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Decision Theory

BY HARSH VARDHAN

Decision Theory provide a method of decision-making wherein data concerning the occurrence of different outcomes (consequences) may be evaluated to enable the decision- maker to identify suitable alternative (or course of action) Decision Models provides frame work to make best possible decision. Decision Alternatives are different possible strategies(course of actions) the decision maker can employ.

Decision Theory/OR/Harsh/11 2

State of Nature A possible future condition event, not under control of decision maker, which may occur. State of nature are mutually exclusive and collectively exhaustive. Payoff The consequence resulting from specific combination of a decision alternative and a state of nature is called payoff. It could be in terms of profit, cost ,time ,distance etc. Payoff Table A table showing pay offs for all combination of decision alternative and 3 states on nature. Decision Theory/OR/Harsh/11

**Pay off Table
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DECISION Carry an Umbrella Not carry an Umbrella

STATE OF NATURE

RAIN DOES NOT RAIN

NOT WET NOT WET

WET NOT WET

CONSEQUENCE

Decision Theory/OR/Harsh/11 4

**Steps in Decision Theory Approach
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**Decision Making Environments
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Step 1 Determine the various alternative courses of action (or choice of strategies) from which the final decision is to be made. Step 2 Identify the possible outcomes, called the states of nature or events for the decision problem. Step 3 Construct a payoff table for each possible combination of alternative course of action and state of nature. Step 4 Choose the criterion which results in largest payoff. The criterion may be economic, quantitative or qualitative(market share, profit)

Decision Theory/OR/Harsh/11

Decision analysis is used to determine optimum strategies amongst several decision alternatives. There are four types of decision environments: 1. 2. 3. 4. Decision under Decision under Decision under Decision under Certainty Uncertainty Risk Conflict

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Decision Theory/OR/Harsh/11

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Decision Theory/OR/Harsh/11 7 3. 3. Decision under conflict – In many situations. Criterion of Pessimism. Thus there may be more than on state of nature for which me makes assumption about its probability. The profit from each is dependent on the rainfall during the growing season. Criterion of Regret(Minimax Regret) Decision Theory/OR/Harsh/11 12 2 . 4. ( example LAUNCHING A NEW PRODUCT). Hurwicz Criterion (farmers degree of optimism being 0. Maximax Criterion(Optimism) 2. The decision maker has complete knowledge (perfect information) of consequences of every decision (course of action or alternative). medium and low.6) 4. Y will be PM in the next election.5 4. His estimated profit for each is shown in the table in the next slide: Decision Theory/OR/Harsh/11 10 9 Problem-1 Rainfall High Medium Low Estimated conditional profit (Rs) Crop A 8000 4500 2000 Crop B 3500 4500 5000 Crop C 5000 5000 4000 Problem -2 States nature S1 S2 S3 of A1 200 160 120 Courses of Action A2 210 170 130 A3 230 190 140 If the farmer wishes to plant only one crop. 5. decide which should be his best crop using : 1. Decision under certainty – Whenever there exists only one outcome for a decision. P(head) =0. Decision under risk – These refer to decision situations wherein the decision-maker chooses from several possible outcomes where the probability of occurrence can be stated objectively from the past data. the decision-maker has a knowledge about the states of nature that happen but lacks the knowledge about the probabilities of their occurrence. it is termed as decision-making under partial uncertainty or conflict. Mr. 2. Maximin Criterion(Pessimism) 3. Criterion of Optimism (Maximax or Minimin) Criterion of Pessimism (Minimax or Maximin ) Equally Likely Decision (Laplace) Criterion Criterion of Realism (Hurwicz Criterion) Criterion of Regret (Savage Criterion) or Minimax Regret Criterion Decision Theory/OR/Harsh/11 A farmer wants to decide which of the three crops he should plant on his 100 acre farm. There are several criteria of decision-making in this situations which includes: 1. 3. Laplace Criterion(Equally likely criterion) 5. α being 0. we are dealing with this category.Decision Making Environments 1. Minimax regret Criterion Decision Theory/OR/Harsh/11 11 Evaluate the above pay off table and determine suitable course of action by following methods 1. The farmer has categorized the amount of rainfall as high. The decision maker is unable to assign probabilities with which each state of nature will occur. neither states of nature are completely known nor are they completely uncertain.Hurwitz Criterion [ degree of optimism. 4. Decision Theory/OR/Harsh/11 8 Problem-1 Decision Making Under Uncertainty Under condition of uncertainty.Criterion of Optimism. Infrastructure Bond. Pick up an alternative that yields largest payoff for known future(state of nature)-Investment in PPF .Equally Likely Decision Criterion. The decision maker has less than complete knowledge of consequences of each decision choice and is unsure of which outcome will occur. Partial knowledge is available and therefore. 2. 2. Decision under uncertainty – These refer to situations where more than one outcome can result from any single decision.6] and 5.

000 and if it is warm he can expect to make a profit of Rs 3.000 if the weather is warm . These probabilities could be obtained from past record or from simply the subjective judgment of decision maker.00.50. A company wishes to decide which of the three components A.if the weather is cool and rainy. Ashok has Rs. e)Criterion of Regret or Savage Criterion or Minimax Regret. This is represented in the following table: Strategies S1 S2 S3 States of Nature N1 7. Decision Theory/OR/Harsh/11 14 Problem Mr.000 3.5). S2 and S3. If the weather is cool and rainy . The power consumption for each type of component has been categorized low. medium and high . EMV for a given course of action is the weighted average pay off. His estimated profit for each is shown below: Estimated conditional profit (Rs) A Low Medium High 200 450 B 500 450 C 400 500 2. and N3.000 5.50. A food products company is contemplating the introduction of a revolutionary new product with three strategies S1. N2.000 0 3.000 3. Some criterion under condition of risk for evaluating alternatives are: What is the best strategy under : (i) Laplace criterian (ii) Maximax. His possible returns under each economic condition are given below: Strategy A B C States of Nature Inflation Recession No Change 2000 1200 1500 3000 800 1000 2500 1000 1800 Decision Under Risk Decision Maker has sufficient information to assign probabilities to each state.B and C they should manufacture. On the hand if his choice is to run an ice cream and cold drink stall .000 to invest in one of the three options A.4) Decision Theory/OR/Harsh/11 13 Which strategy should the concerned executive choose on the basis of a) Maximax Criterion(Optimism ) b) Maximin Criterion(Pessimism) c) Realism Criterion (alpha being 0.(iii) Minimax .00.000 80 350 500 If the company wishes to manufacture one component .and Rs 3000 . B or C. The marketing department of the company worked out the payoffs in terms of yearly profits for each of the strategies of three events (expected sales).000 N2 3. There is 40% chance of weather being warm in the coming season. which is sum of payoffs for each course of action multiplied by probabilities associated with each state of nature.(iv)Hurwitz criterian (alpha = 0. Should he opt for running the hot snack stall or an ice cream stall? Decision Theory/OR/Harsh/11 18 Problem Decision Theory/OR/Harsh/11 17 3 . decide the best a) Maximax Criterion b) Maximin Criterion c) Laplace Criterion d) Minimax Regret Criterion e) Hurwicz Criterion (degree of pessimism being 0. (v) Equally likely Decision Theory/OR/Harsh/11 15 Expected Monetary Value (EMV) Criterion Expected Opportunity Loss (EOL) Decision Theory/OR/Harsh/11 16 Expected Monetary Value (EMV) Criterion The Expected Monetary Value(EMV) for a given course of action is the expected value of conditional payoff for that action.000 by running a hot snack stall.00.he can expect to make a profit of Rs 18.000 4. The three possible states of nature or events (expected sales) are N1.00. A person has choice of running a hot snack stall or an ice cream /cold drink stall at Amritsar.7)(Hurwicz) d)Equally Likely Criterion (Laplace) .Problems Problems 1.000 N3 1.00. 10.he can expect to make a profit of Rs 15. the return on his investment depend on weather the economy experiences inflation recession or no change at all.00. The profit from each is dependent on the power consumption.

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