Decision Theory/Analysis

Decision Making under Risk

Decision Making under Uncertainty
Decision Tree Analysis
Objective
 Decision analysis - many decisions are made in
environments that are fraught with uncertainty
 Identify the states of nature
 Identify the alternative courses of action
 Create a pay-off table
 Learn decision rules under uncertainty
 Learn decision rules under risk
 Decision Tree Analysis
The decision making process
1. Identify possible outcomes – States of
Nature / Events [Ei]
2. Identify all - courses of Action [Aj] – the
strategies available to the decision maker
3. Determine the - pay-off function [Vij] –
the payoff resulting from ith event and jth
strategy
4. Choosing from among various alternatives
on the basis of some criterion
Question
Selling price – Rs 100 / unit
Cost Price – Rs 80 / unit
Unsold Units – disposed off for Rs 30 / unit
Annual demand – 18 to 23 Units
How many units should the seller stock so
as to maximize his profit??
Profit per unit = 20
Loss per unit = 50
States of nature
 There are 6 possible events/ states of nature.
 The demand could be 18 or 19 or 20 or 21
or 22 or 23
 E1 = 18
 E2 = 19
 E3 = 20
 E4 = 21
 E5 = 22
 E6 = 23
Courses of action
 There are 6 possible courses of action /
decision that the seller could take
 Stock 18 units, 19 units, 20 units, 21 units, 22
units, or 23 units.
 A1 = 18
 A2 = 19
 A3 = 20
 A4 = 21
 A5 = 22
 A6 = 23
The pay-off function
 It is a conditional value – a conditional
profit or a conditional loss.
 Let:
 Q = quantity to be purchased – available with
the seller
 D = demand for the product
 P = profit
P = 20 Q when D >= Q
P = 20 D – 50 Q when D < Q
 The pay-off table
A1 (18) A2 (19) A3 (20) A4 (21) A5 (22) A6 (23)

=18x20 - =18x20 - =18x20 - =18x20 - =18x20

18 E1 =18x20
50 100 150 200 -250

19 E2

20 E3

21 E4

22 E5

23 E6
 The pay-off table
A1 (18) A2 (19) A3 (20) A4 (21) A5 (22) A6 (23)

18 E1 360 310 260 210 160 110

19 E2 360 380 330 280 230 180

20 E3 360 380 400 350 300 250

21 E4 360 380 400 420 370 320

22 E5 360 380 400 420 440 390

23 E6 360 380 400 420 440 460

 Opportunity Loss Table
A1 (18) A2 (19) A3 (20) A4 (21) A5 (22) A6 (23)

18 E1 0 50 100 150 200 250

19 E2 20

20 E3 40

21 E4 60

22 E5 80

23 E6 100
 Opportunity Loss Table
A1 (18) A2 (19) A3 (20) A4 (21) A5 (22) A6 (23)

18 E1 0 50 100 150 200 250

19 E2 20 0 50 100 150 200

20 E3 40 20 0 50 100 150

21 E4 60 40 20 0 50 100

22 E5 80 60 40 20 0 50

23 E6 100 80 60 40 20 0
Decision Making
 The pay-off table is used to find the
optimum alternative for the decision
maker according to an appropriate
criterion.
 Information from either table can be used
depending on the requirement of the
criterion.