DECISION THEORY

INTRODUCTION
• The success or failure that an individual or
organisation experiences, depends, to a large
extent on the ability to make appropriate decision.
• Making decision require an enumeration of
feasible and viable alternatives (course of action or
strategies), the projection of consequences
associated with different alternatives to identify
the best alternative (in terms of maximizing profit
or minimizing losses.
 DEFINITION

Decision is a choice arrived at after

considering two or more
alternatives/options.

The decision theory (or decision analysis) is a

technique used for decision making in an
uncertain condition or situation. It provides a
framework and methodology for rational
decision making when the outcomes are
uncertain.
DECISION MAKING PROCESS
Define problem

Explore
Implement
available data &
decision
information

Identify
Select the best
available
decision
alternatives

Identify the
Analyze feasible
possible
alternatives
outcomes
List the payoff
or profit for
each
combination of
alternatives &
outcome
 Types of Decision Situations

Ignorance Uncertainty Risk Certainty

The complete knowledge (certainty) is on

the far right and the complete ignorance
is on the far left. Between the two are
risk and uncertainty.
 Decision under certainty
The outcome of a specific decision can be
predetermined with certainty (perfect
knowledge).
Here, the state of nature (outcome) that
will definitely occur as a result of a
decision is known with certainty.
All the information required for making
the decision are known and are at the
disposal of the decision maker.
 Decision under risk
or Stochastic decision
This is a situation where the decision maker has
less than complete knowledge of the
consequences of every decision choice. E.g. the
chance of getting head in the toss of a coin is 0.5

This means there is more than one state of

nature for which he makes an assumption of the
likelihood (chances) attached to the various
states of nature.
 Decision Under Uncertainty.

This is a situation where the decision maker is unable

to ascertain or subjectively estimate neither the
outcome nor probability associated with the various
state of nature (outcome).
However, this is not the case of decision making under
ignorance because the possible state of nature are
known.
Most management decisions are made in an
environment of uncertainty
For example, the outcome or probability that one of
you will become the governor in your state in 2023 is
not known.
 Criteria of Decision Making
Under Uncertainty
•Optimism (maximax or minimin)
•Pessimism (maximin or minimax)
•Equal probabilities (Laplace)
criteria
•Coefficient of optimism (Hurwiez)
•Regret (Salvage) criterion
 CRITERIA FOR DECISION MAKING

MAXIMAX RULE (OPTIMISM)

Decision criterion is a very optimistic or risk seeking
criterion. It is not a criterion which preserves capital
in the long run. It is based on selecting the
maximum of the maximum outcome.
STEP:
1. Identify the maximum payoff for each
alternative
2. Pick the largest maximum payoff
 MAXIMIN RULE (pessimism)
Decision criterion is a very conservative or risk
averse criterion. It is a pessimistic criterion
and based on selecting the maximum
of all the minimum outcome
STEPS:
1. Identify the minimum payoff for each
alternative
2. Choose the highest minimum payoff
 MINIMAX REGRET (or Savage)
This is also a conservative criterion. It is not as
pessimistic as the maximin criterion. Also known
as opportunity loss decision because decision
maker feels regret after adopting a wrong
course of action or alternative resulting in
opportunity loss or payoff. Thus he always
intend to minimize this regret or his losses.
• STEP:
1. Identify the largest element in the first column
2. Subtract each element in the column from the
largest element to compute the opportunity loss
and regret for each column
3. Identify the maximum regret for each alternative
and then choose that alternative with the minimum
(smallest) maximum regret
 Equally likely or Laplace Rule
• since the probability of state of nature are not
known, it is assumed that all states of nature will
occur with equal probability, i.e each state of
nature is assigned an equal probability.
• STEP:
1. assigned equal probability to each state of
nature
2. compute the expected or average payoff
3. select the best expected payoff value (maximum for
profit and minimum for cost)
Hurwicz Rule: This suggests that a rational decision
maker should neither be completely optimistic nor
pessimistic and therefore must display a mixture of
both.

He introduce the idea of a coefficient of optimism

(denoted by a) to measure the decision makers
degree of optimism.

This coefficient lies between 0 and 1, where 0

represents a complete pessimistic attitude about
the future.
Thus if a = coefficient of optimism,
then (1-a) = coefficient of pessimism.
Hence: H = a(maximum column) + 1- a (minimum in column)
Step
1. Determine the coefficient of optimism “a”
and the coefficient of pessimism “1-a”
2. For each alternative, select the largest &
lowest payoff & multiply by values
respectively.
3. Select alternative with best anticipated
weighted average payoff value
 Criteria of Decision Making Under RISK
• Decision making under risk is a probabilistic
decision situation in which more than one states of
nature exists and the decision maker has sufficient
information to assign probability values to the
likely occurrence of each of these states
• The most widely used criterion for evaluating
various course of action (alternatives) under risk is
the Expected Monetary Value (EMV) or Expected
Utility (EU).
Expected Monetary Value (EMV): This
is the weighted sum of possible
payoff for a given course of action. It
is obtained by summing the payoffs
for each course of action, multiply by
the probabilities associated with each
state of nature.
Action: this means the decision maker must make a
choice from all possible alternatives

State of nature: this is future conditions (also called

consequences, events or scenarios) that affect the
result of the decision. They are factors outside the
control of the decision maker.

Payoff: A numerical value (outcome) resulting from

each possible combination of alternatives and states
of nature. The payoff values are always conditional
value because of unknown states of nature.
 STEPS
 Construct a payoff matrix listing all possible
course of action and state of nature with the
probabilities of occurrence of each state of nature
 Calculate EMV for each course of action/strategy
by multiplying the conditional payoffs by
associated probabilities
 Select the course of action with the highest EMV