Management Science

Decision Theory
Introduction to Management Science
By
 William J. Stevenson & Ceyhun Ozgur

Dr. Md. Rostam Ali

Associate Professor
Department of Business Administration
Mawlana Bhashani Science and Technology University
Santosh, Tangail-1902, Bangladesh

1
 T1 T2
T0

Bank Deposit 100 105 ----

Alternatives

200 or 50
Share Market 100 Probabilities 20% 80% ---
Probabilities 80% 20%

Lend to Someone 100 --- 115

2
 Learning Objectives
After completing this chapter, you should be able to:
1. Outline of the characteristics of a decision theory approach to
decision making.
2. Taking decisions under certainty, risk, and complete
uncertainty.
3. Develop decision trees that consist of a combination of
decision alternatives and events.
4. Determine if acquiring additional information in a decision
problem will be worth the cost.
5. Analyze the sensitivity of decisions to probability estimates.
6. Use software to solve decision-making problems.
 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 and state of nature.
4. An assessment of the degree of certainty of possible future
events.
5. A decision criterion: The process of selecting one alternative
from a list of alternatives.
 Example 11-1

Suppose that a real estate developer must decide on a plan for

developing a certain piece of property. After careful consideration, the
developer has 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 11–1 General Format of a Decision Table
Table 11–2 Payoff Table for Real Estate Developer

State of Nature

No Medium Large
center center center
Alternatives

Residential 4,00,000 16,00,000 12,00,000

Commercial #1 6,00,000 5,00,000 14,00,000

Commercial #2 -1,00,000 4,00,000 15,00,000

Table 11–3 Decision Making under Certainty
If it is known that no shopping center will be built then only the first column Payoffs
would be relevant

State of Nature

No Medium Large
center center center
Alternatives

Residential 4,00,000 16,00,000 12,00,000

Commercial #1 6,00,000 5,00,000 14,00,000

Commercial #2 -1,00,000 4,00,000 15,00,000

 Decision Making under
Complete Uncertainty

Approaches to decision making under complete uncertainty:

1. Maximin: Considering the maximum from the minimum payoffs of the alternatives.
2. Maximax: Considering the maximum from the maximum payoffs of the alternatives.
3. Minimax Regret: Considering the minimum opportunity loss from the maximum
opportunity loss of the alternatives.
4. Hurwicz: Weighted Average or Realism Criterion
5. Equal likelihood: Compute average payoff of each row and select the alternative
that has the highest row average.
 Table 11–4 Maximin Solution for Real Estate Problem

State of Nature
No Medium Worst
Large center
center center Payoff
Alternatives

Residential 4,00,000 16,00,000 12,00,000 4,00,000

5,00,000 Maximum
Commercial #1 6,00,000 5,00,000 14,00,000

-1,00,000
Commercial #2 -1,00,000 4,00,000 15,00,000

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 11–5 Maximax Solution for Real Estate Problem

State of Nature
No Medium Best
Large center
center center Payoff
Alternatives

16,00,000 Maximum
Residential 4,00,000 16,00,000 12,00,000

14,00,000
Commercial #1 6,00,000 5,00,000 14,00,000

15,00,000
Commercial #2 -1,00,000 4,00,000 15,00,000

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 11–6 Payoff Table with Similar Maximum Payoffs

Both the Maximax and Maximin strategies can be criticized because

they focus only a single, extreme payoff and exclude the other Payoffs.
Thus, Maximax strategy ignores the possibility that an alternative with
a slightly smaller payoff might offer a better choice. Such as,
 Table 11–6 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.
 Minimax Regret
• Original Payoff Table
State of Nature
Alternatives No center Medium center Large center

Residential 4,00,000 16,00,000 12,00,000

Commercial #1 6,00,000 5,00,000 14,00,000

Commercial #2 -1,00,000 4,00,000 15,00,000

Best Payoff
6,00,000 16,00,000 15,00,000
In column
 MINIMAX REGRET
• Opportunity Loss Table: The difference between best possible payoff and each
payoff the in a column (i.e., given a state of nature).

Opportunity Loss Table

State of Nature Maximum
Alternatives No center Medium center Large center Loss
3,00,000 Minimum
Residential 2,00,000 0 3,00,000
11,00,000
Commercial #1 0 11,00,000 1,00,000
12,00,000
Commercial #2 7,00,000 12,00,000 0
 Limitation of Minimax Regret

Although this approach use more information than either Maximax or

Maximin, it still ignore some information and, therefore can lead to a
poor decision. Such as,
 The Hurwicz 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.
– In order to use the Hurwicz Criterion, for each alternative, the best payoff is
multiplied by α and worst payoff is multiplied by 1- α, and the result are added.

That is :- α (Best Payoff ) + (1- α)(Worst Payoff )

– The totals for all alternatives are then compared, and the alternative that has the
best overall result (Maximum Payoff) is selected.
 The Hurwicz Criterion (Weighted Average or Realism Criterion)

• Original Payoff Table

State of Nature
Alternatives No center Medium center Large center

Residential 4,00,000 16,00,000 12,00,000

Commercial #1 6,00,000 5,00,000 14,00,000

Commercial #2 -1,00,000 4,00,000 15,00,000

State of Nature
Alternatives No center Medium center Large center

Residential 4,00,000 16,00,000 12,00,000

Commercial #1 6,00,000 5,00,000 14,00,000

Commercial #2 -1,00,000 4,00,000 15,00,000

 The Hurwicz Criterion (Weighted Average or Realism Criterion)
Suppose the decision maker feels somewhat pessimistic and chooses the
coefficient of optimism equal to .30 that α = .30 and 1- α = .70. What is
the best alternative for real estate example?
The formula of Hurwicz Criterion is:-
α (Best Payoff ) + (1- α)(Worst Payoff )
Alternatives Best Payoff Worst Payoff Total

Residential .30(16,00,000) + .70(4,00,000) = 7,60,000

Commercial #1 .30(14,00,000) + .70(5,00,000) = 7,70,000 Best

Commercial #2 .30(15,00,000) + .70(-1,00,000) = 3,80,000

 Equal Likelihood Criterion

• Equal Likelihood Criterion incorporate more information.

• It treats the state of nature are equally likely (Equal probability of
occurrence)
• Compute average payoff of each row and select the alternative that
has the highest row average.

Alternatives S1 S2 S3 S4 S5 Row average

23.2 Maximum
a1 28 28 28 28 4
9.6
a2 5 5 5 5 28
9.6
a3 5 5 5 5 28
Table 11–11 Summary of Methods for Decision Making under Complete Uncertainty
 Decision Making under Risk

• Decision making under partial uncertainty

–Distinguished by the present of probabilities for the
occurrence of the various states of nature under
partial uncertainty.
–The term risk is often used in conjunction with partial
uncertainty.
• Sources of probabilities
–Subjective estimates
–Expert opinions
–Historical frequencies
 Decision Making under Risk
Approaches to decision making under risk:
• Expected Monetary Value (EMV) approach
– Provides the decision maker with a value that represents weight average
payoff for each alternative and the alternative with the highest expected
payoff is selected as the best choice.
• Expected Opportunity Loss (EOL)
– The opportunity losses for each alternative are weighted by the
probabilities of their respective states of nature to compute a long-run
average opportunity loss, and the alternative with the smallest expected
loss is selected as the best choice.
• Expected Value of Perfect Information (EVPI)
– A measure of the difference between the certain payoff that could be
realized under a condition of certainty and the expected payoff under a
condition involving risk.
 Table 11–12 Expected Monetary Value (EMV) approach

Expected Monetary Value (EMV) approach

Provides the decision maker with a value that represents weight average
payoff for each alternative. The best alternative is, then, the one that has the
highest expected monetary value. The average or expected payoff of each
alternative is a weighted average: The state of nature probabilities are used
to weight the respective payoffs.
 Table 11–12 Expected Monetary Value (EMV) approach

State of Nature
Probability Probability Probability
Alternatives .2 .5 .3 Expected
No center Medium center Large center Payoff
12,40,000 Maximum
Residential 4,00,000 16,00,000 12,00,000
7,90,000
Commercial #1 6,00,000 5,00,000 14,00,000
6,30,000
Commercial #2 -1,00,000 4,00,000 15,00,000

EMVR = .2(4,00,000) + .5(16,00,000) + .3(12,00,000) = 12,40,000

EMVc1 = .2(6,00,000) + .5(5,00,000) + .3(14,00,000) = 7,90,000
EMVc2 = .2(-1,00,000) + .5(4,00,000) + .3(15,00,000) = 6,30,000
 Table 11–12 Expected Opportunity Loss (EOL)

State of Nature
Probability Probability Probability
Alternatives .2 .5 .3 Expected
No center Medium center Large center Payoff
1,30,000 Minimum
Residential 2,00,000 0 3,00,000
5,80,000
Commercial #1 0 11,00,000 1,00,000
7,40,000
Commercial #2 7,00,000 12,00,000 0

EOLR = .2(2,00,000) + .5(0) + .3(3,00,000) = 1,30,000

EOLc1 = .2(0) + .5(11,00,000) + .3(1,00,000) = 5,80,000
EOlc2 = .2(7,00,000) + .5(12,00,000) + .3(0) = 7,40,000
 Table 11–12 Expected Value of Perfect Information (EVPI)

A measure of the difference between the certain payoff that could be realized
under a condition of certainty and the expected payoff under a condition
involving risk.

EVPI = EPC – EMV

Where,

EPC = Expected Payoff under certainty

EMV = Expected Payoff under risk

 Expected Value of Perfect Information (EVPI)

State of Nature
Probability Probability Probability
Alternatives .2 .5 .3

No center Medium center Large center

Residential 4,00,000 16,00,000 12,00,000

Commercial #1 6,00,000 5,00,000 14,00,000

Commercial #2 -1,00,000 4,00,000 15,00,000

EVC = .2(6,00,000) + .5(16,00,000) + .3(15,00,000) = 13,70,000
EMV = 12,40,000

It is known that
EVPI = EPC – EMV
= 13,70,000 – 12,40,000 = 1,30,000
 Exhibit 11-2 Using Excel to Make Decisions under Risk

Copyright © 2007 The McGraw-Hill Companies. All rights reserved. McGraw-Hill/Irwin 11–29
 Figure 11–1 Decision Tree

Decision trees are used by decision makers to obtain a

visual portrayal of decision alternatives and their possible
consequences.

 Decision tree is the composed of ‘Squares’, ‘Circles’, and

‘Lines’.
 Squares indicate decision points
 Circles indicate change events
 Lines that emanate from square indicate alternatives
 Lines that emanate from circle indicate states of nature
 Tree is read from the right to lest.
 Figure 11–1 Decision Tree

Payoff Table: Decision making requires single decision

Decision Trees: Decision making requires single decision or

sequential decision
 Figure 11–1 Decision Tree Format
State of Nature
Probability .2 Probability .5 Probability .3
Alternatives
No center Medium center Large center

Residential 4,00,000 16,00,000 12,00,000

Commercial #1 6,00,000 5,00,000 14,00,000

Commercial #2 -1,00,000 4,00,000 15,00,000

 Figure 11–1 Decision Tree Format
State of Nature
Probability .2 Probability .5 Probability .3
Alternatives
No center Medium center Large center

Residential 4,00,000 16,00,000 12,00,000

Commercial #1 6,00,000 5,00,000 14,00,000

Commercial #2 -1,00,000 4,00,000 15,00,000

 Figure 11–1 Decision Tree Format

State of Nature
Probability .2 Probability .5 Probability .3
Alternatives
No center Medium center Large center

Residential 4,00,000 16,00,000 12,00,000

Commercial #1 6,00,000 5,00,000 14,00,000

Commercial #2 -1,00,000 4,00,000 15,00,000

 The worst payoff will result if no shopping center is build

 Suppose the decision maker considers the following
additional alternatives in the event that no center is build.
1. Do nothing
2. Develop a small shopping center
3. Develop a park
Figure 11–3 Real Estate Problem with a Second Possible Decision
Figure 11–4 Sequential Decision Tree for Unicom Inc. (Example 11-1.)

State of Nature
Alternatives Probability .55 Probability .45
Favorable Demand Unfavorable Demand
Build Small Plant 9,50,000 7,00,000
Build Large Plant 15,00,000 -50,000

Build Small Plant (Favorable Demand)

State of Nature
Alternatives Probability .40 Probability .60
High Return Low Return
Same Plant 9,50,000 9,50,000
Expand the Plant 13,30,000 7,20,000
Figure 11–4 Sequential Decision Tree for Unicom Inc.
(Example 11-1.)
 Figure 11–4 Sequential Decision Tree for Unicom Inc.
(Example 11-1.)

EMV1 = .4(13,30,000) + .6(7,20,000) = 9,64,000

EMV3 = .45(7,00,000) + .55(9,64,000) = 8,45,200
EMV4 = .45(-50,000) + .55(15,00,000) = 8,02,500
 Figure 11–5 Decision Making with Additional Information (Example 11-2)

Suppose an advertising manager is trying to decide which of two

advertising proposals to use for upcoming promotion. The manager
has developed the following payoff table:
State of Nature (Market)
Alternatives Probability .70 Probability .20
Strong (,000) Weak (,000)

Print Media 40 20

Video Media 50 10
 Suppose the manager has the option to test the market
 This test will provide the additional information in the form of
revised probabilities.
 This test will cost $ 1000.
 Figure 11–5 Decision Making with Additional Information (Example 11-2)

 The probability that the market test will show the strong market is
.59 and weak market is .41.
Figure 11–5 Decision Making with Additional Information (Example 11-2)
 Test Market Payoffs

Expected Payoff of Market Test (EMVM) = .59(48) + .41(26.8) = 39,308

Additional Expected Value for Market Test = 39,308 – 38000 = 1,308

Expected Gain = 1,308 – 1,000 = 308
Answer: The manager should use the market test which will lead to expected gain of $ 308.
 Efficiency of Sample Information

Expected Value of Sample Information (EVSI)

= Expected Value with Sample Information – (Expected Value without Sample Information )

State of Nature (Market)

Alternatives Probability .70 Probability .30
Strong (,000) Weak (,000)

Print Media 40 20

Video Media 50 10
Expected Value under Certainty ( EPC) = .70(50) + .30(20) = 41

Expected Value of Perfect Information (EVPI) = EPC – EMV = 41 – 38 = 3

Test Market Payoffs
 Figure 11–6 Summary of Analysis of Market Test Example

Copyright © 2007 The McGraw-Hill Companies. All rights reserved. McGraw-Hill/Irwin 11–53
 Table 11–13 Reliability of Market Test

Copyright © 2007 The McGraw-Hill Companies. All rights reserved. McGraw-Hill/Irwin 11–54
 Table 11–14 Probability Calculations Given the Market Test Indicates a
Strong Market

Copyright © 2007 The McGraw-Hill Companies. All rights reserved. McGraw-Hill/Irwin 11–55
 Table 11–15 Probability Calculations Given the Market Test Indicates a
Weak Market

Conditional probabilities express the reliability of

the sampling device (e.g., market test) given the
condition of actual market type.

Copyright © 2007 The McGraw-Hill Companies. All rights reserved. McGraw-Hill/Irwin 11–56
 Exhibit 11–11 Calculation of the Revised Probabilities for the Market Test
Example

Copyright © 2007 The McGraw-Hill Companies. All rights reserved. McGraw-Hill/Irwin 11–57
 Figure 11–7 Format of Graph for Sensitivity Analysis

Sensitivity Analysis enables decision makers to identify a range

of probabilities over which a particular alternative would be optimal.

Copyright © 2007 The McGraw-Hill Companies. All rights reserved. McGraw-Hill/Irwin 11–58
 Figure 11–8 The Expected Value Line for Alternative a.

Copyright © 2007 The McGraw-Hill Companies. All rights reserved. McGraw-Hill/Irwin 11–59
 Figure 11–9 Example of Finding the Expected Value for Alternative a when
P(#2) Is .50

Copyright © 2007 The McGraw-Hill Companies. All rights reserved. McGraw-Hill/Irwin 11–60
 Figure 11–10 All Three Alternatives Are Plotted on a Single Graph

Copyright © 2007 The McGraw-Hill Companies. All rights reserved. McGraw-Hill/Irwin 11–61
 Figure 11–11 The Line with the Highest Expected Profit Is Optimal for a
Given Value of P(#2)

Copyright © 2007 The McGraw-Hill Companies. All rights reserved. McGraw-Hill/Irwin 11–62
 Utility
• Utility (of a payoff)
– A measure of the personal satisfaction associated with a payoff.
• Risk
– A decision problem in which the states of nature have
probabilities associated with their occurrence.
• Risk Averters
– Individuals that avoid taking risks. The decision maker has less
utility for greater risk.
• Risk Takers
– Individuals that like taking risks and that have a greater utility for
the potential winnings even though their chances of winning are
very low.

Copyright © 2007 The McGraw-Hill Companies. All rights reserved. McGraw-Hill/Irwin 11–63
 Figure 11–12 Converting P(#2) Ranges into P(#1) Ranges

Copyright © 2007 The McGraw-Hill Companies. All rights reserved. McGraw-Hill/Irwin 11–64
 Exhibit 11–12 Solved Problem 1: Decision Making under Complete
Uncertainty—A Profit Maximization Problem (Part f)

Copyright © 2007 The McGraw-Hill Companies. All rights reserved. McGraw-Hill/Irwin 11–65
 Exhibit 11–13 Solved Problem 2: Decision Making under Complete
Uncertainty—A Cost Minimization Problem (part f)

Copyright © 2007 The McGraw-Hill Companies. All rights reserved. McGraw-Hill/Irwin 11–66
 Exhibit 11–14 Calculation of the Revised Probabilities and Expected Value
of Perfect Information for Solved Problem 3 (part c)

Copyright © 2007 The McGraw-Hill Companies. All rights reserved. McGraw-Hill/Irwin 11–67
 Exhibit 11–15 Calculation of the Revised Probabilities for Solved Problem 5
(part c)

Copyright © 2007 The McGraw-Hill Companies. All rights reserved. McGraw-Hill/Irwin 11–68
 Exhibit 11–16 TreePlan Dialog Box to Add Branches, Decision Nodes, or Events

Exhibit 11–17 TreePlan Dialog Box to Add or Change Decision Nodes or Events

Copyright © 2007 The McGraw-Hill Companies. All rights reserved. McGraw-Hill/Irwin 11–69
 Exhibit 11–18 Decision Tree for Solved Problem 5 (part c)

Copyright © 2007 The McGraw-Hill Companies. All rights reserved. McGraw-Hill/Irwin 11–70