for certain which
state of nature is going to prevail. The EVPI is the measure
of the difference between the certain payoffs that could be
realized under a condition involving risk.
 Example 7

For the previous problem calculate the EVPI

• If the decision maker knows that S1 will occur, A2 would
be chosen with a payoff of $5.
• Similarly for S2 $16 (for A1) and for S3, $15 (with A3)
would be chosen.
• Hence, the expected payoff under certainty (EPC) would
be:
• EPC = 0.20(5) + 0.50(16) + 0.30(15) = 13.50
• The difference between this figure and the expected
monetary value-EMV (i.e. payoff under risk) is the
expected value of perfect information.

• Thus: EVPI = EPC – EMV = 13.50 – 12.40 = 1.10