# Chapter 5. Decision Theory.

5. DECISION THEORY.

5.1. INTRODUCTION OF THE DECISION THEORY.
5.1.1. DEFINITIONS. Decision Theory is an analytic and systematic approach to studying decision making. What Makes the Differences between BAD & GOOD DECISION? A GOOD DECISION is one that is based on logic, considers on available data and possible alternatives, and applied the quatitative approach. Occasionally, a good decision results is an unexpected or unfavorable outcome. A BAD DECISION is one that is not based on logic, does not use all available information, does not consider all alternatives , and does not employ appropriate quantitative techniques. If you make a bad decision, but are lucky and a favorable outcome occurs, you still have l make a bad decision. Managers make many decisions. Although occasionally good decisions yield bad results, in the long run, using decision theory will result in successful outcomes. 5.1.2. 1. 2. 3. 4. THE SIX STEPS IN DECISION THEORY.

Clearly Define The Problem. List The Possible Alternatives. Indentify The Possible Outcomes. List The Payoff or profit of each combination of Alternatives & Outcomes. 5. Select one of The Mathematical Decision Theory Models. 6. Apply The Model and Make your Decision.

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each with a given probability. Type 3. Large facility A2. namely. Decision making under Uncertainty. Decision Theory.Chapter 5.40 = 60. FORMULAE. DECISION MAKING UNDER RISK. Decision Making under risk is a probability decision situation.20 0 0.5 -180 . EMV(Alternative i) = Σ (Payoff(state j) * Prob(X=xj) EXEMPLE 1.4. Type 2. We have the following Decision Table: ALTERNATIVES STATES OF FAVORABLES MARKET NATURE UNFAVORABLE MARKET A1. TYPES OF DECISION – MAKING ENVIRONMENTS.5 EMV 10 40 0 Select decision = A 2 DEFINITION. we consider one of the most popular methods of making decisions under risk. 27 . Small facility A3. Thus the most Thompson would be willing to pay for perfect information is 60\$.3. Type 1.EMV From the above example. EVPI (Expected Value of Perfect Information) is defined as following: EVPI = Σ Best Outcome for State i* P[X=xi] . EXPECTED MONETARY VALUE (EMV). Decision making under Certainty. selecting the alternative with the highest expected monetary value.1. Do nothing PROBABILITIES 200 100 0 0. 5. Several possible states of nature may occur. we have: EVPI = 200/2 +0/2 . In this section.1. 5. Decision making under Risk.

State i) = Best Outcome of State i . Opportunity loss.100 = 100 200 0.5 0 = 200 0 .20) = 20 0 . OPPORTUNITY LOSS. Decision Theory.Chapter 5. STEP 1. sometimes called regret. and that The following relationship always hold: EVPI = Min EOL. METHOD FOR CALCULATING THE EOL.State i)* P[X=xj] For the above example.0 = 0 0. Large facility A2. An alternative approach to maximizing expected monetary value (EMV) is to minimize EXPECTED OPPORTUNITY LOSS (EOL). Compute The EOL by the following Formulae: EOL(Alternative j) =Σ OL(Alternative j. j. Create the Opportunity Loss Table (OL). 28 . FORMULAE. refers to the difference between the optimal profit or payoff and the actual payoff received. Minimum EOL will always result in the same decision as Maximum EMV.Actual Outcomes STEP 2. OL(Alter. Do nothing PROBABILITIES 200 – 200 = 0 200 . we have The OL Table as follows: ALTERNATIVES STATES OF FAVORABLES MARKET NATURE UNFAVORABLE MARKET A1.(.5 EOL 90 60 100 Select decision = A 2 NOTE.(-180) = 180 0 . Small facility A3.

Criterion realism. Do nothing PROBABILITIES 200 100 0 0. we can use the following criteria for making the decision: Maximax.5.1. Large facility A2.5. Maximin.5 200 100 0 Select decision = A 1 5. Large facility A2.20 0 0. Decision Theory. we have: ALTERNATIVES STATES OF FAVORABLES MARKET NATURE UNFAVORABLE MARKET MAX in Row A1.Chapter 5.5 -180 .5.1.20 0 0. The Maximax Criterion finds the Alternative that maximizes the maximum outcomes or consequence for every alternative. The Maximin Criterion finds the Alternative that maximizes the minimum outcomes or consequence for every alternative. Small facility A3. 5. MAXIMIN. For the above example.1.5 -180 . Small facility A3. For the above example. Equally likely.5 -180 . When the probability of occurrence of each state of nature cannot be assessed. MAXIMAX. we have: ALTERNATIVES STATES OF FAVORABLES MARKET NATURE UNFAVORABLE MARKET MIN in Row A1.20 0 Select decision = A 3 29 .2. Minimax. 5. Do nothing PROBABILITIES 200 100 0 0.1. DECISION MAKING UNDER UNCERTAINTY.

Decision Theory. Do nothing PROBABILITIES 0 100 200 0. Minmax finds the Alternative that minimizes the maximum opportunity loss within each alternative.5 180 100 200 Select decision = A 2 5.5 10 40 0 Select decision = A 2 30 . we have: ALTERNATIVES STATES OF FAVORABLES MARKET NATURE UNFAVORABLE MARKET MAX in Row A1.5 180 20 0 0. we have: ALTERNATIVES STATES OF FAVORABLES MARKET NATURE UNFAVORABLE MARKET AVERAGE A1. Do nothing PROBABILITIES 200 100 0 0.1. EQUALLY LIKELY. For the above example. Large facility A2. Small facility A3. Large facility A2. The Equally Criterion finds that Alternative with the highest average outcomes. MINMAX.180 20 0 0. 5.Chapter 5.3.5.1. For the above example.5 . Small facility A3.5. The Mimax Criterion based on opportunity loss.4.

2. STEP 4. we have: ALTERNATIVES STATES OF FAVORABLES MARKET NATURE UNFAVORABLE MARKET W.A . W. 76 0 Select decision = A 1 5. Assign Probabilities to the States of Nature. STEP 2.A). FORMULAE. a=. STEP 1.8 A1.180 20 0 0. 5. Small facility A3.A = a(Max in Row) + (1-a)(Min in Row) For the above example. Ο a State Node.1. Do nothing PROBABILITIES 200 100 0 0. with a coefficient of realism a. Structure or Draw the Decision Tree. STEP 3. Calculate EMV for each state. STEP 5. CRITERION REALISM (WEIGHTED AVERAGE = W. Decision Theory. TREE DECISION.5 . Large facility A2.5. DEFINITION. 31 .2.5. 5. Estimate Payoffs for each Possible combination of alternatives and the States of nature. NOTION: a Decision Node. The criterion is a compromise between an optimistic and a pessimistic decision.5 124.1. Any Problem that can be presented in a decision Table can also be graphically illustrated in a decision tree. Define the Problem.Chapter 5. Analyzing Problems with Decision Tree involves five Steps.

5 32 . Small facility A3.20 Small Plant 2 EMV(2)=40 Decision Node 5. Do not Conduct Survey. B = 2 events.2. Do nothing PROBABILITIES STATES OF NATURE FAVORABLES UNFAVORABLE MARKET (FM) MARKET (UM) 190 -190 90 . For The above example.5 0.30 0 0 0.2. Large facility A2. BAYES ‘S FORMULAE BAYES ‘S FORMULAE P P(A\B) = P( B \ A )P(( B \) A )P((BA\)A )P( A ) P A + where A. we have: State of Nature Node Favorable Market EMV(1)=10 Plant Large \$ PAYOFF 200 . Decision Theory. A = the complement of A EXEMPLE 1. ALTERNATIVES A1.180 1 Unfavorable Market Favorable Market Unfavorable Market Do Nothing 100 .Chapter 5.

30 -10 0.73 P( S . Conduct Market Survey.N \ FM )P( FM ) + P( SN \ UM )P( UM ) P(UM\Survey positve) = P(FM\Survey negative) = P(UM\Survey negative) = P(Survey Result Positive) = P(SP\FM)P(FM) + P(SP\UM)P(UM) =0. we have: P(FM\Survey positve) = P( SurveyPositive \ FM )P( FM ) = 0.3 NATURE UNFAVORABLE MARKET (UM) -190 .N \ FM )P( FM ) + P( SN \ UM )P( UM ) P( SurveyNegative \ UM )P( UM ) = 0. Decision Theory.P \ FM )P( FM ) + P( SP \ UM )P( UM ) P( SurveyNegative \ FM )P( FM ) = 0.22 P( S . STATES OF FAVORABLES MARKET (FM) 190 90 -10 0.2 0.8 ALTERNATIVES A1. Small facility A3.78 P( S . Large facility A2.Chapter 5.27 P( S .P \ FM )P( FM ) + P( SP \ UM )P( UM ) P( SurveyPositive \ UM )P( UM ) = 0.45 P(Survey Result Negative)=P(SN\FM)P(FM) + P(SN\UM)P(UM) =0. Do nothing Survey Positive (SP) Survey Negative (SN) Apply the Bayes’s formulae.55 33 .7 0.

I II III IV V S1 10 17 05 35 45 S2 31 67 45 19 51 S3 11 13 13 09 08 S4 39 22 18 29 40 S5 54 43 32 35 45 Which Alternative maximizes expected monetary value? Which is the best decision if you use the opportunity loss.Chapter 5. Draw a decision tree to represent these situations and find the best strategy. A1 A2 A3 Prob. Which Alternative maximizes expected monetary value? 3..2 . 2.2 . S3). The following payoff matrix indicates the monetary values that would be realized for each of the three alternatives (AÙ 1. Consider the following profit table. The prior probabilities associated with S1 to S5 are . where I. A 3 ) and three states of nature (S1.2..25 respectively. 1.2 3. 5. The result of survey as follows: Result of Survey Positive Negative S1 .2.1. S1. 34 .S5 are states of nature.7 . . .8 S2 -200 -100 0 .3 S2 -100 0 100 . Which is the best decision if you use the following criteria: Maxmax. MinMax. A 2.5 S3 .1. A market analyst offers to conduct a survey to determine which state of nature migh occur. Determine The Posterior probabilities.3 S1 900 -100 -500 . . Maxmin..3.3 S2 . S1 1000 0 -400 .5 S3 -2000 100 500 .15 and . S2. For the above Table.8 S3 -2100 0 400 . . 3. Decision Theory.3. V are Alternatives. Suppose the probabilities of occurrence of each state not be assessed.2 A1 A2 A3 Prob. Average. EXERCISES.

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