DECISION THEORY

Introduction:
Decision theory is primarily concerned with helping people and organizations in
making decisions. It provides a meaningful conceptual frame work for important
decision making. The decision making refers to the selection of an act from amongst
various alternatives, the one which is judged to be the best under given
circumstances.
The management has to consider phases like planning, organization, direction,
command and control. While performing so many activities, the management has to
face many situations from which the best choice is to be taken. This choice making
is technically termed as “decision making” or decision taking. A decision is simply
a selection from two or more courses of action. Decision making may be defined as
- “ a process of best selection from a set of alternative courses of action, that course
of action which is supposed to meet objectives up to satisfaction of the decision
maker.”

Meaning
Decision theory is a general approach to decision making when the outcomes
associated with alternatives are often in doubt. It helps operations managers with
decisions on process, capacity, location, and inventory because such decisions are
about an uncertain future.

The decision maker: The decision maker refers to individual or a group of

individual responsible for making the choice of an appropriate course of action
amongst the available courses of action.

Acts (or courses of action): Decision making problems deals with the selection of
a single act from a set of alternative acts. If two or more alternative courses of action
occur in a problem, then decision making is necessary to select only one course of
action. Let the acts or action be a1, a2, a3,… then the totality of all these actions is
known as action space denoted by A. For three actions a1, a2 a3; A = action space =
(a1, a2, a3) or A = (A1, A2, A3). Acts may be also represented in the following matrix
form.
Events (or States of nature): The events identify the occurrences, which are
outside of the decision maker’ s control and which determine the level of success for
a given act. These events are often called ‘ States of nature’ or outcomes. An
example of an event or states of nature is the level of market demand for a particular
item during a stipulated time period.
A set of states of nature may be represented in any one of the following ways:

S = {S1, S2, …,Sn} or E = {E1, E2, …,En} or Ω = {θ1, θ2, θ3}

For example, if a washing powder is marketed, it may be highly liked by outcomes

(outcome θ1) or it may not appeal at all (outcome θ2) or it may satisfy only a small
fraction, say 25% (outcome θ3)
Ω = {θ1 , θ2, θ3}

In a tree diagram the places are next to acts. We may also get another act on the
happening of events as follows:

In a matrix form, they may be represented as either of the two ways.

Pay-off: The result of combinations of an act with each of the states of nature is
the outcome and monetary gain or loss of each such outcome is the pay-off. This
means that the expression pay-off should be in quantitative form.

Pay -off may be also in terms of cost saving or time saving. In general, if there are
k alternatives and n states of nature, there will be k × n outcomes or pay-offs. These
k × n payoffs can be very conveniently represented in the form of a k × n pay -off
table.

Where aij = conditional outcome (pay-off) of the i th event when j th

alternative is
chosen. The above pay-off table is called pay-off matrix.

The Six Steps in Decision theory

1. Clearly define the problem

2. List the possible alternatives

3. Identify the possible outcomes

4, List the payoff or profit of each combination of alternatives and outcomes
5. Select one of the mathematical decision theory model

6. Apply the model and make your decision

classification of decision situation in quantitative research

Classification of Quantitative Technique Quantitative techniques may be defined as
those techniques which provide the decision makes a systematic and powerful means
of analysis, based on quantitative data. It is a scientific method employed for
problem solving and decision making by the management. With the help of
quantitative techniques, the decision maker is able to explore policies for attaining
the predetermined objectives. In short, quantitative techniques are inevitable in
decision-making process. Classification of Quantitative Techniques There are
different types of quantitative techniques. We can classify them into
three categories. They are:
1. Mathematical Quantitative Techniques
2. Statistical Quantitative Techniques
3. Programming Quantitative Techniques Mathematical Quantitative Techniques
1. Mathematical Quantitative Techniques

A technique in which quantitative data are used along with the principles of
mathematics is known as mathematical quantitative techniques. Mathematical
quantitative techniques involve
1. Permutations and Combinations
2. Set Theory:
3. Differentiation:
4. Differential Equation.
Statistical techniques involve: It is a mathematical equation which involves the
differential coefficients of the dependent variables. Statistical Quantitative
Techniques Statistical techniques are those techniques which are used in conducting
the statistical enquiry concerning to certain Phenomenon. They include all the
statistical methods beginning from the collection of data till interpretation of those
collected data
1. Collection of data
2. Measures of Central Tendency.
3. Correlation and Regression Analysis:
4. Index Numbers
5. Time series Analysis:

Programming Techniques Programming techniques are also called operations

research techniques. Programming techniques are model building techniques used
by decision makers in modern times.
Programming techniques involve.
1. Linear Programming
2. Queuing Theory.
3. Game Theory.
4. Decision Theory.
5. Inventory Theory.

Types of decision making: Decisions are made based upon the information
data available about the occurrence of events as well as the decision situation. There
are two types of decision making situations: certainty and uncertainty

1. decision making under certainty: A decision-making environment in which

the future outcomes or states of nature are known.
2. decision making under risk: A decision-making environment in which
several outcomes or states of nature may occur as a result of a decision or
alternative. The probabilities of the outcomes or states of nature are known.
3. decision making under uncertainty: A decision-making environment in
which several outcomes or states of nature may occur. The probabilities of
these outcomes, however, are not known. It means there is 100% risk.
1. The decision-making under a certainty situation involves the following state
i. determines the alternative course of action
ii. Calculate the payoff, one for each course of activity
ii. select the alternative with the largest profit or smallest cost either by the
method of the complete enumeration (if the number of alternatives is small)
or with the aid of appropriate mathematical models.

2. Decision Making Under the Conditions of Risk:

This decision making under risk is a probabilistic decision situation. Several
possible states of nature may occur, each with a given probability.
i. Expected Monetary Value (EMV): The expected (the mean value)
Monetary value is the long run average value that would result if the decision
were repeated a large number of times. This is determined by multiplying the
monetary values by their respective probabilities.
EMV = ∑ 𝑷𝒂𝒚 𝒐𝒇𝒇𝒊 × 𝒑𝒓𝒐𝒃𝒂𝒃𝒊𝒍𝒊𝒕𝒚

ii. Expected Opportunity loss (EOL): Opportunity loss, sometimes called

regret refers to the difference between the optimal profit or payoff for the
given state of nature and actual pay off received.
iii. Expected value of perfect information (EVPI): The Expected Value of
Perfect Information (EVPI) is the difference between the expected payoff with
perfect information (EPPI) and the expected payoff without any information
(EMV). This is the most that a decision maker would be willing to pay for the
information. EVPI = EPPI – EMV
Or, EVPI = ∑ 𝐵𝑒𝑠𝑡 𝑃𝑎𝑦 𝑜𝑓𝑓𝑖 × 𝑝𝑟𝑜𝑏𝑎𝑏𝑖𝑙𝑖𝑡𝑦 - max (EMV)

iv. Use of marginal analysis

Marginal analysis is an examination of the associated costs and potential benefits
of specific business activities or financial decisions. The goal is to determine
if the costs associated with the change in activity will result in a benefit that
is sufficient enough to offset them.
WE expect,
Marginal Profit ≥ marginal loss
Or, P(MP) ≥ (1-P) ×ML
Or, P(MP) ≥ ML- P(ML) here, P= Probability
 Or, P(MP)+ P(ML) ≥ ML
Or, P(MP+ML) ≥ ML
𝑀𝐿
Or, P ≥
MP+ML

3. Decision rules usually adopted in context of decision making under conditions

of uncertainty.
When probability of occurrence of each state of nature can be assessed, the
EMV or, EOL are usually appropriate. When probability of data isn’t
available, the following criteria are apace-
1. Optimistic (Maximax): This selects the alternative with the highest
possible return. (Maximum alternative is chosen)
2. Pessimistic (maximin): This alternative maximizes the minimum payoff.
It selects the alternative with the best of the worst possible payoffs.
(Maximum alternative is chosen)
3. Criterion of realism (Hurwicz): A decision-making criterion that uses a
weighted average of the best and worst possible payoffs for each alternative.
(Maximum alternative is chosen)
Weighted average = α ×max in row + (1-α) ×min in row
4. Equally likely (Laplace): A decision criterion that places an equal weight
on all states of nature. (Maximum alternative is chosen
5. Minimax regret: A criterion that minimizes the maximum opportunity
loss. (Minimum alternative is chosen)

Maximin and Minimax strategy

Maximin criteria
This criterion is the decision to take the course of action which maximizes the
minimum possible pay-off. Since this decision criterion locates the alternative
strategy that has the least possible loss, it is also known as a pessimistic decision
criterion. The working method is:

(i) Determine the lowest outcome for each alternative.

(ii) Choose the alternative associated with the maximum of these.

Minimax criteria
This criterion is the decision to take the course of action which minimizes the
maximum possible pay-off. Since this decision criterion locates the alternative
strategy that has the greatest possible gain. The working method is:

(i) Determine the highest outcome for each alternative.

(ii) Choose the alternative associated with the minimum of these.

Example
Consider the following pay-off (profit) matrix Action States

Determine best action using maximin principle.

Solution:
Example
A business man has three alternatives open to him each of which can be followed by
any of the four possible events. The conditional pay offs for each action - event
combination are given below:

Determine which alternative should the businessman choose, if he adopts the

maximin principle.

Solution:

Max (–10,–4, 0) = 0. Since the maximum payoff is 0, the alternative Z is selected by

the businessman.

Example
Consider the following pay-off matrix
Using minmax principle, determine the best alternative.

Solution:

min( 27, 25, 23, 32) = 23. Since the minimum cost is 23, the best alternative is E3
according to minimax principle.

Problem: Risk
Suppose, a grocer is faced a problem of how many cases of Milk to stock to meet
tomorrow’s demand. All the cases of milk left at the end of the day are worthless.
Each case of Milk is sold tk. 8 and purchased for tk. 5. Hence, each case sold bring
a profit of tk. 3 but if it is not sold at the end of the day, then, it must be loss of tk.
5.
Number of cases of Number of times of Probability of each
Milk Demanded Milk Demanded event
0-12 0 0.00
13 5 0.05
14 10 0.10
15 20 0.20
16 30 0.30
17 25 0.25
18 10 0.10
Over 18 0 0.00
Grocer has the perfect knowledge
Requirement:
a. What should be the optimal decision concerning the number of cases of milk
to stock?
 b. How much be expected opportunity loss will for taking optimum decision?
What item should be stock?
c. Make a decision on what item should be stored using marginal profit analysis.
d. What will be the marginal probability of milk cases? Make decision using
marginal analysis.
Solve:
Req. a.
Sale value per case = 8
Marginal loss =5
Marginal Profit =3
Possible action concerning stock =Earning -loss

Possible action (cash inflow) concerning stock

supply
13 14 15 16 17 18
Demanded
13 39 34 29 24 19 14
14 39 42 37 32 27 22
15 39 42 45 40 35 30
16 39 42 45 48 43 38
17 39 42 45 48 51 46
18 39 42 45 48 51 54

Calculation of EMV
Stock 13 = 39×0.05+39×0.10+39×0.20+39×0.30+39×0.25+39×0.10 = 39
Stock 14 = 34×0.05+42×0.10+42×0.20+42×0.30+42×0.25+42×0.10
= 41.6
Stock 15 =43.4
Stock 16 = 43.6
Stock 17 = 41.4
Stock 18 = 37.2

Decision: The highest EMV is 43.60 corresponding to action of stock 16 cases of

milk. The optimal course of action under the given condition of risk is to stock 16
cases of Milk.
Req. b
Possible action (opportunity loss) concerning stock
Available
13 14 15 16 17 18
Demanded
Stock 13 0 5 10 15 20 25
14 3 0 5 10 15 20
15 6 3 0 5 10 15
16 9 6 3 0 5 10
17 12 9 6 3 0 5
18 15 12 9 6 3 0

Calculation of EOL
Stock 13 = 0×0.05+3×0.10+6×0.20+9×0.30+12×0.25+15×0.10
= 8.70
Stock 14 = 5×0.05+0×0.10+3×0.20+6×0.30+9×0.25+12×0.10
= 6.10
Stock 15 =4.30
Stock 16 = 4.10
Stock 17 = 6.30
Stock 18 = 10.50
Decision: The lowest EOL is 4.10 corresponding to action of stock 16 cases of milk.
The optimal course of action under the given condition of risk is to stock 16 cases
of Milk.
Req. c
Stock Profit Conditional value Probability Expected
Value
13 3 39 0.05 1.95
14 3 42 0.1 4.2
15 3 45 0.2 9
16 3 48 0.3 14.4
17 3 51 0.25 12.75
18 3 54 0.1 5.4
EPPI 47.7
From req. a, we get max EMV = 43.60
 EVPI =EPPI - max (EMV)
= 47.70-43.60
= 4.10
Hence, the expected value of perfect information ECPI = tk. 4.10 being the value of
transformation risk into certainty.

Req. d
𝑀𝑎𝑟𝑔𝑖𝑛𝑎𝑙 𝐿𝑜𝑠𝑠
P≥
Marginal Profit +Marginal Loss
5
P≥ = 0.625
3 +5

Point Probability Cumulative

probability
13 or 0.05 0.05
more
14 or 0.10 0.15
more
15 or 0.20 0.35
more
16 or 0.30 0.65
more
17 or 0.25 0.90
more
18 or 0.10 1.00
more

Hence, the optimum action to stock 16 cases of milk.

 Decision Tree
A decision tree is a support tool with a tree-like structure that models probable
outcomes, cost of resources, utilities, and possible consequences. Decision trees
provide a way to present algorithms with conditional control statements. They
include branches that represent decision-making steps that can lead to a favorable
result.

The flowchart structure includes internal nodes that represent tests or attributes at
each stage. Every branch stands for an outcome for the attributes, while the path
from the leaf to the root represents rules for classification.

Decision trees are one of the best forms of learning algorithms based on various
learning methods. They boost predictive models with accuracy, ease in
interpretation, and stability. The tools are also effective in fitting non-linear
relationships since they can solve data-fitting challenges, such as regression and
classifications.

Types of Decisions

There are two main types of decision trees that are based on the target variable, i.e.,
categorical variable decision trees and continuous variable decision trees.

1. Categorical variable decision tree

A categorical variable decision tree includes categorical target variables that are
divided into categories. For example, the categories can be yes or no. The categories
mean that every stage of the decision process falls into one category, and there are
no in-betweens.

2. Continuous variable decision tree

A continuous variable decision tree is a decision tree with a continuous target

variable. For exam

ple, the income of an individual whose income is unknown can be predicted based
on available information such as their occupation, age, and other continuous
variables.

Applications of Decision Trees

1. Assessing prospective growth opportunities

One of the applications of decision trees involves evaluating prospective growth

opportunities for businesses based on historical data. Historical data on sales can be
used in decision trees that may lead to making radical changes in the strategy of a
business to help aid expansion and growth.

2. Using demographic data to find prospective clients

Another application of decision trees is in the use of demographic data to find

prospective clients. They can help streamline a marketing budget and make informed
decisions on the target market that the business is focused on. In the absence of
decision trees, the business may spend its marketing market without a specific
demographic in mind, which will affect its overall revenues.
Let’s start with a basic decision tree about planning the events of the day. As you
can see, if a friend would visit, then we can just visit a restaurant. If not, then it would
depend on the weather. If it is rainy, then it is better to stay indoors while on a sunny
day, we can go out and play. In case if, it is windy, and then we can, go either
shopping or movies, depending on the available money.
Examples
By now, you would be able to understand what is a decision tree and its major
symbols. To further learn about their working and application, let’s consider a few
decision tree examples. In this way, you can understand how a decision tree can play
a crucial role in different scenarios.

Planning a day
Let’s start with a basic decision tree about planning the events of the day. As you
can see, if a friend would visit, then we can just visit a restaurant. If not, then it would
depend on the weather. If it is rainy, then it is better to stay indoors while on a sunny
day, we can go out and play. In case if, it is windy, and then we can, go either
shopping or movies, depending on the available money.

Production Unit Decision

This is a more advanced decision tree in which we will explore the options for mobile
phone production. Each of the units has their high and low profit margins. In the end,
we can see the terminator nodes with their results. On the basis of that, Technology
A has been chosen while Technology B has been rejected.
Buying a car
As you can see, most of the decision tree examples are related to real-life problems
and their visual representation. In this, we will consider a person’s preference for
buying a car. If the color is red, then further constrains like built year and mileage is
considered. If not, then the brand of the vehicle is kept in mind. Wherever these
conditions are not met, the car is not bought. On the other hand, it would be bought
if it is red and newer than 2010, red car with good mileage, or a yellow Ferrari.
Money investment decision
This is another one of those decision tree examples that we face in real-world on a
frequent basis. In this, we will consider different options for investing money. If we
just keep it in the savings account, then we will get a certain return. Another option
involves investing money in stocks while further dividing it into two sources by half.
Since the return from the stocks is more, it seems like a better investment option.

Adding Rates and Values to the Decision Tree Outcome

After visualising all the decisions and uncertain outcomes on the decision tree, we
need to add a rating for each outcome based on its expected strength. The rating can
be either a percentage or a fraction of 1.0 for each outcome group. The total sum of
all the values assigned to each decision outcome should be 100 per cent or 1.0. For
example, the below values can be assigned to the use of a new marketing idea as
follows: high (5%), moderated (3%), and low (2%). The percentage represents the
probability of the out come.

Then, we can write the expected gross revenues next to each outcome. For example,
if the market impact of creating a new advertising campaign is high, then the
expected revenues for the company will reach $500,000. If the outcome is
moderated, the expected revenues will be $300,000.
After adding the probability value of each outcome and its expected revenues, the
total outcome value is calculated by multiplying the probability value times the profit
value. For example, the value for the new marketing idea option would be as follows:
5% X 500,000 = $25,000
3% X 300,000 = $9,000
2% X 150,000 = $3,000.

THE END