Decision Theory

• Making decision under uncertainty

• Use of statistical techniques to solve problems for which information
is incomplete, uncertain or completely lacking
 Decision Environment
• An objective function, the decision maker is trying to reach
• Several course of actions/alternatives.
• Calculate measure of benefit( payoff) of the various alternatives
• Events beyond the control of the decision maker
• Uncertainty concerning the events
Buying decision under uncertainty

• Computing probabilities
• Expected profit
Calculating probabilities
Daily sales No. of days sold Probability
10 15 0.15
11 20 0.20
12 40 0.40
13 25 0.25
 Conditional Profit Table
• Cost price = $20, Selling Price = $ 50, Salvage value =0
• Possible stock Level
Demand 10 11 12 13
10 300 280 260 240
11 300 330 310 290
12 300 330 360 340
13 300 330 360 390
 Expected Profit
•
Possible stock Level
•
Demand 10 11 12 13 Probability
10 300 280 260 240 0.15
11 300 330 310 290 0.2
12 300 330 360 340 0.4
13 300 330 360 390 0.25
Expected 300 322.5 335.5 327.5

Profit
 Expected profit with Perfect Information
• Complete and accurate information about future.

Possible stock Level

Demand 10 11 12 13
10 300
11 330
12 360
13 390
 Expected profit with perfect Information
• Expected profit with perfect information
• 0.15 *300 + 0.20*330 + 0.4*360 + 0.25*390 = 352.50
• Additional benefit = 352.5 -335 = 17.5
 Problem 17-7
• Emily Scott, head of a small business consulting firm, must decide how many employees
• . Emily knows from experience that the probability distribution for consulting job her firm will get each year
is as follows
Consulting jobs 24 27 30 33
Probability 0.3 0.2 0.4 0.1
----------------------------------------------------------------------
Emily also knows that each MBA hired will be able to handle exactly
Three jobs per year. The salary of each MBA is $60,000. Each consulting job is worth $30,000 to the firm.
Each consulting job that the company is awarded but cannot complete costs the firm $10,000 in future
business lost.
How many MBAs should the firm hire?. Expected value of perfect information.

•
 Conditional Profit Table
• MBA salary = $60 K, Job worth = $ 30 K, loss in Job not done =10 K
•
Hire MBA
Job 8 9 10 11
24 240 K
210 K
27
30 180 K
33 150 K
 Decision Theory

• Decision theory is a general approach to decision making

when the outcomes associated with alternatives are often in
doubt.
• A manager makes choices using the following process:
1. List the feasible alternatives
2. List the chance events (states of nature).
3. Calculate the payoff for each alternative in
each event.
4. Estimate the probability of each event. (The
total probabilities must add up to 1.)
5. Select the decision rule to evaluate the alternatives.
Decision Trees

• Decision Trees are schematic models of

alternatives available along with their possible
consequences.
• They are used in sequential decision situations.
• Decision points are represented by squares.
• Event points are represented by circles.
Decision Trees
E 1 & Probability
Payoff 1
E 2 & Probability
Payoff 2
E 3 & Probability
1 Payoff 3
e
ativ
rn
lte Alternative 3
Payoff 1
A
Alternative 4
Payoff 2
1 2 Alternative 5
y
1st ilit Payoff 3
Al
te b ab Possible
decision rn ro
at P 2nd decision
ive &
2 E1
E 2 & Probability
Payoff 1
= Event node E 3 & Probability
Payoff 2
= Decision node
Decision Trees

After drawing a decision tree, we solve it by working from right to left, starting
with decisions farthest to the right, and calculating the expected payoff for
each of its possible paths.

We pick the alternative for that decision that has the best expected payoff.

We “saw off,” or “prune,” the branches not chosen by marking two short lines
through them.

The decision node’s expected payoff is the one associated with the single
remaining branch.
Drawing the Tree
Example A.8

y
cilit
fa
all
Sm

1
La
rg
ef
ac
ilit
y
Drawing the Tree
Example A.8 continued
Low demand [0.4]
$200

Hi Don’t expand
gh
d
ic lit
y [0 ema
.6] n
fa d
all Expand
$223
Sm
2
$270
1
La
rg
ef
ac
ilit
y
Completed Drawing
Example A.8
Low demand [0.4]
$200

Hi Don’t expand
gh
d
ic lit
y [0 ema
.6] n
fa d
all Expand
$223
Sm
2
$270
Do nothing
1
La $40
rg Advertise Modest response [0.3]
ef $20
ac an
d 3
ilit m
y de .4]
w
Lo [0 Sizable response [0.7]
$220

High demand [0.6]

$800
Solving Decision #3
Example A.8
Low demand [0.4]
$200

Hi Don’t expand
gh
d
ilit
y [0 ema
c .6] n
ll fa d
$223
a Expand
Sm
2
$270
Do nothing
1 0.3 x $20 = $6
La $40
rg Advertise Modest response [0.3]
ef $20
ac an
d 3
ilit m
y de .4]
w
Lo [0 Sizable response [0.7]
$220
$6 + $154 = $160
0.7 x $220 = $154

High demand [0.6]

$800
Solving Decision #3
Example A.8
Low demand [0.4]
$200

Hi Don’t expand
gh
d
ilit
y [0 ema
c .6] n
ll fa d
$223
a Expand
Sm
2
$270
Do nothing
1
La $40
rg Advertise Modest response [0.3]
ef $20
ac an
d 3
ilit m
y de .4]
w
Lo [0 $160 Sizable response [0.7]
$220
$16
0

High demand [0.6]

$800
Solving Decision #2
Example A.8
Low demand [0.4]
$200

Hi Don’t expand
gh
d
ilit
y [0 ema
c .6] n
ll fa d
$223
a Expand
Sm
2
Expanding has a higher
$27 $270 value.
Do nothing
1 0
La $40
rg Advertise Modest response [0.3]
ef $20
ac an
d 3
ilit m
y de .4]
w $16
Lo [0 Sizable response [0.7]
0 $220
$16
0

High demand [0.6]

$800
Solving Decision #1
Example A.8
Low demand [0.4]
$200 x 0.4 = $80
$242
Hi Don’t expand
gh
d $470
ic lit
y [0 ema
.6] n
fa d
all Expand
$223
Sm
2
$27 $270 x 0.6 = $162
Do nothing
1 0
La $40
rg Advertise Modest response [0.3]
ef $20
ac an
d 3
ilit m
y de .4]
w $16
Lo [0 Sizable response [0.7]
0 $220
$16
0

High demand [0.6]

$800
Solving Decision #1
Example A.8
Low demand [0.4]
$200
$242
Hi Don’t expand
gh
d
ic lit
y [0 ema
.6] n
fa d
all Expand
$223
Sm
2
$27 $270
Do nothing
1 0
La $40
rg Advertise Modest response [0.3]
ef $20
ac an
d 3
ilit m
y de .4]
w $16
Lo [0 Sizable response [0.7]
$220
0.40x $160 = $64 $16
0

$544 High demand [0.6]

$800 x 0.6 = $480
Solving Decision #1
Example A.8
Low demand [0.4]
$200

Hi Don’t expand
gh
d
ic lit
y
$24 [0 ema
.6] n
fa d
all 2
Expand
$223
Sm
2
$27 $270
Do nothing
1 0
La $40
rg Advertise Modest response [0.3]
ef $20
ac an
d 3
$544 ilit m
y de .4]
w $16
Lo [0 Sizable response [0.7]
0 $220
$16
0

$54 High demand [0.6]

$800
4
Application A.6
OM Explorer Solution
 Solved Problem 4

Bad times [0.3]

$191

Normal times [0.5]

$240
One lift
$225.3
Good times [0.2]
$240
$256.0
Bad times [0.3]
$151

Two lifts Normal times [0.5]

$245

$256.0
Good times [0.2]
$441
 Problem on Decision Tree
• Sue Reynold has to decide if she should get information at a cost of $20, 000 to invest in a retail store. If she gets the
information, there is a 0.60 probability that information will be favorable and 0.4 probability that the information will not
favorable. If the information is favorable, there is 0.9 probability that the store will be success. If the information is not
favorable, the probability of successful store is only 0.2. Without any information, Sue estimates that the probability of a
successful store will be 0.6. A successful store will give a return of $100, 000. If the store is built but not successful, Sue
will see a loss of $80,000. Of course, she could always decide not to build the retail store. Draw the decision tree and
recommend suitable action