The problem of statistical decision theory is that given a situation where there are several

available alternative courses of action, each of which may lead to a set of mutually exclusive
outcomes associated with certain probabilities, which course of action should a decision maker
take?

Structure of Decision Making Problem:

1. The Decision maker:

The decision maker refers to the individual or a group of individuals responsible for
making a choice of an appropriate course of action from the available courses of action.
2. Courses of action:
Courses of action are also called actions, alternatives, acts or strategies.
3. States of nature:
States of nature are sometimes called outcomes or events. The decision maker must
develop an exhaustive list of all possible future events. However decision maker has no
control over the occurrence of specific event.
4. Pay off:
Each combination of a course of action and an event is associated with a payoff , which
measures the net benefits to the decision maker that occurs from a given combination of
decision alternatives and events.
5. Payoff table:

Courses of A1 A2 ….. An
action

Events
E1 P11 P12 P1n
…
Em Pm1 …. Pmn
6. Regret ( Opportunity loss):
The opportunity loss has been defined to be the difference between the highest possible
profit for an event (state of nature) and the actual profit obtained for the particular action
taken, i.e, an opportunity loss is the loss incurred because of failure to take the best
possible action.

Types of decision making environment:

1. Decision making Under the conditions of Certainty:

Here only one state of nature exist
2. Decision making under the conditions of uncertainty
3. Decision making under the conditions of Risk
Decision making under the conditions of uncertainty:
1. Maximax(Optimistic)
2. Maximin(Pessimistic)
3. Minimax Regret Criterion
4. Laplace Criterion
5. Hurwicz Criterion (Criterion of Realism)

Example:

The following matrix gives the payoff of different strategies S1, S2 and S3 against conditions
N1,N2, N3,N4

N1 N2 N3 N4
S1 4000 -100 6000 18000
S2 20000 5000 400 0
S3 20000 15000 -2000 1000
Indicate the decision taken under the following approaches.

i. Pessimistic
ii. Optimistic
iii. Equal probability
iv. Regret
v. Hurwicz criterion, his degree of optimism being .7

Solution:

For the given payoff matrix, the values corresponding to the pessimistic, optimistic equal
probability criteria are given below in the following payoff table

Pessimistic(min Optimistic(Max. Equal prob.

payoff) Payoff)
S1 -100 18000 ¼(4000-
100+6000+18000)=
S2 0 20000 6350
S3 -2000 20000 8500
Maximin “0” Maximax 20000 Max Payoff 8500
Decision S2 S2, S3 S3
IV. The following table represents the regrets for every event and for each alternative calculated
by the expression

Ith regret = (max payoff-ith payoff) for the jth event

N1 N2 N3 N4 Max Regret
Regret Regret Regret Regret
S1 16000 15100 0 0 16000
S2 0 10000 5600 18000 18000
S3 0 0 8000 17000 17000

The decision alternative S1 would be chosen since it corresponds to the minimal of the
maximum possible regrets.

V. Hurwicz criterion, his degree of optimism being .7

For the given payoff matrix the minimum and the maximum payoff for each alternative are given
below

Alternative Max payoff Min payoff Payoff= α.max+(1−α ¿.min

S1 18000 -100 .7*18000-.3*100=12570

S2 20000 0 14000
S3 20000 -2000 13400

Thus under Hurwicz rule S2 should be chosen as it is associated with the highest payoff 14000.