UNIT X: STATISTICAL DECISION THEORY

CHAPTER 15
In decision-making problems, there are certain common elements which are
called ingredients of decision problems.

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These ingredients are:

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1. Alternative Courses of Action: The decision procedure involves
selecting

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among the alternatives a single course of action that can be actually
carried

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out. The process of decision-making involves the selection of a single act
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from among some set of alternative acts.
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2. Uncertainty: When the outcome of some action is not known in advance,
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then outcome is said to be Uncertain.

3. Pay Offs: In order to evaluate each possible course of action, the result of
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each event with each course of action has a value (or pay off) placed
BH

upon it .

Table No.1
SI
N

States of Nature S1 S2 S3
S(Events)
A

Alternative courses of
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actions A
A1 P11 P12 P13
A2 P21 P22 P23
A3 P31 P32 P33

where Pij stands for pay off value assigned to the respective Action –
State
combination.
4. Decision criteria: The decision-maker must-determine how to select the
best
course of action and for this he used different criteria. In most decision
problems following criteria are used

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(A)Under uncertainty

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(i) Maximax criterion: the maximax criterion is known as Optimistic criterion
that attempts to maximise the maximum gain i.e. maximax chooses the act

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that is the "best of the best".

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Maximax=Maximum{ max A1, max A2, max A3,….. max An}
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(ii) Maximin or Wald decision criteion: The maximin criterion is a criterion
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of pessimism. The decision maker should always be pessimistic or
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conservative, resulting in a maximin criterion where the attempt is to

maximise the minimum gains or it try to "pick the best of the worst".
A

Maximin=Maximum{ min A1, min A2, min A3,….. min An}

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(iii) Minimax Regret Criterion: Also known as Savage criterion as he regrets

making a wrong decision and hence tries to minimize the loss .Therefore, he
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selects the act that will give the minimum of the maximum opportunity losses.
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To employ this criterion, one must transform the payoff matrix into a regret
matrix by replacing every payoff in a row of the payoff matrix with the
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difference obtained by subtracting the payoff from the row's maximum payoff.
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This regret or opportunity loss represents the lost profit.

Minimax Regret = Minimum{ max A1, max A2, max A3,….. max An}

(iv) Laplace’s Average Criterion: This criterion is based on the assumption

of equally likely when the probabilities of the various outcomes are unknown.

Laplace’s Average= Maximum{ Avg A1, AvgA2, Avg A3,….. ,Avg An}
(B)Under uncertainty with Probabilities

(1) Expected Monetary Value (2) Expected Opportunity Loss

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When there is certainty about occurrence of events, a decision-maker to

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reach the optimal solution of a problem used probabilities of the states of
natures (Events) and calculates the EP/EOL for each Alternative–State

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combination.

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(1) Expected Monetary Value (EMV)
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The decision criterion here is to choose the Optimal Act (OA), the act that
yields the maximum Expected Pay off(E)P.
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(2) Expected Opportunity Loss (EOL)

The alternative decision criterion here the decision maker calculates the
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expected value of the opportunity loss values for each alternative–State

BH

combination, and then he chooses the decision that has the minimum EOL.

Note: If we replace the payoffs by their corresponding opportunity losses

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we
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get a new table called loss table. Refer Table No.1

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Decision Tree:

A Decision Tree diagram is a graphical representation of various alternatives

and the sequence of events in a decision problem.

Constructing a decision tree:

 1. The tree is constructed starting from left and moving towards right.

2. The square box denotes a decision point at which the available

strategies are considered.

3. The circle O represents the chance node or event, the various states of
nature or outcomes emanate from this chance event.

4. At each circle O, there can be one or more branches represented by a

straight line.

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5. Any branch that is not followed by another decision or chance node is

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called a terminal branch

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Advantages of Decision Tree Approach

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The decision tree analysis as a tool of decision-making is important because
of the following: 16
1. Decision trees are of great help in complicated kinds of decision
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problems.
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2. It structures the decision process making managers, approach decision

in an orderly sequential fashion.
3. It helps decision-maker to examine all possible outcomes desirable and
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undesirable.
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4. It communicates clearly the decision-making process to others.

5. It allows a group to discuss alternatives by focusing on each financial
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figure, probability value and underlying assumption one at a time.

6. It can be used with a computer so that many different sets of
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consumptions can be simulated and their effects on the final outcomes

observed.
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