Chapter 3: Decision Analysis

Decision theory – is an analytic and systematic approach to the study of decision making.

6 Steps in Decision Making

1. Clearly define the problem at hand

2. List the possible alternatives
3. Identify the possible outcomes or states of nature
4. List the payoff (profit) of each combination of alternatives and outcomes
5. Select one of the mathematical decision theory models
6. Apply the model and make your decision.

Alternative – is defined as a course of action or a strategy that the decision maker can choose.

States of nature – those outcomes over which the decision maker has little or no control

Decision table/payoff table – easiest way to present these values is by constructing these.

Types of Decision Making Environments

 Decision making under certainty - decision makers know with certainty the consequence of every
alternative or decision choice. Naturally, they will choose the alternative that will maximize their well-being
or will result in the best outcome.
 Decision making under uncertainty
o Optimistic - the best (maximum) payoff for each alternative is considered, and the alternative with
the best (maximum) of these is selected. Maximax Criterion

o Pessimistic - the worst (minimum) payoff for each alternative is considered, and the alternative with
the best (maximum) of these is selected. Maximin Criterion

o Criterion of Realism (Hurwicz) – often called the weighted average, is a compromise between an
optimistic and a pessimistic decision.
 Coefficient of realism (𝛼) – this measures the degree of optimism of the decision maker and
is between 0 and 1.
 𝑊𝑒𝑖𝑔ℎ𝑡𝑒𝑑 𝑎𝑣𝑒𝑟𝑎𝑔𝑒 = 𝛼(𝐵𝑒𝑠𝑡 𝑖𝑛 𝑟𝑜𝑤) + (1 − 𝛼)(𝑊𝑜𝑟𝑠𝑡 𝑖𝑛 𝑟𝑜𝑤)
 o Equally likely (Laplace) - One criterion that uses all the payoffs for each alternative is the equally
likely. This involves finding the average payoff for each alternative and selecting the alternative with
the best or highest average.

o Minimax regret – Opportunity loss or regret refers to the difference between the optimal profit or
payoff for a given state of nature and the actual payoff received for a particular decision for that
state of nature.
 Opportunity loss table – determining the opportunity loss for not choosing the best
alternative for each state of nature. calculated by subtracting each payoff in the column
from the best payoff in the same column

 Decision making under risk - decision situation in which several possible states of nature may occur and the
probabilities of these states of nature are known.

Expected Monetary Value - Given a decision table with conditional values (payoffs) that are monetary values and
probability assessments for all states of nature, it is possible to determine the EMV for each alternative.
Expected Value of Perfect Information (EVPI) - There are times that accurate and complete information are
available for the decision maker to take advantage of. But such information is not free.

Perfect information - can be from accurate historical data or a product of technical analysis of the market or of any
production processes.

 𝐸𝑉𝑃𝐼 = 𝐸𝑉𝑤𝑃𝐼 − 𝐵𝑒𝑠𝑡 𝐸𝑀𝑉

Expected Opportunity Loss - An alternative approach to maximizing EMV is to minimize expected opportunity loss.

Decision Tree - Any problem that can be presented in a decision table can also be graphically illustrated in a decision
tree.

 A decision node from which one of several alternatives may be chosen

 A state-of-nature node out of which one state of nature will occur

Five Steps of Decision Tree Analysis

 Define the problem.

 Structure or draw the decision tree.
 Assign probabilities to the states of nature.
 Estimate payoffs for each possible combination of alternatives and states of nature.
 Solve the problem by computing EMVs for each state-of-nature node.