CH-5 Decision Theory

Slide 1.
1
2.1
Chapter 5
Decision Theory
05/07/2022 Decision
Saunders, Theory
Lewis and Thornhill, 1
Research Methods for Business Students, 5th Edition, © Mark Saunders, Philip Lewis and Adrian Thornhill 2009
Slide 1.2
2.2
Decision Theory
Making a decision requires enumeration of
feasible and viable alternatives, the consequences
associated with different alternatives, and
measure of effectiveness by which the most
preferred alternative is identified.
Decision theory provides an analytical and
systematic approach to the study of decision
making.
It provides a method of natural decision making
wherein data concerning the occurrence of
different outcomes may be evaluated to enable
the decision maker to identify suitable
alternative.
05/07/2022 2
Decision
Saunders, Theory
Lewis and Thornhill, Research Methods for Business Students, 5th Edition, © Mark Saunders, Philip Lewis and Adrian Thornhill 2009
Slide 1.3
2.3
cont’d
Decision models useful in helping decision makers
make the best possible decisions are classified
according to the degree of certainty. The scale of
certainty can range from complete certainty to
complete uncertainty. The region which falls
between this two is decision making under risk or
probabilistic problems.
05/07/2022 3
Decision
Saunders, Theory
Slide 1.4
2.4
Some Important Terminologies

List of alternatives: are a set of mutually exclusive
and collectively exhaustive decisions that are available
to the decision maker.
Two or more alternatives are said to be mutually
exclusive alternative if they cannot occur
simultaneously.
States of nature: the set of possible future
conditions, or events, beyond the control of the
decision maker.
Payoffs: the payoffs might be profits, revenues,
costs, or other measures of value. The number of
payoffs depends on the number of alternative/state
of nature combination.
05/07/2022 Decision
Saunders, Theory
Slide 1.5
2.5
Degree of certainty: the approach often

used by a decision maker depends on the
degree of certainty that exists.
one extreme is complete certainty and the
other is complete uncertainty. Between these
two extreme there is a risk.
Decision criteria: the decision maker’s
attitude toward the decision as well as the
degree of certainty that surrounds a decision.
Example; maximize the expected payoffs.
05/07/2022 Decision
Saunders, Theory
Slide 1.6
2.6
 Some decision makers are more optimistic (wants

to maximize gains) and some decision makers are
pessimistic (protecting against large losses).
 The payoff table; a payoff table is a device that
a decision maker can use to summarize
information relevant to a particular decision.
It includes:
 List of alternative
 Possible future state of nature
 The payoffs associated with each of the
alternative/state of nature combination.
 Probabilities
05/07/2022 Decision
Saunders, Theory
Slide 1.7
2.7
The Payoff Table

States of Nature
S1 S2 S3
P1 P2 p3
A1 V11 V12 V13
Alternatives A2 V21 V22 V23
A3 V31 V32 V33
where:
Ai = the ith alternative
Sj = the jth states of nature
Pi = probability under each state of nature
Vij = the value or payoff that will be
realized if alternative i is chosen
05/07/2022 and event
Decision Theoryj occurs. 7
Saunders, Lewis and Thornhill, Research Methods for Business Students, 5th Edition, © Mark Saunders, Philip Lewis and Adrian Thornhill 2009
Slide 1.8
2.8
The decision making process involves the following

steps:
1. Identification of the various possible outcomes, called
state of nature or events, Ei’s for the decision
problem. The events are beyond the control of the
decision maker.
2. Identification of all the course of action, Aj’s or the
strategies that is available to the decision maker. The
decision- maker has control over choice of these.
3. Determination of the payoff function which describes
the consequence resulting from the different
combinations of the acts and events. The payoff may
be designed as Vij’s. The payoff resulting from ith
events and jth strategy.
4. Choosing from among the various alternatives on the
basis of some
05/07/2022
criterion, which may involve the8
Decision Theory
Slide 1.9
2.9
Example 1: suppose that a real estate developer must

decide on a plan for developing a certain piece of
property. After careful consideration, the developer has
left with the following list of acceptable alternative.
 Residential proposal
 Commercial proposal #1
 Commercial proposal #2
The main factor that will influence the profitability of
the development is whether or not a shopping center
built, and the size of the shopping center, if one is built.
Suppose that developer views the possibilities as:
 No-shopping center
 Medium –size shopping center
 Large shopping center
05/07/2022 Decision
Saunders, Theory
Slide 1.10
2.10
The following payoff table provides data about profits

of the various states of nature/alternative combination
in $
States of nature
No SC MS SC LS SC
R 400,00 1,600,00 1,200,00
Alternativ 0 0 0
es C#1 600,00 500,000 1,400,00
If the residential proposal
0 is chosen and 0 no shopping
center is built, the developer will realize a profit of $
400,000. If theC#2second- commercial
400,000 1,500,00
proposal is selected
100,00
and no center is built, the 0 $ 100,000
developer will lose
0
05/07/2022 Decision
Saunders, Theory
Slide 1.11
2.11
1. Decision Making Under Certainty

 When decision is made under conditions of complete
certainty, the attention of the decision maker is
focused on the column in payoff table that corresponds
to the state of nature that will occur. The decision
maker then selects the alternative that yields the best
payoff, given that state of nature.
 For example, if there is an announcement that no
shopping center will be built, the developer then can
focus on the first column of the payoff table. Because
the commercial proposal # has the highest payoff in
that column ($6), it would be selected
05/07/2022 Decision
Saunders, Theory
Slide 1.12
2.12
2. Decision Making Under Complete Uncertainty

(Without Probabilities)
The decision maker either is unable to estimate
the probabilities for the occurrence of the
different state of nature
Approaches to decision making under complete
uncertainty:
 Maxi-max,
 Maxi-min,
 Mini-max regret,
 Equal likelihood and
 Hurwitz,
05/07/2022 Decision
Saunders, Theory
Slide 1.13
2.13
A. Maxi mal/ maxi max (optimistic strategy)

The best payoff for each alternative is defined, and the
alternative with the maximum of these is the designed
decision. For the above problem
05/07/2022 Decision
Saunders, Theory
Slide 1.14
2.14
B. Maxi-Min / Pessimistic Criteria

Consists of identifying the worst (minimum) payoff for each
alternative, and, then, selecting the alternative that has the
best (maximum) of the worst payoffs. Many people view the
maxi-min criterion as pessimistic because they believe that
the decision maker must assume that the worst will occur
For the previous problem:
05/07/2022 Decision
Saunders, Theory
Slide 1.15
2.15
C. mini-max regret
An approach that takes all payoffs into
account. To use this approach, it is necessary
to develop an opportunity loss table that
reflects the difference between each payoff
and the best possible payoff in a column (i.e.,
given a state of nature).
Hence, opportunity loss amounts are found by
identifying the best payoff in a column and
then subtracting each of the other values in
the column from that payoff.
05/07/2022 Decision
Saunders, Theory
Slide 1.16
2.16
For the above example:
05/07/2022 Decision
Saunders, Theory
Slide 1.17
2.17
C. mini-max regret
05/07/2022 Decision
Saunders, Theory
Slide 1.18
2.18
D. Principle of Insufficient Reason/

Equal Likelihood/ Laplace
It treats the states of nature as if each was equally
likely and it focuses on the average payoff for each
row, selecting the alternative that has the highest row
average.
States of Nature Row average
S1 S2 S3
A1 400,000 1,600,00 1,200,00 1,066,666.67
Alternativ 0 0
es A2 600,000 500,000 1,400,00 833,333.3
0
A3 - 400,000 1,500,00 600,000
05/07/2022 Decision
Saunders, Theory
Slide 1.19
2.19
E. The Hurwitz Criterion

The approach offers the decision maker a compromise
between the maximax and the maximin criteria.
Requires the decision maker to specify a degree of
optimism, in the form of a coefficient of optimism α,
with possible values of α ranging from 0 to 1 (0< < 1).
The closer the selected value of α is to 1, the more
optimistic the decision maker is, and the closer the value
of α is to 0, the more pessimistic the decision maker is.
05/07/2022 Decision
Saunders, Theory
Slide 1.20
2.20
If  = 1, then the decision maker is said to be

completely optimistic,
 If = 0, then the decision maker is completely
pessimistic. Given this definition, if  is
coefficient of optimism,
1- is coefficient of pessimism.
The Hurwitz criterion requires that for each
alternative, the maximum payoff is multiplied by 
and the minimum payoff be multiplied by 1-.
05/07/2022 Decision
Saunders, Theory
2009
Slide 1.21
2.21
Example: If  = 0.4 for the above example,

States of Nature
S1 S2 S3
A1 400,000 1,600,000 1,200,000
Alternatives A2 600,000 500,000 1,400,000
A3 -100,000 400,000 1,500,000
A1 = (0.4x1600000) + (0.6x400000) = 880,000

A2 = (0.4x1400000) + (0.6x500000)= 860,000
A3 = (0.4x1500000) – (0.6x100000)= 540,000
05/07/2022 Decision
Saunders, Theory
Slide 1.22
2.22
Summary of Methods for Decision Making

under Complete Uncertainty
05/07/2022 Decision
Saunders, Theory
2009
Slide 1.23
2.23
3. Decision Making Under Risk (With

Probabilities)
A. Expected Monetary Value (EMV)
The EMV approach provides the decision maker
with a value which represents an average payoff
for each alternative. The best alternative is,
then, the one that has the highest EMV. The
average or expected payoff of each alternative
is a weighted average:
05/07/2022 Decision
Saunders, Theory
2009
Slide 1.24
2.24
Cont’d
Where:
EMVi = The EMV for the ith alternative
Pi = The probability of the ith state of
nature
Vij = The estimated payoff for
alternative i under state of nature j.
Note: the sum of the probabilities for all states of nature
must be 1.
Sources of probabilities: Subjective estimates, Expert
opinions and Historical frequencies
05/07/2022 Decision
Saunders, Theory
2009
Slide 1.25
2.25
For the above Example

State of Nature
S1 S2 S3
Probability
0.20 0.50 0.30
S1 S2 S3
Expected
payoff
EMV (A1) = 0.20(400000) + 0.50(1600000) + 0.30(1200000) =

1,240,000,* maximum
EMV (A2) = 0.20(6) + 0.50(5) + 0.30(14) = 790,000
EMV (A3) = 0.20(-1) + 0.50(4)1600000
A1 40000 + 0.30(15)1200000
= 630,000 1,240,000* max
Alternatives
05/07/2022 Decision 0Theory 25
Slide 1.26
2.26
B. Expected Opportunity Loss (EOL)

The opportunity losses for each alternative are
weighted by the probabilities of their
respective state of nature to compute a long
run average opportunity loss, and the
alternative with the smallest expected loss is
selected as the best choice.
05/07/2022 Decision
Saunders, Theory
2009
Slide 1.27
2.27
Opportunity Loss Table

States of Nature
S1 S2 S3
0.2 0.5 0.3
A1 600,000- 1,600,000- 1,500,000-1,200,000
Alternative 400,000= 200,000 1,600,000 = 0 =300,000
s A2 600,000- 1,600,000-500,000 1,500,000-1,400,000
600,000=0 = 1100000 =100,000
A3 600,000-(- 1,600,000 -400,000 1,500,000-1,500,000
100,000)
EOL (A1) = 0.20(2) + 0.50(0) += 0.30(3)
= 1,200,000 =0
= 130,000 *minimum
EOL (A2) = 0.20(0)
700,000+ 0.50(11) + 0.30(1) = 580,000
EOL (A3) = 0.20(7) + 0.50(12) + 0.30(0) = 740,000
The EOL approach resulted in the same alternative as the EMV
approach (Maximizing the payoffs is equivalent to minimizing the
opportunity losses).
05/07/2022 Decision
Saunders, Theory
2009
Slide 1.28
2.28
C. Expected Value of Perfect Information (EVPI)

The EVPI is the measure of the difference between
the certainty payoffs that could be realized under a
condition involving risk.
If the decision maker knows that S1 will occur, A2
would be chosen with a payoff of $6. Similarly for S2
$16 (for A1) and for S3, $15 (with A3) would be
chosen.
 Hence, the expected payoff under certainty (EPC)
would be:
EPC= 0.20(600,000)+0.50(1,600,000) +
0.30(1,500,000) = 1,370,000
05/07/2022 Decision
Saunders, Theory
2009
Slide 1.29
2.29
Cont’d
 The difference between this figure and the expected
payoff under risk (i.e., the EMV) is the expected value
of perfect information. Thus:
EVPI = EPC – EMV
= 1,370,000 – 1,240,000 = 130,000
 The EOL indicates the expected opportunity loss due
to imperfect information, which is another way of
saying the expected payoff that could be achieved by
having perfect information.
05/07/2022 Decision
Saunders, Theory
2009
Slide 1.30
2.30
Decision Trees
Decision tree, like probability tree, is composed
of squares, circles, and lines:
The squares indicate decision points and Circles
represent chance events (circles and squares are
called nodes)
The lines (branches) emanating from squares
represent alternatives. The lines from circles
represent states of nature
The tree is read from right to left.
05/07/2022 Decision
Saunders, Theory
2009
Slide 1.31
2.31
Cont’d
05/07/2022 Decision
Saunders, Theory
Slide 1.32
2.32
Decision Trees
05/07/2022 Decision
Saunders, Theory
2009
Slide 1.33
2.33
Example: Pay Off Table For Real Estate Investment
Decision (Purchase) State of Nature

Good Economic Poor Economic
Conditions Conditions
0.60 0.40
Apartment Building 50,000 30,000
Office Building 100,000 -40,000
Warehouse 30,000 10,000

05/07/2022 Decision
Saunders, Theory
2009
Slide 1.34
2.34
The decision tree for the above example will be:

Good E conditions (0.60)
$50,000
2 $30,000
Bad E conditions(0.40)
Purchase Apartment Good E conditions (0.60)

1 $100,000
Office building 3
- Bad E conditions(0.40)
$40,000
4 $30,000 Good E conditions (0.60)
Warehouse
$10,000 Bad E conditions(0.40)
 EV(node 2) = .60($ 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
05/07/2022 Decision
Saunders, Theory
2009
Slide 1.35
2.35
Exercise
The research department of HABESHA B.S.C. has recommended the
marketing department to launch three different alcohol level beers.
The marketing manager has to decide one of the three of beer to be
launched under the following estimated pay-off (in millions of birr)
for various levels of sales
Estimated Levels of Sale
Types of Beer (Unit)

1500 1000 5000
0 0
HABESHA- 3.5 Alcohol 30 10 10
a. What willlevel
be the marketing manager decision if I) maxi-min II) maxi-max III)
Laplace IV) mini-max regret
HABESHA – 5 Alcohol level 40 15 5
b. Suppose the research department has assigned probabilities of 0.2 for 15000
estimatedHABESHA – 7.5
sale, 0.5 for Alcohol
10000 55 and 0.3
estimated sale 20 for 50003estimated sale .
Which alternative will be chosen using expected monetary value decision criteria,
level the expected value of perfect information for the problem
and determine
05/07/2022 Decision
Saunders, Theory
2009

CH-5 Decision Theory

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

CH-5 Decision Theory

Uploaded by

Copyright:

Available Formats

Slide 1.

Some Important Terminologies

Degree of certainty: the approach often

 Some decision makers are more optimistic (wants

The Payoff Table

The decision making process involves the following

Example 1: suppose that a real estate developer must

The following payoff table provides data about profits

1. Decision Making Under Certainty

2. Decision Making Under Complete Uncertainty

A. Maxi mal/ maxi max (optimistic strategy)

B. Maxi-Min / Pessimistic Criteria

For the above example:

D. Principle of Insufficient Reason/

E. The Hurwitz Criterion

If  = 1, then the decision maker is said to be

Example: If  = 0.4 for the above example,

A1 = (0.4x1600000) + (0.6x400000) = 880,000

Summary of Methods for Decision Making

3. Decision Making Under Risk (With

For the above Example

EMV (A1) = 0.20(400000) + 0.50(1600000) + 0.30(1200000) =

B. Expected Opportunity Loss (EOL)

Opportunity Loss Table

C. Expected Value of Perfect Information (EVPI)

Example: Pay Off Table For Real Estate Investment

Decision (Purchase) State of Nature

Office Building 100,000 -40,000

Warehouse 30,000 10,000

The decision tree for the above example will be:

Purchase Apartment Good E conditions (0.60)

 EV(node 2) = .60($ 50,000) + .40($ 30,000) = $42,000

Types of Beer (Unit)

You might also like