Chapter Four

Decision Theory

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Chapter Topics

■ Components of Decision Making

■ Decision Making without Probabilities
■ Decision Making with Probabilities
■ Decision Analysis with Additional Information

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 Introduction to Decision Analysis
• The field of decision analysis provides a framework
for making important decisions.
• Decision analysis allows us to select a decision from a
set of possible decision alternatives when
uncertainties regarding the future exist.
• The goal is to optimize the resulting payoff in terms
of a decision criterion.
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 Decision Making Criteria
• Classifying decision-making criteria

– Decision making under certainty.

• The future state-of-nature is assumed known.

– Decision making under risk.

• There is some knowledge of the probability of the states of nature
occurring.

– Decision making under uncertainty.

• There is no knowledge about the probability of the states of nature
occurring.

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 Payoff Table Analysis
• Payoff Tables
– Payoff table analysis can be applied when:
• There is a finite set of discrete decision alternatives.
• The outcome of a decision is a function of a single future
event.
– In a Payoff table -
• The rows correspond to the possible decision alternatives.
• The columns correspond to the possible future events.
• Events (states of nature) are mutually exclusive and
collectively exhaustive.
• The table entries are the payoffs.

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 Components of Decision Making
■ A state of nature is an actual event that may occur in the future.
■ A payoff table is a means of organizing a decision situation,
presenting the payoffs from different decisions given the various
states of nature.

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1.Decision Making Without Probabilities

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 1) Decision Making without Probabilities

Decision-Making Criteria
1) Maximax 2) Maximin 3) Minimax
4) Minimax regret 5) Hurwicz 6) Equal likelihood
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 1) Maximax Criterion
In the Maxi-max criterion the decision maker selects the
decision that will result in the maximum of maximum payoffs; an
optimistic criterion.
Decision State of Nature Row max
Good economic Poor economic
condition condition
Apartment Building 50,000 30,000 50,000
Office building 100,000 -40,000 100,000 Maxim
um pay
Warehouse 30,000 10,000 30,000 off

Payoff Table Illustrating a Maximax Decision

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 Solution to maximax

Select the maximum of each alternative decision,

Here maximum of each is 50,000, 100,000 and
30,000.
The maximum of them is 100,000
The decision is to buy “office building at good
economic condition

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 2) Maxi-Min Criterion
In the maximin criterion the decision maker selects the decision
that will reflect the maximum of the minimum payoffs; a
pessimistic criterion.
Decision State of Nature Row
Good economic Poor economic min
condition condition
Apartment 50,000 30,000 30,000
Maximum pay of
Building
Office building 100,000 -40,000 -40,000

Warehouse 30,000 10,000 10,000

Payoff Table Illustrating a Maximin Decision

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 Solution to maximin

Select the minimum of each alternative decision

Here, minimum of each decision is 30,000 and
-40,000 and 10,000.
The maximum of them is 30,000
The decision is to buy “apartment building at
poor economic condition

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 3) Mini-Max Regret Criterion
Regret is the difference between the payoff from the best decision
and all other decision payoffs.
The decision maker attempts to avoid regret by selecting the
decision alternative that minimizes the maximum regret.
The maximum for good is 100,000 and poor is 30,000. subtract
them from each
Decision State of Nature row maximum
Good economic Poor economic
condition condition
Apartment Building 100,000- 30,000-30,000=0 50,000 Minimum
50,000=50,000 payoff
Office building 100,000-100,000=0 30,000-(- 70,000 regrets
40,000)=70,00
Warehouse 100,000-30,000= 30,000- 70,000
70,000 10,000=20,000
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 Solution
The min-max regret decision value is 50,000 “
select apartment building”

Regret Table Illustrating the Minimax Regret Decision

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 4) Hurwicz Criterion
The Hurwicz criterion is a compromise between the maxi-max
and maxi-min criterion.
A coefficient of optimism, , is a measure of the decision
maker’s optimism.
The Hurwicz criterion multiplies the best payoff by  and the
worst payoff by 1- ., for each decision, and the best result is
selected. Assume that alpha is 0.4.
Decision Values
Apartment building $50,000(0.4) + 30,000(0.6)= 38,000
Office building $100,000(0.4) - 40,000(0.6) = 16,000
Warehouse $30,000(0.4) + 10,000(0.6) = 18,000

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 Solution to Hurwizc

 Therefore, the decision maker will select

(purchase) Apartment building as the best
alternative;
 since it provides the maximum pay off
from the available alternatives i.e. 38,000

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 5) Equal Likelihood Criterion
The equal likelihood ( or Laplace) criterion multiplies the
decision payoff for each state of nature by an equal weight, thus
assuming that the states of nature are equally likely to occur.
Decision Values
Apartment building $50,000(.5) + 30,000(.5)= 40,000
Office building $100,000(.5) - 40,000(.5) = 30,000
Warehouse $30,000(.5) + 10,000(.5) = 20,000
Solution
Therefore, the decision maker will select Apartment Building as
the best alternative; since it provides the maximum pay off
from the available alternatives i.e. 40,000.

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 Summary of Criteria Results

■ A dominant decision is one that has a better payoff than another

decision under each state of nature.
■ The appropriate criterion is dependent on the “risk” personality
and philosophy of the decision maker.
Criterion Decision (Purchase)
Maximax Office building
Maximin Apartment building
Minimax regret Apartment building
Hurwicz Apartment building
Equal likelihood Apartment building

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 2) Decision Making with Probabilities
a)Expected Value
Expected value is computed by multiplying each decision
outcome under each state of nature by the probability of its
occurrence.

EV(Apartment) = $50,000(0.6) + 30,000(0.4) = 42,000

EV(Office) = $100,000(0.6) - 40,000(0.4) = 44,000 selected
EV(Warehouse) = $30,000(0.6) + 10,000(0.4) = 22,000
Because the office alternative has the largest expected monetary value, it
would be selected using this criterion
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 b) Expected Opportunity Loss
■ The expected opportunity loss is the expected value of the regret
for each decision.
■ The expected value and expected opportunity loss criterion
result in the same decision.

EOL(Apartment) = $50,000(.6) + 0(.4) = 30,000

EOL(Office) = $0(.6) + 70,000(.4) = 28,000 selected
EOL(Warehouse) = $70,000(.6) + 20,000(.4) = 50,000
Because the office alternative has the minimum expected opportunity loss, it
would be selected
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 C) Decision Trees (1 of 4)
A decision tree is a diagram consisting of decision nodes
(represented as squares), probability nodes (circles), and
decision alternatives (branches).

Payoff Table for Real Estate Investment Example

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 Decision Trees (2 of 4)

Decision Tree for Real Estate Investment Example

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 Decision Trees (3 of 4)
■ The expected value is computed at each probability node:
EV(node 2) = .60($50,000) + .40(30,000) = $42,000
EV(node 3) = .60($100,000) + .40(-40,000) = $44,000
EV(node 4) = .60($30,000) + .40(10,000) = $22,000

■ Branches with the greatest expected value are selected.

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 Decision Trees (4 of 4)

Decision Tree with Expected Value at Probability Nodes

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 D) Sequential Decision Trees (1 of 4)

■ A sequential decision tree is used to illustrate a situation

requiring a series of decisions.

■ Used where a payoff table, limited to a single decision, cannot

be used.

■ Real estate investment example modified to encompass a ten-

year period in which several decisions must be made:

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Decision Analysis with Additional
Information Bayesian Analysis

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 Bayes’ Theorem and Posterior Probabilities
• Knowledge of sample (survey) information can be used
to revise the probability estimates for the states of
nature.
• Prior to obtaining this information, the probability
estimates for the states of nature are called prior
probabilities.
• With knowledge of conditional probabilities for the
outcomes or indicators of the sample or survey
information, these prior probabilities can be revised by
employing Bayes' Theorem.
• The outcomes of this analysis are called posterior
probabilities or branch probabilities for decision trees.

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• Bayes’ Theorem provides a procedure to
calculate these probabilities

|
P(B Ai)P(Ai)
P(Ai|B) =
| |
P(B A1)P(A1)+ P(B|A2)P(A2)+…+ P(B An)P(An)

Posterior Probabilities Prior probabilities

Probabilities Probability estimates
determined determined based on
after the additional info current info, before the
becomes available. new info becomes available.
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 Bayesian Analysis (2 of 3)
■ Bayesian analysis uses additional information to alter
the marginal probability of the occurrence of an event.

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 Bayesian Analysis (2 of 3)

■ A conditional probability is the probability that an event will

occur given that another event has already occurred.
■ Economic analyst provides additional information for real
estate investment decision example, forming conditional
probabilities:
g = good economic conditions
b = poor economic conditions
P = positive economic report
N = negative economic report
P(Pg) =0 .80 P(Ng) =0 .20
P(Pb) = 0.10 P(Nb) =0 .90

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 Bayesian Analysis (3 of 3)

■ A posterior probability is the altered marginal probability of an

event based on additional information.
■ Prior probabilities for good or poor economic conditions in real
estate decision:
P(g) = 0.60; P(b) = 0.40
■ Posterior probabilities by Bayes’ rule:
P(gP) = P(Pg)P(g)/[P(Pg)P(g) + P(Pb)P(b)]
= (0.80)(0.60)/[(0.80)(0.60) + (0.10)(0.40)] = 0.923
■ Posterior (revised) probabilities for decision (Workout on):
P(gN) = 0.250 P(bP) = 0.077 P(bN) = 0.750

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 Decision Analysis with Additional Information
Decision Trees with Posterior Probabilities (1 of 4)

Decision tree with posterior probabilities differ from earlier

versions in that:
■ Two new branches at beginning of tree represent report
outcomes.

■ Probabilities of each state of nature are posterior

probabilities from Bayes’ rule.

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Decision Trees with Posterior Probabilities (2 of 4)

Decision Tree with Posterior Probabilities

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Decision Trees with Posterior Probabilities (3 of 4)

Decision Tree Analysis

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Decision Trees with Posterior Probabilities (4 of 4)

EV (apartment building) = $50,000(.923) + 30,000(.077)

= $48,460

EV (strategy) = $89,220(.52) + 35,000(.48) = $63,194

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Decision Analysis with Additional Information: Utility (1 of 2)

Payoff Table for Auto Insurance Example

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Decision Analysis with Additional Information: Utility (2 of 2)

Expected Cost (insurance) = .992($500) + .008(500) = $500

Expected Cost (no insurance) = .992($0) + .008(10,000) = $80
Decision should be do not purchase insurance, but people
almost always do purchase insurance.
■ Utility is a measure of personal satisfaction derived from
money.
■ Utilities are units of subjective measures of utility.
■ Risk averters forgo a high expected value to avoid a low-
probability disaster.
■ Risk takers take a chance for a bonanza on a very low-
probability event in lieu of a sure thing.

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 Additional Example of Decision Analysis

Reading Assignment on additional decision

analysis examples

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Game Theory

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 Game theory describes the situations involving
conflict in which the payoff (outcome) is affected by
the actions and counter-actions of intelligent
opponents.
 Game theory is indeed about modeling for winning
business in a competitive environment.

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 Types of Games
• Based on number of persons participating
– two player game

– multiple player game

• Based on the outcomes of the game

– two-persons-zero-sum game

– n-persons game

 Two-person zero-sum games play a central role in

the development of the theory of games
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 Strategy of a game
Strategy for a player is the list of all possible actions (moves or
courses of action) that the player will take for every payoff
(outcome) that might arise.
1. Pure strategy: It is the decision rule which is always used by
the player to select the particular strategy (Courses of action)
2. Mixed strategy: Courses of action that are to be selected on a
particular occasion with some fixed probability.
 Thus, there is a probabilistic situation and objective of the
players is to maximize expected gains or to minimize
expected losses by making choice among pure strategies with
fixed probabilities
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 Examples of competitive situations that can be organized into two-
person, zero-sum games :

 A union negotiating a new contract with management;

 Two armies participating in a war game;

 Two politicians in conflict over a proposed legislative, one

attempting to secure its passage and the other attempting to defeat
it;
 A firm trying to increase its market share with a new product and a
competitor attempting to minimize the firm’s gains; and
 A contractor negotiating with a government agent for a contract on
a project, etc.
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 Example: Two-persons-Zero-Sum game

• In general, a two-person game is characterized by

1. The strategies of player 1

2. The strategies of player 2

3. The payoff table

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• Consider the following game in which player “I”, has two
choices from which to select, and player “II” has three
alternatives for each choice of player “I”.
• The payoff matrix T is given below:
Player 2
i/j j1 j2 j3
i1 4 1 3
Player 1
i2 2 3 4

T= The Payoff Matrix

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• In the payoff matrix, the two rows (i = 1, 2) represent the two
possible strategies that player I can employ, and the three columns (j
= 1, 2, 3) represent the three possible strategies that player II can
employ.
• Player I is called maximizing player as he would try to maximize the
gains.
• Player II is called minimizing player as he would try to minimize his
losses.

• Here the objective is to determine the optimum strategies of both

the players that result in optimum payoff to each, irrespective of the
strategy used by the other.
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 Player 2
i/j j1 j2 j3
i1 4 1 3
Player 1
i2 2 3 4

• The payoff matrix is oriented to player I, meaning that a

positive tij is a gain for player I and a loss for player II, and a
negative tij is a gain for player II and a loss for player I.
• For example, if player I uses strategy 2 and player II uses
strategy 1, then player I receives t21 = 2 units and player II
thus loses 2 units.
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• Clearly, in our example player II always loses; however, the
objective is to minimize the payoff to player I.
In a game situation it is assumed that the pay-off
tables is known to all players.
The game is organized in such away that the player
who wants to maximized the gain is on the left, and
the player who wants to minimize the gain is on the
top.
The best strategy for each player is optimal strategy.
In a pure strategy game, each player adopts a single
strategy as an optimal strategy

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 1.Pure strategies
- Uses minimax and maximin principles(Game with saddle point)
Exapmle1.
• Two companies, A and B, sell two products.
• Company A advertises in Radio (A1), television (A2), and
newspapers (A3). Company B in addition to using radio (B1),
television (B2), and newspapers (B3), also uses mails and brochures
(B4). Depending on the effectiveness of each advertising campaign,
one company can capture a portion of the market from the others.

• The following matrix summarizes the percentage of the market

captured or lost by company A.

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 Company B
Strategies B1 B2 B3 B4
Company A A1 8 -2 9 -3
A2 6 5 6 8
A3 -2 4 -9 5
 Determine the optimal strategy for the game, and the value of the
game?
Solution
• The solution of the game is based on the principle of securing the best of
the worst for each player. Each competitor will act so as to minimize his
max loss or maximize his min gain.
Company B Maximin
Strategies B1 B2 B3 B4
Company A
Maximum of the
A1 8 -2 9 -3 -3
A2 6 5 6 8 5
minimum row
A3 -2 4 -9 5 -9
Minimax 8 5 9 8

Minimum of the
maximum column 12-59
• If company A selects strategy A1, then regardless of what B does,
the worst what can happen is that A loses 3% of the market share
to B.
 This is represented by the minimum value of the entries in row 1.

• Similarly, the strategy A2 worst outcome is for A to capture 5% of

the market share from B. and the strategy A3 worst outcome is for
A to loss 9% to B. These results are listed in the “Row min” column.

• To achieve the best of the worst, Company A chooses strategy A2

because it corresponds to the maximum value, or the largest
element in the “rowmin” column.

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• Next, consider Company B’s strategy. Because the given payoff
matrix is for A, B’s best of the worst criterion requires determining
the minmax value. The result is that company B should select
strategy B2.

• The optimal solution of the game calls for selecting strategies A 2,

and B2, which means that both companies should use television
advertising.
• The payoff will be in favor of company A, because its market share
will increase by 5%.
• In this case, we say that the value of the game is 5%, and that A and
B are using a saddle-point solution.
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• The saddle –point solution precludes the selection of a better
strategy by either company.

• If B moves to another strategy (B1, B3, or B4), Company A can

stay with strategy A2, which ensures that B will lose a worse
share of the market (6% or 8%).
• By the same token, A does not want to use a different strategy
because if A moves to strategy A3, B can move to B3 and realize
a 9% increase in market share.

• A similar conclusion is realized if A moves to A2, as B can move

to B4, and realize a 3% increase in market share.
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• The optimal saddle-point solution of a game need not
be a pure strategy.
• Instead, the solution may require mixing two or more
strategies randomly.
• If there is no saddle point, neither player can optimize
his chances by using a pure strategy, they must mix
some or all of their courses of actions, resulting in
mixed strategies.

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 2. Mixed Strategy
• An "equilibrium decision point", that is a "saddle point", also
known as a "minimax and maximin "point, represents a decision
by two players upon which neither can improve by unilaterally
departing from it.
 When there is no saddle point, one must choose the strategy
randomly.
• This is the idea behind a mixed strategy.

• A mixed strategy for a player is defined as a probability

distribution on the set of the pure strategies.

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 Analytical Method
• A 2 x 2 payoff matrix where there is no saddle
point can be solved by analytical method.
• Given the matrix

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Example

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Strategy X1 and X2 must be the share of the strategies A
should use to be in the market, and B also the same.

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 Dominant situation
• Consider the following game in which player I has two choices
from which to select, and player II has three alternatives for each
choice of player I. The payoff matrix T is given below:
Player II
Strategies j=1 j=2 j=3
i=1 4 1 3
Player I
i=2 3 2 4

Dominance occurs when all the payoffs for one strategy are better
than the corresponding payoffs for another strategy.
In the above table the values of player II for strategy 2 ,1<4
(strategy 1) and 1<3 (strategy 3) & 2<3 (strategy 1) and 2<4
(strategy 3).
Since Strategy 2 dominates Strategy 1 and strategy 3, these two
later strategies can be eliminated from consideration.
 But for player 1, no dominance rule works.
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 Example: Mixed strategies
• Table7.3: Payoff tables for Camera Companies
Company I Company II strategies
Strategies A B C

1 9 7 2
2 11 8 4
3 4 1 7
Let the values in table are the percentage increase or decrease in market
share for company I. Determine an optimal strategy for company I and
II and , and also find the value of the game.

Solution
The first step is to check the payoff table for any dominant strategies.
Doing so, we find strategy 2 dominates strategy I, and strategy B
dominates strategy A. Thus, strategies 1 and A can be eliminated from
the payoff table
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Solution
The first step is to check the payoff table for any dominant
strategies. Doing so, we find strategy 2 dominates strategy I,
and strategy B dominates strategy A. Thus, strategies 1 and
A can be eliminated from the payoff table
Player II Maximin
Player 1 B C

2 8 4 4
3 1 7 1
Minimax 8 7
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 a) Game Value (V)
• V= ad-bc/(a+d)-(b-c)
= 8*7-4*1/(8+7)-(4+1) = 5.2
b) Coordinates (proportions of the strategies played
by the players in mixed %)
X1= d-c/(a+d)-(b+c)= 7-1/10= 0.6
X2= a-b/10= 8-4/10=0.4
Y1=d-b/10= 7-4/10= 0.3
Y2= a-c/10= 8-1/10= 0.7
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Example
A T-shirt producing company has two firms. Each produces
white, black and red color t-shirts and sells their products in
the market with the indicated net profit per product. At each
of the production sites, the firm can produce only one shirt.
Determine which shirts must be produced using game theory.

Garment products produced by B

White Black Red Maxmin
300 320 230  
White 300 0 -20 70 -20
Garment Black 320 20 0 90 0
Products
produced by A Red 230 -70 -90 0 -90
minmax   20 0 90  

Since saddle point exists, the strategy 2 (black) T-

shirt production is recommended.
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