Decision Theory and

Game Theory

Dr. Himani Gupta

 Decision Theory
• Decision theory problems are characterized by
the following:
1. A list of alternatives.
2. A list of possible future states of nature.
3. Payoffs associated with each alternative/state of
nature combination.
4. An assessment of the degree of certainty of possible
future events.
5. A decision criterion.
 Example 1

Suppose that a real estate developer must decide on a

plan for developing a certain piece of property. After
careful consideration, the developer has ruled out “do
nothing” and is left with the following list of acceptable
alternatives:
1. Residential proposal.
2. Commercial proposal #1.
3. Commercial proposal #2.
Suppose that the developer views the possibilities as
1. No shopping center.
2. Medium-sized shopping center.
3. Large shopping center.
Table 1 General Format of a Decision Table
Table 2 Payoff Table for Real Estate Developer
Table 3 If It Is Known That No Shopping Center Will be Built, Only the
First Column Payoffs Would Be Relevant

Decision Making under Certainty

 Decision Making under
Complete Uncertainty

• Approaches to decision making under complete

uncertainty:
1. Maximin
2. Maximax.
3. Minimax regret.
4. Hurwicz
5. Equal likelihood
Table 4 Maximin Solution for Real Estate Problem

Maximin
The maximin 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. In effect,
the decision maker is setting a floor for the potential payoff; the actual
payoff cannot be less than this amount.
Table 5 Maximax Solution for Real Estate Problem

Maximax
The maximax approach is the opposite of the previous one: The
best payoff for each alternative is identified, and the alternative with
the maximum of these is the designated decision.
Table 6 Payoff Table with Similar Maximum Payoffs

Minimax Regret
An approach that takes all payoffs into account. To use this approach,
it is necessary to develop an opportunity loss table that 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.
Table 7 Opportunity Loss Table for Real Estate Problem
Table 8 Identifying the Minimax Regret Alternative
Table 9 Minimax Regret Can Lead in a Poor Decision
The Hurwicz (Realism) Criterion (Weighted
Average or Realism Criterion)
• The approach offers the decision maker a compromise
between the maximax and the maximin criteria.
– Requires the decision maker to specify a degree of optimism, in
the form of a coefficient of optimism α, with possible values of
α ranging from 0 to 1.00.
– The closer the selected value of α is to 1.00, the more optimistic
the decision maker is, and the closer the value of α is to 0, the
more pessimistic the decision maker is.
Table 10 Equal Likelihood Criterion
Table 11 Summary of Methods for Decision Making under Complete
Uncertainty
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. 80per Kg. and sells at
the rate 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 for the store is Rs. 15 per Kg for the unsatisfied
portion of the demand. Based on the past experience, it
is found that demand varies from 50 Kg to 250Kg, in
steps of 50. The possible value of the order size are
from 75Kg to 300Kg in steps of 75Kg. Determine the
optimal order size which will maximize the daily profit of
the store.
 Game Theory

• Game theory can be used to determine

optimal decisions in face of other decision
making players.

• All the players are seeking to maximize their

return.

• The payoff is based on the actions taken by

all the decision making players.
Classification of Games

– By number of players
• Two players - Chess
• Multiplayer – Poker
– By total return
• Zero Sum - the amount won and amount lost by all
competitors are equal (Poker among friends)
• Nonzero Sum -the amount won and the amount lost by all
competitors are not equal (Poker In A Casino)
– By sequence of moves
• Sequential - each player gets a play in a given sequence.
• Simultaneous - all players play simultaneously.
Dominance property :
Reduce the size of payoff matrix by eliminating
redundant rows or columns

• In the payoff matrix of Player A, if all the entries in a row

(X) are greater than or equal to the corresponding
entries of another row (Y), then the row Y is dominated
by row X. Under such situation, row Y of the payoff
matrix can be deleted.

• In the payoff matrix of such Player A, if each of the sum

of the entries of any two rows (sum of the entries of row
X and row Y) is greater than or equal to the
corresponding entry of a third row (Z); then row Z is
dominated by row X and row Y. Under such situation.
Row Z of the payoff matrix can be deleted.
 Dominance property
Reduce the size of payoff matrix by eliminating
redundant rows or columns

• In the payoff matrix of Player A, if all the entries in a

column (X) are lesser than or equal to the
corresponding entries of another column (Y), then the
column Y is dominated by column X. Under such
situation, column Y of the payoff matrix can be deleted.

• In the payoff matrix of such Player A, if each of the sum

of the entries of any two columns (sum of the entries of
column X and column Y) is lesser than or equal to the
corresponding entry of a third column (Z); then column
Z is dominated by column X and column Y. Under such
situation. Column Z of the payoff matrix can be deleted.
IGA SUPERMARKET

• The town of Gold Beach is served by two

supermarkets: IGA and Sentry.

• Market share can be influenced by their advertising

policies.

• The manager of each supermarket must decide

weekly which area of operations to discount and
emphasize in the store’s newspaper flyer.
IGA SUPERMARKET

• Data
– The weekly percentage gain in market share for
IGA, as a function of advertising emphasis.
Sentry's Emphasis
Meat Produce Grocery Bakery
IGA's Meat 2 2 -8 6
Emphasis Produce -2 0 6 -4
Grocery 2 -7 1 -3

– A gain in market share to IGA results in equivalent

loss for Sentry, and vice versa (i.e. a zero sum
game)
IGA needs to determine an advertising
emphasis that will maximize its expected
change in market share regardless of
Sentry’s action.
IGA SUPERMARKET - Solution

• To prevent a sure loss of market share, both

IGA and Sentry should select the weekly
emphasis randomly.
• Thus, the question for both stores is:
What proportion of the time each area should be
emphasized by each store?
IGA’s Linear Programming Model

• Decision variables
– X1 = the probability IGA’s advertising focus is on
meat.
– X2 = the probability IGA’s advertising focus is on
produce.
– X 3 = the probability IGA’s advertising focus is on
groceries.

• Objective Function For IGA

– Maximize expected market increase regardless of
Sentry’s advertising policy.
 IGA’s Perspective

• Constraints
– IGA’s market share increase for any given
advertising focus selected by Sentry, must be at
least V.
• The model
IGA’s expected change
Max V in market share.
S.T.
Meat 2X1 – 2X2 + 2X3  V
Sentry’s Produce 2X1 – 7 X3  V
advertising Groceries -8X1 – 6X2 + X3  V
emphasis Bakery 6X1 – 4X2 – 3X3  V
Probability X1 + X2 + X3 = 1
Sentry’s Linear Programming Model

• Decision variables
– Y1 = the probability Sentry’s advertising focus is on meat.
– Y2 = the probability Sentry’s advertising focus is on
produce.
– Y 3 = the probability Sentry’s advertising focus is on
groceries.
– Y4 = the probability Sentry’s advertising focus is on
bakery.

• Objective Function For Sentry

Minimize the changes in market share in favor of IGA
Sentry’s perspective

• Constraints
– Sentry’s market share decrease for any given advertising
focus selected by IGA, must not exceed V.
• The Model
Min V
S.T.
2Y1 + 2Y2 – 8Y3 + 6Y4  V
-2Y1 + 6Y3 – 4Y4  V
2Y1 – 7Y2 + Y3 – 3Y4  V
Y1 + Y2 + Y3 + Y4 = 1

Y1, Y2, Y3, Y4 are non-negative; V is unrestricted

IGA SUPERMARKET – Optimal Solution

• For IGA
– X1 = 0.3889; X2 = 0.5; X3 = 0.1111

• For Sentry
– Y1 = .3333; Y2 = 0; Y3 = .3333; Y4 = .3333

• For both players V =0 (a fair game).