Decision Theory

INOPER3 Notes
Definition
 Decision Theory (DT) is a set of
concepts, principles, tools, and
techniques that aid the decision maker
in dealing with complex decisions under
uncertainty.
Components of a DT Problem
 The Decision Maker
 Alternative Courses of Actions
 This is the controllable aspect of the problem
 States of Nature or Events
 These are the scenarios or states of the
environment not under the control of the decision
maker. The events defined should be mutually
exclusive and collectively exhaustive.
Components of a DT Problem
 Consequences
 The consequences that must be assessed
by the decision maker are measures of the
net benefit, payoff, cost or revenue
received by the decision maker. There is a
consequence (or vector of consequences)
associated with each action-event pair. The
consequences are summarized in a
decision matrix.
Classification of DT Problems
 Single Stage Decision Problems
 A decision is made only once.
 Multiple Stage/Sequential Decision Problems
 Decisions are made one after another.
 Discrete DT Problems
 The alternative courses of actions and states of nature are finite.
 Continuous DT Problems
 The alternative courses of actions and states of nature are infinite.
 DT Problems can also be classified as those with or without
experimentation. Experimentation is performed to obtain
additional information that will aid the decision maker.
Discrete Decision Theory
Problems
 Decision Trees
 A discrete DT problem can be represented
pictorially using a tree diagram or decision tree. It
chronologically depicts the sequence of actions
and events as they unfold.
 A square node ( ) precedes the set of possible
actions that can be taken by the decision maker. A
round node ( ) precedes the set of events or
states of nature that could be encountered after a
decision is made. The nodes are connected by
branches ( ).
Decision Tree
E1

2
A1
E2

E1
A2
3

E2
Decision Under Risk and
Uncertainty
 If no probabilities are assigned to the
possible consequences, then the
decision situation is called "decision
under uncertainty".
 If probabilities are assigned then the
situation is called "decision under risk".
Decision Under Risk and
Uncertainty
 Consider a DT Problem with m alternative
courses of actions and maximum of n events
or states of nature for each alternative course
of action.
Define:
Ai = alternative course of action i; I = 1,2,…,m
Øj = state of nature j; j = 1,2,…,n
Decision Under Risk and
Uncertainty
 The decision matrix of payoff is given by:

Ø1 Ø2 … Øn

A1 v(A1, Ø1) v(A1, Ø2) … v(A1, Øn)

A2 v(A2, Ø1) v(A2, Ø2) … v(A2, Øn)

: : : : :
Am v(Am, v(Am, … v(Am,
Ø1) Ø2) Ø n)
Decision Under Risk and
Uncertainty
A. Laplace Criterion
 This criterion is based on what is known as the
principle of insufficient reason. Here the
P(
probabilities associated with the occurrence of the
event Øj is unknown. We do not have sufficient
reason to conclude that the probabilities are
different. Hence, we assume that all events are
equally likely to occur.
1
P (   j )  j
n
Decision Under Risk and
Uncertainty
A. Laplace Criterion (con’t.)
 Then, the optimal decision rule is to select
action Ai* corresponding to:
1 n 
max   v( Ai ,  j )
Ai
 n j 1 
Example
 Blockwood Inc. is a newly organized manufacturer of furniture products.
The firm must decide what type of truck to purchase for use in the
company's operations. The truck is needed to pick up raw material
supplies, to make deliveries and to transport product samples to
commercial exhibits during the coming year. Three alternatives were
identified by the firm:
 A small commercial import truck
 A standard size pick-up
 A large flatbed truck
It is expected that sales in the first year will fall in one of four
categories:
 Low (0-200,000)
 Moderately low (200,000-400,000)
 Moderately high (400,000-600,000)
 High (above 600,000)
Example (con’t)
 The payoff table for the firm would be:
Actions States of Nature
Truck Type Low Moderately Low Moderately High High
Import 20 10 15 25
Standard 15 25 12 20
Faltbed -20 -5 30 40
•Find the appropriate decisions using
•Laplace Criterion
•Minimax Criterion (Assume loss payoff table)
•Maximin Criterion
•Savage Minimax Regret Criterion
•Hurwicz Criterion ( = 0.6)
Decision Under Risk and
Uncertainty
B. Minimax (Maximin) Criterion
 This is the most conservative criterion
since it is based on making the best of the
out of the worst possible conditions. For
each possible decision alternative, we
select the worst condition and then select
the alternative corresponding to the best of
the worst conditions.
Decision Under Risk and
Uncertainty
 The Minimax strategy is given by:

min maxv( Ai ,  j )

Ai   j 
 The Maximin strategy is given by:

max minv( Ai ,  j )

Ai   j 
Decision Under Risk and
Uncertainty
C. Savage Minimax Regret Criterion
 The Minimax rule is an extremely conservative
type of decision rule. The savage Minimax regret
criterion assumes that a new loss matrix is
constructed in which v(Ai,Øj) is replaced by
r(Ai,Øj), which is defined by:
maxv( Ak ,  j ) v( Ai ,  j ), if v is profit
r ( Ai ,  j )   A
 v( Ai ,  j )  minv( Ak ,  j ),
k

if v is loss
 Once the loss matrix is constructed using the
above formula, we can now apply the Minimax
criterion defined in b.
 Decision Under Risk and
Uncertainty
D. Hurwicz Criterion
 This criterion represents a range of attitudes from the
most optimistic to the most pessimistic.
 Under the most optimistic conditions, one would
choose the action yielding:
max maxv( Ai ,  j )
Ai   j 
 Under the most pessimistic conditions, the chosen
action corresponds to:
max minv( Ai ,  j )
Ai   j 
Decision Under Risk and
Uncertainty
D. Hurwicz Criterion (con’t.)
 The Hurwicz criterion strikes a balance between
the extreme pessimism and extreme optimism by
weighing the above conditions by respective
weights α and (1- α), where 0<α<1. That is, the
action selected is that which yields:
max 
 max v ( Ai ,  j )  (1   ) min v ( Ai ,  )
j 

Ai  j j 
 [Note: the above formulas represent the case
where payoffs are expressed as profits]
Decision Under Risk and
Uncertainty
D. Hurwicz Criterion (con’t.)
 If α=1, the decision rule is referred to as the

Maximax Rule, and if α=0, the decision rule

becomes the Maximin. For the case where
the payoff represent costs, the decision rule
is given by:

min  min v( Ai ,  j )  (1   ) max v( Ai ,  j )

Ai  j j 
Decision Under Risk and
Uncertainty
E. Bayes’ Rule
 Here, we assume that the probabilities
associated with each state of nature are
known. Let
P(   j )  Pj

 The action which minimizes (maximizes)

the cost (profit) is selected.
n 
max  Pj * v( Ai ,  j )
Ai
 j 1 
Decision Under Risk and
Uncertainty
E. Bayes’ Rule (con’t.)
 The backward induction is used. With the
aid of a decision tree, expected values are
computed each time a round node is
encountered and the above decision rule is
utilized each time a square node is
encountered, i.e., a decision is made each
time a square node is encountered.
Example (con’t)
 Suppose that the firm has assessed that
probabilities for the 4 sales levels as:
P(1) = 0.20 P(3) = 0.30
P(2) = 0.35 P(4) = 0.15
What decision would be reached using
Bayes' Rule?
Decision Under Risk and
Uncertainty
F. Expected Value-Variance Criterion
 This is an extension of the expected value
criterion. Here, we simultaneously maximize profit
and minimize the variance of the profit. If Z
represents profit as a random variable with
variance σ2, then the criterion is given by:
max imize E ( z )  K var( z )
 Where K is any specified constant. If Z represents
cost:
min imize E ( z )  K var( z )
Decision Under Risk and
Uncertainty
G. Decision Making with Experimentation
 In some situations, it may be viable to secure
additional information to revise the original
estimates of the probability of occurrence of the
state of nature.
 Preposterior Analysis considers the question of
deciding whether or not it would be worthwhile to
get additional information or to perform further
experimentation.
 Posterior Analysis deals with the optimal choice
and evaluation of an action subsequent to all
experimentation and testing using the
experimental results.
Decision Under Risk and
Uncertainty
 G. Decision Making with Experimentation
(con’t.)
 Prior probabilities are the initial probabilities
assumed without the benefit of experimentation.
Posterior probabilities refer to the revised
probability values obtained after experimentation.
 Let
Pj = prior probability estimate of event Øj
P{Zk/Øj} = conditional probability of experimental outcome
Zk
P{Øj/Zk} = posterior probability of event Øj
Decision Under Risk and
Uncertainty
 G. Decision Making with Experimentation
(con’t.)
 The experimental results are assumed to be given
by Zk, k=1,2,…,l. The conditional probability can
be considered to be a measure of the reliability of
the experiment. The idea is to calculate the
posterior probabilities by combining the prior
probabilities and the conditional probabilities of
the experimental outcome Zk.
Decision Under Risk and
Uncertainty
 G. Decision Making with Experimentation
(con’t.)
 The posterior probabilities are given by:

P{ j  Z k } P{Z k /  j } * P{ j }

P{ j / Z k }   m
P{Z k }
 P{Z
i 1
k /  j } * P{ j }
Decision Under Risk and
Uncertainty
 G. Decision Making with Experimentation
(con’t.)
 Once the posterior probabilities are calculated, the
original problem can be viewed as a multiple
state/sequential DT problem. The first stage
involves the decision of whether to perform
additional experimentation or not. Once this is
decided, the outcomes of the experiment are
considered together with the original set of
decision alternatives and events.
Decision Under Risk and
Uncertainty
G. Decision Making with Experimentation
(con’t.)
 A perfect information source would provide, with
100% reliability, which of the states of nature
would occur.
 Define:
EPPI = expected profit from a perfect information source
EVPI = expected value of the perfect information source
EP = Bayes’ expected profit without experimentation
Decision Under Risk and
Uncertainty
G. Decision Making with Experimentation
(con’t.)
 Then:
EVPI = EPPI – EP
 Where: n
EPPI   Pj * maxv( Ai ,  j )
Ai
j 1

n 
EP  max  Pj * v( Ai ,  j )
Ai
 j 1 
 EVPI is easily seen as a measure of the maximum
amount a decision maker should be willing to pay
for additional information.
Decision Under Risk and
Uncertainty
G. Decision Making with Experimentation
(con’t.)
 Define:
EVSI = expected value of sample information
ENGS = expected net gain from sampling
CAI = cost of getting additional information
Decision Under Risk and
Uncertainty
G. Decision Making with Experimentation
(con’t.)
 Then:
l n 
 
EVSI   P{Z k } max  P  j / Z k * v( Ai ,  j )  EP
Ai
k 1  j 1 

ENGS = EVSI – CAI

 The information source would be viable if
ENGS > 0.
Example (con’t)
 Find the expected profit using Perfect Information Source
(EPPI).
 Find the expected value of perfect information (EVPI).
 Suppose the firm acquires the services of a consulting firm, ABC
Inc. ABC will conduct market study that will result in one of 2
outcomes.
 O1 will be favorable indication of the market for the firm's products.
 O2 will be unfavorable indication of the market for the firm's products.
O1 and O2 are referred to as sample outcomes.
Example (con’t)
 The following conditional probabilities were arrived at
from considerable ABC experience, using historical
market research record in ABC's files and the
statisticians' judgment.
P(Oj/SI)
S1 S2 S3 S4
O1 0.05 0.30 0.70 0.90
O2 0.95 0.70 0.30 0.10

Find the posterior probabilities, expected payoff with sample

information, and expected value of sample information
If ABC charges Php1000, find the expected net gain from
sample information.
Continuous Decision Theory
 As previously mentioned, continuous decision
theory problems refer to those where the
number of alternatives and/or states of
nature can be considered as infinite. The
optimization model in this case is given by:

max f ( A)   v( A,  )h ( )d


 Where:
hØ(Ø) = prior distribution function of the states of nature
Continuous Decision Theory
 In the above model, it is assumed that no
additional information is available and the
expression is evaluated with respect to the
prior distribution of the states of nature. If
additional information is available, we update
the prior distribution of the states of nature
by determining its posterior distribution,
which is nothing but the conditional
distribution of the states of nature given the
experimental outcome.
Continuous Decision Theory
 Hence, the optimization converts to:

max f ( A)   v( A,  )h / Z  z ( )d


 Where:
hØ/Z=z(Ø)=conditional distribution of the state of
nature given the experimental outcome
Continuous Decision Theory
hz /  ( z )h ( )
h / Z  z 
hz ( z )
 hz/Ø(z) = conditional distribution of the
experimental outcome given the state
of nature
 hz(z) = marginal distribution function of
the experimental outcomes