Decision Theory

Kshitij Pillai

Definition
According to the functional cycles of management, the managerial activity as a whole includes 5 phase or life processes which are planning, organization, direction, supervision & control. In performing all these activities the management has to face several such situations where they have to make a choice of the best among a no. of alternative courses of action. The choice making is technically termed as decision making

Steps
Clearly identify and define the problem at hand Specify objectives and decision criteria. Identify and evaluate the possible alternatives. Formulate one of the mathematical decision theory moddels. Apply the model and select the best alternative. Conduct a sensitivity analysis of the solution. Communication and implementation of decision. Follow up and feedback of results of decision.

Structure of Decision Making

The Decision Maker. Objectives. Environment. Payoff. Alternative coarse of action.

Problems in Decision Making

Deterministic Problems
Those problems in which each coarse of action results in only one outcome. For such outcomes, the probability of each outcome is known to be believed as either 1 or 0. Complete and accurate knowledge of the outcome of each alternative as there is only one outcome.

Stochastic Problems
Those problems in which each coarse of action can result in alternative outcomes, the probabilities of which are known or can be estimated. A probability of occurrence can be attached to each.

Problems Under Uncertainty

Probabilities of which cannot be assigned as the decision maker does not know which outcomes can or will occur. This means that decision maker has to act with imperfect information in such a situation. Such situations arise when a new product is introduced in the market or a new plant is set up.

Methods for Solving Uncertainity

Hurwitz criterion or the Maximax Decision
The maximax looks at the best that could happen under each action and then chooses the action with the largest value. They assume that they will get the most possible and then they take the action with the best best case scenario. The maximum of the maximums or the "best of the best". This is the lotto player; they see large payoffs and ignore the probabilities.

Maximin Decision
The maximin person looks at the worst that could happen under each action and then choose the action with the largest payoff. They assume that the worst that can happen will, and then they take the action with the best worst case scenario. The maximum of the minimums or the "best of the worst". This is the person who puts their money into a savings account because they could lose money at the stock market.

 Minimax Decision
Minimax decision making is based on opportunistic loss. They are the kind that look back after the state of nature has occurred and say "Now that I know what happened, if I had only picked this other action instead of the one I actually did, I could have done better". So, to make their decision (before the event occurs), they create an opportunistic loss (or regret) table. Then they take the minimum of the maximum. That sounds backwards, but remember, this is a loss table. This similar to the maximin principle in theory; they want the best of the worst losses.

Laplace Criterion
It assumes that all the states of nature are equally likely to occur. Thus if there are n states of nature , probability of occurrence of each state of nature will ne 1/n. Using these equal probabilities, the expected payoff for each strategy is computed and the strategy with maximum expected value is regarded as optimal.

Problem
A retail store desires to determine the optimal daily order size for a perishable item. The store buys the perishable item at the rate of Rs. 80 per kg and sells at the rate of Rs. 100 per kg. If the order size is more than the demand, the excess quantity can be sold at Rs. 70 per kg in a secondary market; otherwise, the opportunity cost of the store is Rs. 15 per kg for the unsatisfied portion of the demand. Based on the past experience, it is found that the demand varies from Rs 50 kg to 250 kg in steps of 50 kg. the possible values of the order size are from 75 kg to 300 kg in steps of 75 kg. Determine the optimal order size which will maximize the daily profit of the store.

Solution
Purchase price of the perishable item= Rs 80/ kg Selling price of the perishable item in the primary market= Rs. 100/ kg Profit in the primary market P1= 100-80= Rs 20/ kg Selling price in the secondary market= Rs 70/ kg Profit in the secondary market P2= 70-80= Rs -10/ kg Opportunity Cost of not meeting the demand oc= Rs. 15/ kg Net Profit= Dj * p1 (Qi-Dj) * p2 if Qi Dj Net Profit= Qi * p1 (Dj-Qi) * oc if Dj Qi Qi is the ith order Size and Dj is the demand jth future state.

Demand (Dj) 50 100 150 200 250

Order Size (Qi)

75 150 225 300

50* 20 25 * 10= 750

75* 20 25 * 15= 1125 100* 20 50 * 10= 1500 100* 20 125 * 10= 750 100* 20 200 * 10= 0

75* 20 75 * 15= 750

75* 20 125 * 15= -375

75* 20 175 * 15= 1125 150* 20 100* 15= 1500 225* 20 25 * 15= 4125 250* 20 50 * 10= 4500

50* 20 100 * 10= 0

150* 20 = 3000

150* 20 50 * 15= 2250 200* 20 25 * 10= 3750 200* 20 100 * 10= 3000

50* 20 175 * 10= 750 50* 20 250 * 10= 1500

150* 20 75 * 10= 2250 150* 20 150 * 10= 1500

Laplace Criterion
Based on the principle of insufficient reasoning, the probablity of occurrence of each future state according to laplace is 1/n. Therefore,
The expected outcome of the action i=
=1 1/

Solving the above problem with Laplace we have,

E(Q1)= 1/5 (750 + 1125 + 375 - 375 1125)= 150 E(Q2)= 1/5 (0 + 1500 + 3000 - 2250 1500)= 1650 E(Q3)= 1/5 (- 750 + 750 + 2250 - 3750 4125)= 2025 E(Q4)= 1/5 (- 1500 + 0 + 1500 - 3000 4500)= 1500

Thus the Expected daily net profit is maximum when the order size is Q3.

Maximin Criterion
Demand (Dj)
50 100
1125 1500 750

150
375 3000 2250

200
-375 2250 3750

250
-1125 1500 4125

Minimum
-1125 0* -750

Order Size (Qi)

75 150 225

750 0 -750

300

-1500

1500

3000

4500

-1500

* Maximin value. This means that the optimal daily order size of the perishable item should be 150 kg.

Minimax Criterion
Demand (Dj)
50 100
1125 1500

150
375 3000

200
-375 2250

250
-1125 1500

Maximum
1125 3000*

Order Size (Qi)

75

750

150 0

225 -750
300 -1500

750
0

2250
1500

3750
3000

4125
4500

4125
4500

* Minimax Value. This means that the optimal daily order size of the perishable item should be 750 kg.

Hurwicz Criterion or Maximax Criterion

Huwicz Criterion aims to stike a balance between the extreme optimism and the extreme pessimism by assigning a weight of to the optimism and 1 for the pessimism. In the absence of any bias either towards optimism or pessimism, assume = 0.5. The formula for weighted outcome for each row would be
WOi = =1,2,.. , + 1 =1,2,.., (, )

Demand (Dj) Order Size (Qi)

50
75
750

100
1125 1500 750

150
375 3000 2250 1500

200
-375 2250 3750 3000

250
-1125 1500 4125 4500

Maximum Minimum Weighted Outcome

1125 3000 4125 4500 -1125 0 -750 -1500 0 1500 1687.50* 1500

150 0 225 -750

300 -1500 0

* Maximin Weighted Average Value. Since this is a maximization problem, the rrow with the maximum weighted outcome should be selected as the best action. Hence the action of the row 3 is the best action. This means that the optimal daily order size of the perishable item should be 225 kg.

Thank You