CHAPTER FOUR

DECISION THEORY
• Every one of us has to make decisions throughout life.

• What profession to choose? Where and how much to invest? What to

produce and how much to produce?
• Some of the decisions are really difficult to make because of the
complexity of the decision situation.
• Decision Theory is concerned with how to assist organizations in
making decisions.
• It consists of following steps:
– Decision making Environment
– Objectives of a decision maker
– Alternative plans of action
– Decision payoff

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 1. Decision Making Environment

• The first step is to know the environment under which a

decision is to be taken.
• Who takes the decision? The decision maker may be an
individual or a group of individuals.
• Then they take care of decision situations. These
situations can be:
–  Situation of certainty

–  Situation of Risk
–  Situation of Uncertainty

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 Steps in Decision theory approach:

1. Determine the various alternative courses of action from

which the final decision is to be made.

2. Identify the possible outcomes, called the states of nature or

events for the decision problem. The events are beyond the
control of the decision-maker.
3. Construct a pay off table:
The decision – maker now constructs a pay off table for each
possible combination of alternative course of action and state of
nature.
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If there are m alternative courses of action A1,A2,A3,….Am and n
states of nature E1,E2,E3,….En , the pay off matrix as follows:

  Courses of action
 
  A1 A2 A3……………………. .Am
 
States of E1 a11 a12 a13 …………….. a1m
Nature E2 a21 a22 a23 …………………. .a2m
E3 a31 a32 a33 …………………..a3m
. ……………………………………………..
; ……………………………………………..
;  
;  
En an1 an2 an3 …………………….anm

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Note

• Where aij – the pay off resulting from ith event and jth
action.
4. The decision-maker will choose the criterion which
results in largest pay off.

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 Decisions under Uncertainty

• These refer to situations where more than one outcome

can result from any single decision.
• That is, here more than one states of nature exist but the
decision-maker lacks sufficient knowledge to allow him to
assign probabilities to the various states of nature.
• The following choices are available before the decision-
maker in situations of uncertainty.
(a) Maximax Criterion
(b) Minimax Criterion
(c) Maximin criterion
(d) Laplace Criterion (Criterion of equally likelihood)
(e) Hurwitz Criterion (Criterion of Realism)
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1. Maximax Criterion: In this case the course of action that
maximizes the maximum pay-off is taken. The decision maker lists
down the maximum pay-off associated with each course of action
then selects that alternative having maximum number.
This may be called an optimistic decision criterion as the decision
maker selects the alternative of highest possible gain.
2. Minimax Criterion: In this case the course of action that
minimizes the maximum pay-off is taken.
The decision maker lists down the maximum pay-off associated
with each course of action then selects that alternative having
minimum number. 1 7
3. Maximin Criterion: The course of action that maximizes the
minimum possible pay-off is selected.

The decision maker lists down the minimum outcome within

each course of action ( or act ) and then selects the strategy with
the maximum number.
This is also known as a pessimistic decision criterion as it locates
the strategy having least loss.

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4. Laplace Criterion (Criterion of equally likelihood)
• This criterion is based on the principle of equal
likelihood.
• The decision maker first calculates the average
outcome for each course of action and then selects
the maximum number.
• The equally likely approach assumes that all
probabilities of occurrence for all the state of nature
are equal, and thus each state of nature is equally
likely.

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5. Hurwitz Criterion (Criterion of Realism): The criterion makes
compromise between maximax and maximin i.e. an optimistic and
pessimistic decision criterion. At first, a coefficient of optimism α ( 0 ≤
α ≤ 1) is selected, which is assumed to be degree of optimism. Now
according to Hurwitz select that alternative which maximizes.

h = α (maximum pay-off) + (1 – α ) (Minimum pay-off )

• In other words, we first locate the minimum outcome within every

alternative and then pick that alternative with the maximum number.
Since this decision criterion locates the alternative that has the least
possible loss, it has been called a pessimistic decision criterion.
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 Problems;

1. A Company has to choose one of the three types of

Biscuits, Cream, Coconut and Glucose.
• Sales expected during next year are highly uncertain.
Marketing Department estimates the profits
considering manufacturing cost, Promotional efforts
and distribution set-up etc.,
• What is the best biscuit under?

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Type of Biscuits Profits on estimated level of sales for quantities

5,000 10,000 20,000

Cream(C ) 15 25 45
Coconut(Co) 20 55 65
Glucose(G) 25 40 70

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 What is the best biscuit under?

• I . Maximax Criterion
• (ii) Maximin criterion
• (iii) Minimax Criterion
• (iv) Laplace Criterion (Criterion of equally
likelihood)
• (v) Hurwicz Criterion (Take α = 0.6)

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• (i) Maximax Criterion: The maximum pay-offs are 45, 65,
70 respectively. The maximum among these is 70 which
correspond to Glucose biscuits. The best strategy is Glucose.
• (ii) The minimum pay of for each alternative C,Co,G are
15,20,25 respectively.
• The maximum among these is 25 which corresponds to
Glucose(G) biscuits.
The best strategy is Glucose.

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• (iii) Minimax Criterion: the maximum pay-off are 45, 65, 70
respectively. The minimum among these is 45 which correspond
to cream biscuit.
The best strategy is Cream biscuit
• (iv) Laplace Criterion: When decision maker has no definite
information about the probability of occurrence of various states
of nature, he makes simple assumption that each is equally
likely. Therefore, the probability of each to occur is 1/3.
• Expected pay – offs are:

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• E(C ) = 1/3(15) + 1/3 (25) + 1/3(45) = 28.33
• E( Co) = 1/3(20) + 1/3(55) + 1/3(65) = 46.67
• E(G) = 1/3(25) + 1/3(40) + 1/3(70) = 45
The maximum expected value is 46.67. Hence,
the decision would be to launch coconut Biscuits
(Co).

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(v) Hurwitz Criterion (α = 0.6):
• In this case, the decision maker’s degree of optimism
is represented by α
Here α = 0.6 1- α = 0.4
The quantity h can be calculated as follows
h = α . Maximum pay-off + (1- α ) Minimum pay-off

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 The Maximum h value is 52. Hence, the decision would be to
launch Glucose (G).
  Maximum Minimum h = (α)Maximum pay-off +
pay off pay off (1- α ) Minimum pay-off
 
C 45 15 (0.6) 45 + (0.4) 15 = 33
Co 65 20 (0.6) 65 + (0.4) 20 = 47
G 70 25 (0.6) 70 + (0.4) 25 = 52

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 CHAPTER FIVE
THEORY OF GAMES

• Definition: Game is defined as an activity between two or more

persons involving activities by each person according to a set of
rules, at the end of which each person receives some benefit or
satisfaction or loss .
• Game theory is a body of knowledge that deals with making
decisions when two or more rational and intelligent opponents are
involved under situations of conflict and competition.
 The characteristics of such a game are:-
• Only two players participate in the game
• Each player has a finite number of strategies to use
• Each specific strategy results in a pay off
• Total pay off to the two players at the end of each play is
zero.
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• That is, firms must consider the likely responses
of competitors when they make strategic decisions about
price, advertising, and other variables.
• In other words, the actions and reactions of a firm depend on
the move and countermove of the other firm just like a game.
• The objective, in theory, of games is to determine the rules of rational
behaviour in game situations, in which the outcomes are dependent on the
actions of the interdependent players.
• A game refers to a situation in which two or more players are competing.
• A player may be an individual, a group or an organization.

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 The basic elements of a game
The strategic form (normal form) of a game describes an
economic setting by three elements:
1. Players:
• Each decision maker in a game is called a player.
These players can be individuals (poker game), firms (as
in the Oligopolistic markets), or entire nation
2. Strategies:
• Each course of action open to a player during a game is
called a strategy.
Strategy is a decision rule of players.
• A strategy tells a player how to behave in the settings
being modeled or is a decision rule that instructs a
player how to behave over the course of the game.
3. Payoffs:
• The final return to the players of a game at its conclusion is
called “payoffs”. Example the Payoffs for the firms can be
profit.
• A player’s payoff function describes how it evaluates
different strategies. That is, given the strategies chosen by all
players, a player’s payoff function tells him his state of well
being (or welfare or utility) from players having played
those strategies.
• It is the objective, usually numerical, that a player in a game
aims to maximize.
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 Fundamental Assumptions of game
Game theoretic analysis is built on two fundamental
assumptions: These are
1. Rationality: game theory assumes that players are interested
in maximizing their payoffs.
2. Common Knowledge: all players know the structure of the
game and that their opponents are rational.
3. There are finite number of competitors.
4.There is conflict of interests between them.
5. Players know all possible available choices but does not
know which one is going to be chosen.
6. Players simultaneously select their respective courses of action.
7. Players have to make individual decisions without direct
communication.
 Types of Games
• The economic games that firms play can be either
cooperative or non cooperative.
• A game is cooperative if the players can negotiate
binding contracts that allow them to plan joint strategies.
• A game is non cooperative if negotiation and
enforcement of a binding contract are not possible.
• An example of a cooperative game is the
bargaining between a buyer and a seller over price of a
commodity.
 Types of Games
• Another cooperative game can be the
negotiation of two firms in an industry for a
joint investment to develop a new technology.
• If the firms can sign a binding contract to
divide the profits from their joint investment, a
cooperative out come that makes both parties
better off is possible. Eg. OPEC
An example of a non cooperative game is a
situation in which two competing firms take
each other’s likely behavior into account and
independently determine a pricing or
• Let us assume that there are only two car manufacturers,
company A and company B. The two companies have market
shares for their product. Company A is planning to increase
their market share for the next financial year. The vice-
president of company A has come up with two strategies. One
strategy is to modify the outer shape of the car and to
advertise on TV. Company B, knowing that if these strategies
are adopted by company A, it may lead to decrease in its
market share, develops similar strategies to modify the shape
of their car and to advertise on TV 26
The Pay Off if Both Companies Modify Shape & Advertise on TV

company B

Modify shape Advertise

Company A 4 6
8 5

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• The pay off given is with respect to company A and represents company
A. Company B’s pay off is the opposite of each element. For example, it
means that for modification strategy, Company A wins 4 and company B
loses 4.
• In a game, each player has a set of strategies available. A strategy of a
player is the list of all possible actions (course of action) that are taken
for every pay-off (outcome). The players also know the outcome in
advance.
• The players in the game strive for optimal strategies. An optimal
strategy is the one, which provides the best situation (maximum pay-
off) to the players.
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Cont.….

• Payoff Matrix: Company A has strategies A1, A2,…, Am, and

Company B has strategies B1,B2,….,Bn. The number of pay-
offs or outcomes is m × n. The pay-off a represents company
A’s gains from Company B, if company A selects strategy m
and company B selects strategy n. The pay-off matrix is given

(Table above) with respect to company A.

• The game is zero-sum because the gain of one player is

equal to the loss of other and vice-versa
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 TWO-PERSON ZERO-SUM GAME
• In a game with two players, if the gain of one player is equal to
the loss of another player, then the game is a two person zero-
sum game.
• A game in a competitive situation possesses the following
properties:
–The number of players is finite.
– Each player has finite list of courses of action or strategy.
–A game is played when each player chooses a course of action (strategy)
out of the available strategies. No player is aware of his opponent’s choice
until he decides his own.
–The outcome of the play depends on every combination of courses of
action. Each outcome determines the gain or loss of each player.

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 PURE STRATEGIES: GAME WITH SADDLE POINT
• This decision-making is referred to as the minimax-maximin principle to
obtain the best possible selection of a strategy for the players.
• In a pay-off matrix, the minimum value in each row represents the minimum
gain for player A.
• Player A will select the strategy that gives him the maximum gain among the
row minimum values.
• The selection of strategy by player A is based on maximin principle.
• Similarly, the same pay-off is a loss for player B. The maximum value in each
column represents the maximum loss for Player B.
• Player B will select the strategy that gives him the minimum loss among the
column maximum values.
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• The selection of strategy by player B is based on minimax

principle.

• If the maximin value is equal to minimax value, the game has a

saddle point (i.e., equilibrium point). Thus the strategy selected

by player A and player B are optimal.

• Player B will select the strategy that gives him the minimum loss

among the column maximum values.

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 Nash Equilibrium
• If we assume two firms: A and B, A with the
strategies ‘advertise’ and ‘do not advertise’ and B with
the strategies ‘expand production’ and ‘cut production’.
The payoff for each player is given in the following
table.

19
 Nash Equilibrium.
• In the above table, the strategy (advertise,
expand production) is a Nash equilibrium.
• If A chooses to advertise, the best strategy
for B is to expand production. And if
B chooses to expand production then
optimal choice for A is to choose to
advertise (since 2>0).

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 The Prisoners’ Dilemma

1. The prisoners’ dilemma is one of the most widely used examples for dominant
strategy equilibrium.

2. The game consider a situation where two prisoners who are partners in a crime
where questioned in two separate rooms and communication is not allowed.

3. Each prisoner had a choice of confessing (admit) for the crime and there by
implicating the other or denying that he had participated in the crime.

4. If only one suspect confessed, then he would go free while the other suspect (who
does not confess) will receive 6 year sentence.

5. If both suspects denied being involved in the crime, then both would be held for 1
year. If both confessed, they would be held for 3 years in prison. The payoff
matrix for the game is given in table below.
 Cont’d
…

Which strategy is the optimal strategy for the two suspects?

What is the equilibrium outcome of the game?
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 Cont’d…
To answer these questions let us compare the payoff that the player receives by choosing
a specific combination of strategies.

Let us start form player. A. If player-B decides to deny, player-A is better off confessing
since it will left free.

If player B decides to confess, still player- A is better off by confessing since it

receives 3-year sentence rather than 6 year sentence. Thus whatever player B does,
player A is better off by confessing.

That is the dominant strategy for player A is confessing. Also the dominant strategy for B
is confessing. The reason is that if player A confesses, players B get a three year jail
sentence and six year jail sentence if the does not. This implies the unique Nash
equilibrium of the game is both players to confess.

This equilibrium is also dominant strategy equilibrium, since each player has the same
optimal choice independent of the other player. But the equilibrium outcome (confess,
Confess) is not a Pareto efficient outcome. Because if they coordinate their action and
choice a strategy (deny, deny) both suspects are better off. That is the two suspects
receive only one-year imprisonment by denying.
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 Cont’d…

The strategy (deny, deny) is not only Pareto efficient but also Pareto
Optimal because there is no other strategy choice that makes both
players better off or either of them without making the other worse
off.

Thus, the strategy (confess, confess) is Pareto inefficient for both.

The problem is however there is no way for the two
suspects to communicate with one another to make sure that the
two suspects cooperate. If they could trust each other, then they could
be better off by choosing a strategy (deny, deny).
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 CHAPTER SIX

6.1 INVENTORY MODELS

• What is inventory?
• Traditionally, inventory is viewed as a necessary evil too little of it
causes costly interruptions, too many results in idle capital.
• The inventory problem determines the inventory level that
balances the two extreme cases.
• The term ‘inventory’ is generally used to indicate raw materials in
process, finished product, packaging, spares and others-stocked in
order to meet an expected demand or distribution in the future.

39
 Necessity for maintaining inventory

• It helps in smooth and efficient running of an enterprise.

• In the absence of inventory, the enterprise may have to pay high prices because of

piecemeal purchasing.

• It improves the cash flow by timely delivery of customer orders.

• It provides adequate service to customers.

• It acts as a buffer stock when raw materials are received late and rejections are too

many.

• It helps in maintaining economy by absorbing some of the fluctuation when the

demand for an item fluctuations or is seasonal.

• Inventories like pipeline stocks are quite necessary in larger firms where significant

amounts of times are required to transship items from one location to another .
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1. Purchase model without shortages:
• In this model of inventory, orders of equal size are placed at
periodical intervals. The items against an order are consumed at
constant rate. The purchase price per unit is the same irrespective of
order size.
Let, D = annual demand in units.

C0 = Ordering cost/order

Cc = carrying cost/unit/year

P = the purchasing price per unit

Q = the order size.

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• Economic Order Quantity (E.OQ) =
Q* = 2C 0D
C c

• No.of orders = D/Q*

• Time between orders = Q*/D

42
• Problem: Alpha industry estimates that it will sell 12,000 units of its
production for the forthcoming year. The ordering cost is birr100 per
order and the carrying cost per year is 20% of the purchase price per
unit. The purchase price per unit is birr.50.
• Find (a) Economic Order Quantity (b) No. of orders per year (c) Time
between successive orders.

Solution :
• (a) D = 12,000 units/year

C0 = birr. 100 /order

Cc = birr.50 x 20% = 50 x 0.2 = birr.10 /unit/year

43
• Q= 2 C
C
0

c
D
2 ( 100 )( 12 , 000 )
10

• = 490 units (approx)

(b) No. of orders/year = D/Q* = 12,000/490 = 24.49

(c) Time between successive orders = Q*/D = 490/12,000 = 0.04
year = 48 months

44
 2. Purchase Model with Shortage:

In this model, the items are consumed at a constant rate. The

purchase price per unit remains same irrespective of order size.
If there is no stock at the time of receiving a request for the
items, it is assumed that it will be satisfied at a later date with a
penalty. This is called backordering.

• D = Demand/period Cc = Carrying cost/unit/period

• Co = Ordering cost/order

• Cs = Shortage cost/unit/period.

45
• Economic Order Quantity = (EOQ) =
• Q* = 2C D (C  C )
0 s c

Cc Cs

2C0 D Cs
• Maximum Inventory = Q1* =
Cc (Cs  Cc )

• Maximum Stock out = Q2* = Q* - Q1*

46
Cycle time = t* = Q*/D
Inventory period = t1* = Q1*/D
Shortage period = t2* = Q2*/D

47
• Problem: The annual demand for an automobile component is 24,000
units. The carrying cost is birr.0.40/unit/year, the ordering cost is
birr.20/order and the shortage cost is birr.10/unit/year. Find the
optimal values of the following:
• (i) Economic Order Quantity (ii) Maximum inventory (iii) Maximum
Shortage quantity
• (iv) Cycle time (v) Inventory period (vi) Shortage period.

Sol: D = 24,000 units/year

• Cc = birr 0.40unit/year

• C0 = birr. 20 /order

• Cs = birr.10/unit/year 48
• EOQ=
2 C 0 D (C s  C c )
Cc Cs

= 2(20)(24,000) (10  0.4)

0.40 10
=1580 units
Q 1* = 2C 0 D Cs
C c (C s  C c )

2 ( 20 )( 24 ,000 ) 10
= 0 .40 (10  0 .4 )
=1520 units

49
• (iii) Maximum Stock out = Q2* = Q* - Q1*=1580-1520=60
units
• (iv) Cycle time = t* = Q*/D=(1580/24,000)x365 = 24 days
(v) Inventory period = t1* = Q1*/D= (1520/24,000)x365=23
days
• (vi) Shortage period = t2* = Q2*/D=(60/24,000)x365 = 1 day

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Chapter Seven : Queuing Theory

7.1. Introduction

• Queues are very common in everyday life. We quite often face the

problem of long queues for a bus, banks,barber shop, a movie ticket and

for various other situations.

• In large cities, long queues are seen in front of railway booking offices,

post offices, automobiles waiting at service stations, ships waiting for

berths and patients waiting for doctors.

• Queues are thus a common phenomenon of modern civilized life. The

theory of queuing models has its origin in the work of A.K.Erlang, a

Danish Engineer of the Copenhagen Telephone Company during 1910s.

 Meaning of Queue
• Ordinarily the forms in front of service facilities are
called a waiting line or a queue. A queue thus involves
arriving customers who want to be serviced at the
facility which provide the service they want to have.
Customer’s arrival

Waiting line/Queue

Getting serviced

Departure of customers
Commonly Used Terminology in Queuing Theory
• Queuing System: A system consisting arrival of customers, waiting in
queues, picked up for service, being serviced and the departure of
customers.
• Customer: Persons arriving at a station for service. Customers may be
either persons or other items.
• Service station: Point where service is to be provided.
• Queuing length: It is the number of customers waiting in the queue.
• Waiting time It is the time a customer spends in the queue before being
serviced.
• Number of customers in the system: It is the sum of number of customers
in the queue and number of customers being serviced.
• Time spent by a customer in the system: It is the sum of waiting time and
service time.
• Jockeying: Leaving the first queue and joining the other.
• Reneging: Joining the queue and leaving it afterwards.
• Balking: Customers decides not to join the queue
 Elements of the Queuing System

A queuing system has the following elements

• Arrivals
• Service mechanism
• Queue discipline
• Output of the queue
 1. Arrivals
• Customers arrive at a service station for service. They do not come at regular intervals but an arrival

into the system occurs according to some chance mechanism.

• Arrivals may occur at a constant rate or may be in accordance with some probability distribution such as

Poisson distribution, Normal distribution etc.

• The following information is considered relevant for input process

i) The source population

a) Infinite (very large)

b) Finite (limited Number)

ii) Arrival distribution

iii) Inter-arrival distribution

iv) Mean arrival rate i.e. the average number of customers arriving in one unit of time. It is represented

by λ.

• v) Mean time between arrivals i.e. 1/ λ.

 2. Service mechanism

• It is concerned with the service time and the service

facilities.
Service facilities can be of following types.
A. Single Channel facility: In this, there is only one queue in
which the customer waits till the service point is ready to
take him for servicing.
B. One queue – several service stations facilities: In this,
customer wait in a single queue until one of the service
stations is ready to take them for servicing.
C. Several queues – one service station: In this, customer can
join any one of queue but the service station is only one.
D. Multi channel facility: In this, there are many queues and
many service stations facilities
 3.Queuing discipline
• Specifically it means, existence of some rule
according to which the customer’s actions as to
when their turn comes up for the service.
• First In First out (FIFO) or
• Last in Last out (LIFO).
 Mostly, FIFO rule is applicable in Queuing systems.
 Single-Channel Poisson Arrivals with Exponential
Service Rate (M/M/1)

• See the examples from pdf book.

End!!!!