CHAPTER FOUR

DECISION THEORY

Definition of decision: decision can be defined as the process of identifying and defining the
problem, listing of all possible future events or state of nature, identifying all courses of action
and listing them in the order of importance and selecting the appropriate alternative or
alternatives.

Decision making needs information. Thus, the degree of making good decision depends on the
degree of knowledge about the future state of nature. The degree of knowledge of state of nature
varies from lacking complete knowledge (ignorance) to having a complete knowledge about the
future states of nature and appropriate strategy to adopt (certainty).

In between complete ignorance and complete knowledge about the events and strategy to adopt,
there are decision making environment under uncertainty and decisionmaking under risk.

Terminologies used in decision making

Decision alternatives

These are available courses of actions or strategies to the decision makers when making decision
about something

State of nature

These are future conditions or consequences or events or scenarios that are not under the control
of decision maker .But, can be forecasted based on the previous experience or current events.
States of nature are mutually exclusive and collectively exhaustive.

Payoff

A numerical value (outcomes) resulting from each possible combination of alternatives or course
of action and state of nature.

Types of decision making environment

The decision can be made under the following environment

1. Decision making under certainty

In this environment, decision maker has complete knowledge or perfect information about the
consequences of alternative courses of action and associated payoff and thus, the decision maker
will select the best strategy that maximize the objective. In this decision making environment,
only one state of nature exist.

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 2. Decision making under risk

In this case, the decision maker has less than complete knowledge of the consequences of
alternatives courses of action because it is not definitely known which outcome will occur. Thus,
the decision maker always assigns probability to each state of nature. For example, probability of
getting a head while tossing a coin.

3. Decision making under uncertainty

The decision maker is unable to specify the probabilities of various states of nature even though
the possible states of nature are known.

Decisions under uncertainty are less taken even with less information than decisions under risk.
In the absence of knowledge about the probability of any state of nature occurring, the decision
maker must arrive at a decision only on the actual additional payoff values or based on company
policy and attitude of decision maker .therefore, there are several different criterion of decision
making in this situation. These are:

a. Optimism(maximax or minimin)criterion

Under this criterion, the decision maker selects the strategy or course of action which will give
the maximum of maxima profits or the minimum of minima costs.

Selection procedure or criterion

 Identify the maximum profit or minimum cost payoff for each strategy under each state of
nature
 Select the strategy with maximum profit from maxima profits and the minimum of minima
outcomes or payoff for cost.
b. Pessimism (Maxmin or Minimax)

Decision maker selects strategy which gives the maximum of minimum payoff for profit and
minimum of maximum payoff for cost or loss.

Selection procedure or criterion

 Locate the minimum payoff for each strategy corresponding to each state of nature for
profit, and select the strategy corresponding to maximum profit among located minimum
profits payoffs.
 For loss or cost, locate maximum cost or loss associated with each strategy under each
state of nature, then select strategy that represent in minimum loss or cost among
maximum loss or cost.

The decision maker is conservative about the future and always anticipates the worst possible
outcome (minimum profit and maximum for cost or loss).

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 c. Equal likely hood(Laplace) criterion

Since the decision maker do not know the probabilities of state of nature, it is assumed that all
states of nature will occur with equal probabilities.

As the states of nature are mutually exclusive, theprobabilities of each of these states of nature
1
equal to where n is the number of states of nature.
n

Selection procedure or criterion

1
Multiply possible payoffs associated with each strategy by probability of occurrence of
n
each state of nature and add, then select maximum expected payoff strategy for profit and
minimum for cost or loss.

This criterion is also known as the criterion of insufficient reason because except in a few cases,
some information of the likelihood of occurrence of states of nature is available.

d. Coefficient of optimism (Hurwicz) criterion

This criterion suggests that a rational decision maker should be neither completely optimistic nor
pessimistic and therefore, must display a mixture of both.

The decision makers’ degree of optimism is measured by α which lies between 0 and 1 in which
0 shows completely pessimistic and 1 shows completely optimistic. Therefore, if α is the
coefficient of optimism, then (1- α) will represent the coefficient of pessimism.

In general, theHurwicz approach suggests that the decision maker must select an alternative that
maximizes H (criterion of realism) = α (maximum payoff) + (1- α) (minimum payoff)

And then, select the strategy that represents highest payoff for profit and lowest payoff for cost
or loss.

e. Regret (Savage) criterion

This criterion is also known as opportunity loss decision or minimax regret decision criterion.
This is based on the fact that, the decision maker regret when she/he adopts wrong strategy
resulting in an opportunity loss.

Selection procedure

 Find the maximum payoff to each state of nature

 Subtract all other payoff in that row or column from this maximum value

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  For each strategy, identify the maximum opportunity loss for each strategy and then
identify the minimum of these maximum losses and select the corresponding strategy to
this minimum loss among maximum losses.

Example: 1 consider the following example

XYZ manufacturing company is thinking of several alternatives methods to increase its

production to meet the increasing market demand. For the company, there may be only the
following three options to meet demand:

 Expanding the present plantThese are called alternatives or strategies to

 Construct a new plantmeet increasing demand and also under
 Subcontract production for extra demandthe control of the decision maker

The future expected demand pattern which is not under the control of the decision maker are:

 High demand
 Moderate demand These are called states of nature and beyond the control of
 Low demandthe decision maker
 No change in demand

The expected payoff for each strategy under each states of nature is given in the following table

States of nature (product demand)

Alternatives High demand Moderate demand Low demand No change
Expand the plant 50,000 25,000 -25,000 -45,000
Construct new plant 70,000 30,000 -40,000 -80,000
Subcontract production 30,000 15,000 -1,000 -10,000

Based on the above table, answer the following questions

1. If the company knew that the demand would be high, which alternative is best to choose?

Answer: Since the table shows profit, then the company should choose ‘construct new plant
alternatives because the maximum profit of 70,000 would be obtained by adopting this strategy
when the company is certain that the demand would be high.

2. If the company knew that the demand would be low, which alternative is best to choose?

Answer: If the company certainly knew that the demand would be low, then it best for the
company to subcontract the production to meet extra demand to keep the losses lowest to 1000.

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3. If the company knew that the demand would not be changed, which alternative is best to
choose?

Answer: If the company knew that the demand would not be changed, the best alternative or
strategy to choose must be subcontracting to keep the losses lowest to 10,000.

4. Based on the above information which is provided in the table ,which strategy should the
company choose on the basis of:
a. Maximax criterion
b. Maximin criterion
c. Minimax regret criterion
d. Laplace criterion
e. Hurwicz criterion when α =0.8

Solution

a. Maximax or criterion of Optimistic

With the maximax criterion, the decision maker selects the decision that will result in the
maximum of the maximum payoffs. (In fact, this is how this criterion derives its namea
maximum of a maximum.) The maximax criterion is very optimistic. The decision maker
assumes that the most favorable state of nature for each decision alternative will occur. Thus, for
example, using this criterion, the investor would optimistically assume that good economic
conditions will prevail in the future. Themaximax criterion results in the maximum of the
maximum payoffs.

States of nature (product demand)

Alternatives High Moderate demand Low No change Maximum of row
demand demand
Expand 50,000 25,000 -25,000 -45,000 50,000
Construct 70,000 30,000 -40,000 -80,000 70,000Maximax
Subcontract 30,000 15,000 -1,000 -10,000 30,000

Hence, maximum payoff which is 70,000 is corresponding to the alternative construct new
plantand the company should take this decision under Maximax criterion.

b. Maximin or pessimism(Wald) criterion

In contrast to the maximax criterion, which is very optimistic, the maximin criterion is
pessimistic. With the maximin criterion, the decision maker selects the decision that will reflect

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the maximum of the minimum payoffs. For each decision alternative, the decision maker
assumes that the minimum payoff will occur. Of these minimum payoffs, the maximum is
selected.

States of nature (product demand)

Alternatives High Moderate demand Low demand No Minimum of row
demand change
Expand 50,000 25,000 -25,000 -45,000 -45,000
Construct 70,000 30,000 -40,000 -80,000 -80,000
Subcontract 30,000 15,000 -1,000 -10,000 -10,000maximin

Based on the maximin criterion, the company should choose subcontracting production for
extra demand to keep the losses to the lowest which is -10,000.

c. Minimax regret criterion(Savage)

Under this criterion identify the maximum payoff under each state of nature and subtract other in
the column or row from this maximum value.Then, identify maximum values for each alternative
and finally, select the minimum value among maximum values of each alternative.

States of nature (product demand)

Alternatives High Moderate demand Low No change Minimum of row
demand demand
Expand 50,000 25,000 -25,000 -45,000 -45,000
Construct 70,000* 30,000* -40,000 -80,000 -80,000
Subcontract 30,000 15,000 -1,000* -10,000* -10,000 maximin

The bolded values are the maximum values under each states of nature. Then, by subtracting the
values under each state of nature from the maximum values in each column, we get the following
result:

States of nature (product demand)

Alternatives High Moderate demand Low No change Maximum of row
demand demand
Expand 20,000 5,000 24,000 35,000 35,000Minimax
Construct 0 0 39,000 70,000 70,000
Subcontract 40,000 15,000 0 0 40,000

Therefore, the company will minimize its regret (loss) to 35,000 by selecting an alternative
‘expand the plant’

d. Laplace criterion or criterion of rationality

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When the maximax criterion is applied to a decision situation, the decision maker implicitly
assumes that the most favorable state of nature for each decision will occur. Alternatively, when
the maximin criterion is applied, the least favorable states of nature are assumed. Theequal
likelihood, or LaPlace, criterion weights each state of nature equally, thus assuming that the
states of nature are equally likely to occur.The equal likelihood criterion multiplies the decision
payoff for each state of nature by an equal weight.

States of nature (product demand)

Alternative High demand Moderate demand Low demand No change Expected payoff
s
Expand 50,000 25,000 -25,000 -45,000 -1,250
Construct 70,000 30,000 -40,000 -80,000 -5,000
Subcontract 30,000 15,000 -1,000 -10,000 8,500

Expand =50,000 *1/4 +25,000*1/4 + (-25,000*1/4 ¿+ (-45,000*1/4 ) =-1,250

Construct=70,000*1/4 +30,000*1/4 + (-40,000*1/4 ¿+ (-80,000*1/4 ¿ =-5,000

Subcontract =30,000*1/4 +15,000*1/4 + (-1,000*1/4 ¿+ (-10,000*1/4 ¿ =8,500

Therefore, subcontract results in maximum average payoff of 8,500

e. Hurwicz (criterion of realism)

The Hurwicz criterion strikes a compromise between the maximax and maximin criteria. The
principle underlying this decision criterion is that the decision maker is neither totally optimistic
(as the maximax criterion assumes) nor totally pessimistic (as the maximin criterion assumes).
With the Hurwicz criterion, the decision payoffs are weighted by a coefficient of optimism, a
measure of the decision maker's optimism. The coefficient of optimism, which we will define as
a, is between zero and one (i.e., 0 ≤≤1.0). If  = 1.0, then the decision maker is said to be
completely optimistic; if  = 0, then the decision maker is completely pessimistic. (Given this
definition, if  is the coefficient of optimism, 1 -  is the coefficient of pessimism.)The Hurwicz
criterion is a compromise between the maximax and maximin criteria.The coefficient of
optimism, , is a measure of the decision maker's optimism.

Since degree of optimism α =0.8, then the degree of pessimism is 0.2.Then, determine the
maximum and minimum of each alternative and obtain

H = α (maximum payoff + (1- α) minimum payoff

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 States of nature (product demand)
Alternatives High Moderat Low No change Max Min of α(maximum payoff + (1- α)
e of row row minimum payoff

Expand 50,000 25,000 -25,000 -45,000 50,00 -45,000 0.8(50,000) + 0.2(-45,000)

0 =31,000

Construct 70,000 30,000 -40,000 -80,000 70,00 -80,000 0.8(70,000)+ 0.2(-80,000)

0 =40,000

Subcontract 30,000 15,000 -1,000 -10,000 30,00 -10,000 0.8(30,000) +0.2(-10,000)

0 =22,000

Therefore, α is 0.8 and coefficient of pessimism is 0.2, then alternative ‘construct new plant’
result in maximum of payoff 40,000 and then the company should adopt it.

Example 2: A steel manufacturing company is concerned with the possibility of

anemployeesstrike; it will cost an extra $ 20,000 to acquire an additional stockpile. If there is
strike and the company has not stockpiled, management estimates an additional expense of $
60,000 on account of lost sales.

Required: Should the company stockpile or not based on the following criterion:

a. Optimistic criterion
b. Wald criterion
c. Savage criterion
d. Laplace criterion
e. Hurwicz criterion for α =0.4

Solution

Develop cost table for the problem as follow

States of nature
Alternative Strike (S1) No strike (S2)
Stock pile(A1) 20,000 20,000
Do not stock pile 60,000 0

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 a. Optimistic criterion (Maximax,Minimin)

Since the table represents costs,minimin criterion will be used.

States of nature
Alternative Strike (S1) No strike (S2) Minimum of row Maximum of row
Stock pile(A1) 20,000 20,000 20,000 20,000Minmax
Do not stock pile(A2) 60,000 0 0 Minimin 60,000

Therefore, company should select alternative A2i.e. it should not stockpile and associated cost is
$0 under minimin of optimistic criterion.

b. Pessimistic (Wald)criterion (Maxmin andMinmax)

Since the table represents costs, Minmax criterion will be used. Maximum of alternative A 1 is
$20,000 and A2 is $60, 000, then under minmax alternative A 1 should be selected by the
company and associated cost is $20,000.

c. Savage (Minmax regret ) criterion

States of nature
Alternative Strike (S1) No strike (S2) maximum of regret Min of max regret
Stock pile(A1) 40,000 0 40,000 -
Do not stock pile(A2) 0 20,000 20,000 20,000

Maximum regret for alternative A1 is 40,000 and A2 is $ 20, 000. Therefore, the company should
choose A2which do not stock pile.

d. Laplace criterion

States of nature
Alternative Strike (S1) No strike (S2) Expected cost
Stock pile(A1) 40,000 0 20,000*0.5+20,000*0.5 =20,000
Do not stock pile(A2) 0 20,000 60,000*0.5 +0*0.5 = 30,000

Therefore, since it is cost, then the company should adopt alternative that minimize cost, hence
alternative stock pile best alternative.

e. Hurwicz criterion

States of nature
Alternative Strike (S1) No strike (S2) Max Min α(maximum payoff + (1- α) minimum

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 payoff

Stock pile(A1) 20,000 20,000 20,000 20,000 0.4*20,000 +0.6*20,000 =20,000

Do not stock pile 60,000 0 60,000 0 0.4*60,000 + 0.6*0 =24,000

Since the minimum cost is associated with alternative A1 the company should stock pile.

Decision making under risk

Under this decision making environment, more than one states of nature exist and the decision
maker has sufficient information to assign probabilities to each of these states of nature number
of criterion are available for the decision making under risk.

1. Expected Monetary Value(EMV)

To apply the concept of expected value as a decision-making criterion, the decision maker must
first estimate the probability of occurrence of each state of nature. Once these estimates have
been made, the expected value for each decision alternative can be computed. The expected
value is computed by multiplying each outcome (of a decision) by the probability of its
occurrence and then summing these products.Expected value is computed by multiplying each
decision outcome under each state of nature by the probability of its occurrence.The best
decision is selecting an alternative with the greatest expected value for profit and least expected
value for cost.

2. Expected Opportunity Loss

A decision criterion closely related to expected value is expected opportunity loss. To use this
criterion, we multiply the probabilities by the regret (i.e., opportunity loss) for each decision
outcome rather than multiplying the decision outcomes by the probabilities of their occurrence,
as we did for expected monetary value.Expected opportunity loss is the expected value of the
regret for each decision.

The best decision here is selecting an alternative that results in minimizing the regret, or,
minimizing the expected regret or opportunity loss.

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 3. Expected Value of Perfect Information

It is often possible to purchase additional information regarding future events and thus make a
better decision. For example, a real estate investor could hire an economic forecaster to perform
an analysis of the economy to more accurately determine which economic condition will occur in
the future. However, the investor (or any decision maker) would be foolish to pay more for this
information than he or she stands to gain in extra profit from having the information. That is, the
information has some maximum value that represents the limit of what the decision maker would
be willing to spend. This value of information can be computed as an expected valueshence its
name, the expected value of perfect information (also referred to as EVPI).

The expected value of perfect information is the maximum amount a decision maker would
pay for additional information.

Example

Assume an investor is to purchase one of three types of real estate. The investor must decide
among an apartment building, an office building, and a warehouse. The future states of nature
that will determine how much profit the investor will make are good economic conditions and
poor economic conditions. The profits that will result from each decision in the event of each
state of nature are shown in table below

State of Nature
Decision (Purchase) GOOD ECONOMIC CONDITIONS(0.6) POOR ECONOMIC CONDITIONS(0.4)
Apartment building $50,000 $30,000
Office building 100,000 40,000
Warehouse 30,000 10,000

Let us suppose that, based on several economic forecasts, the investor is able to estimate a
.60probability that good economic conditions will prevail and a .40 probability that poor
economic conditions will prevail. Then determine the best decision that should theinvestor’s
makebased on the following criterion:

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 a. Expected Monetary Value(EMV)

Solution: The expected value (EV) for each decision is computed as follows:

EMV(apartment) = $50,000(.60) + 30,000(.40) = $42,000

EMV(office) = $100,000(.60) 40,000(.40) = $44,000
EMV(warehouse) = $30,000(.60) + 10,000(.40) = $22,000

The best decision is the one with the greatest expected monetary value. Because the greatest
expected value is $44,000, the best decision is to purchase the office building. This does not
mean that $44,000 will result if the investor purchases the office building; rather, it is assumed
that one of the payoff values will result (either $100,000 or $40,000). The expected value means
that if this decision situation occurred a large number of times, an average payoff of $44,000
would result. Alternatively, if the payoffs were in terms of costs, the best decision would be the
one with the lowest expected value.

b. Expected Opportunity Loss

Solution

State of Nature
Decision
(Purchase) GOOD ECONOMIC CONDITIONS.60 POOR ECONOMIC CONDITIONS.40

Apartment building $50,000 $0

Office building 0 70,000
Warehouse 70,000 20,000

The expected opportunity loss (EOL) for each decision is computed as follows:

EOL(apartment) = $50,000(.60) + 0(.40) = $30,000

EOL(office) = $0(.60) + 70,000(.40) = $28,000
EOL(warehouse) = $70,000(.60) + 20,000(.40) = $50,000

As with the minimax regret criterion, the best decision results from minimizing the regret, or, in
this case, minimizing the expected regret or opportunity loss. Because $28,000 is the minimum
expected regret, the decision is to purchase the office building.
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N.BThe expected monetary value and expected opportunity loss criteria result in the same
decision.

Notice that the decisions recommended by the expected value and expected opportunity loss
criteria were the sameto purchase the office building. This is not a coincidence because these two
methods always result in the same decision. Thus, it is repetitious to apply both methods to a
decision situation when one of the two will suffice.

In addition, note that the decisions from the expected value and expected opportunity loss criteria
are totally dependent on the probability estimates determined by the decision maker. Thus, if
inaccurate probabilities are used, erroneous decisions will result. It is therefore important that the
decision maker be as accurate as possible in determining the probability of each state of nature.

c. Expected Value of Perfect Information

Solution

To compute the expected value of perfect information, we first look at the decisions under each
state of nature. If we could obtain information that assured us which state of nature was going to
occur (i.e., perfect information), we could select the best decision for that state of nature. For
example, in our real estate investment example, if we know for sure that good economic
conditions will prevail, then we will decide to purchase the office building. Similarly, if we know
for sure that poor economic conditions will occur, then we will decide to purchase the apartment
building. These hypothetical "perfect" decisions are summarized in Table below

State of Nature
Decision (Purchase) GOOD ECONOMIC CONDITIONS .60 POOR ECONOMIC CONDITIONS .40
Apartment building $ 50,000 $ 30,000
Office building 100,000 -40,000
Warehouse 30,000 10,000

The probabilities of each state of nature (i.e., .60 and .40) tell us that good economic conditions
will prevail 60% of the time and poor economic conditions will prevail 40% of the time (if this
decision situation is repeated many times). In other words, even though perfect information

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enables the investor to make the right decision, each state of nature will occur only a certain
portion of the time. Thus, each of the decision outcomes obtained using perfect information must
be weighted by its respective probability:

$100,000(.60) + 30,000(.40) = $72,000

The amount $72,000 is the expected value of the decision, given perfect information, not the
expected value of perfect information. The expected value of perfect information is the
maximum amount that would be paid to gain information that would result in a decision better
than the one made without perfect information. Recall that the expected value decision without
perfect information was to purchase an office building, and the expected value was computed as

EMV(office) = $100,000(.60) 40,000(.40) = $44,000

The expected value of perfect information is computed by subtracting the expected value without
perfect information ($44,000) from the expected value given perfect information ($72,000):

EVPI = $72,000 44,000 = $28,000

EVPI equals the expected value, given perfect information, minus the expected value without
perfect information.

The expected value of perfect information, $28,000, is the maximum amount that the investor
would pay to purchase perfect information from some other source, such as an economic
forecaster. Of course, perfect information is rare and usually unobtainable. Typically, the
decision maker would be willing to pay some amount less than $28,000, depending on how
accurate (i.e., close to perfection) the decision maker believes the information is.

It is interesting to note that the expected value of perfect information, $28,000 for our example,
is the same as the expected opportunity loss (EOL) for the decision selected, using this later
criterion:

EOL (office) = $0(.60) + 70,000(.40) = $28,000

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The expected value of perfect information equals the expected opportunity loss for the best
decision.

This will always be the case, and logically so, because regret reflects the difference between the
best decision under a state of nature and the decision actually made. This is actually the same
thing determined by the expected value of perfect information.

Reading assignment: briefly discuss the following by giving examples

 Decision Analysis with Additional Information

 Decision Trees with Posterior Probabilities
 The Expected Value of Sample Information
 The efficiency of sample information

Exercise

An investor has $5,000 to invest in either savings bonds or a real estate deal. The expected return
on each investment, given good and bad economic conditions, is shown in the following payoff
table:

Economic Conditions
Investment Good (0.6) Bad (0.4)

Savings bonds $ 1,000 $1,000

Real estate 10,000 2,000

What should be the decision by an investor based on the following criterion?

a. Expected Monetary Value(EMV)

b. Expected Opportunity Loss
c. Expected Value of Perfect Information

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