DECISION THEORY

Dr. T. T. Kachwala

Mumbai | India
DECISION THEORY - INTRODUCTION

In an environment of uncertainty, a decision making process leads a manager to one or

more optimum solutions from amongst the alternates available within the constraints of the
available resources and such that the manager optimizes the value of the objective function
and simultaneously minimizes the risk involved

Operations Research or Management Science or Decision Science is a science of

application of mathematical models and statistical theories for the betterment or
improvement of management decision making process.
STATISTICAL THEORIES & MATHEMATICAL
MODEL

• Statistical Theories refer to the Statistical Tools & Techniques like Mean, Standard
Deviation, Regression & Normal Distribution which are used for Business Analysis
• Mathematical Model is a Mathematical Equation which Simulates a Business
situation to predict the possible outcome for known or assumed values of the
Decision Variables.
COST, REVENUE & VOLUME MODEL

• Consider the Cost, Revenue & Volume Model.

– Revenue & Volume; S = s*Q

– Cost & Volume; C = F + v*Q
▪ ‘s’ is the selling price per unit

▪ ‘v’ is the variable cost per unit

▪ ‘Q’ is the level of output (assuming we produce only what we can

sell)
▪ ‘F’ is the given Fixed cost
COST, REVENUE & VOLUME MODEL.

– Profit & Volume;

▪ S=F+V+P
▪ S*Q = F + v*Q + P
▪ (s – v)* Q – F = P
• For a given selling price per unit, variable cost per unit & level of output (assuming
we produce only what we can sell) and the given Fixed cost, we can calculate the
Profits using the above model (equation).
CHARACTERISTICS OF MATHEMATICAL
MODEL
• A mathematical model or equation is characterized by a constant value & a
variable component;
– Example: In the Profit equation; P = (s – v)* Q – F, the fixed components are s, v & F
& the variable component is Q.

• A decision maker can use the above mathematical model to estimate the profit for
given level of volume.
– Example: for small levels of volume decision maker will incur a loss, for larger valves
of volume, decision maker gains a profit and at breakeven sales the decision maker
neither gains profit nor incurs a loss. Math Model BEAnalysis.xlsx
CHARACTERISTICS OF MATHEMATICAL
MODEL

Such Mathematical Models are a critical part of any Quantitative Approach to

Decision Making. They enable a Decision maker to make inferences about
the real situation by studying and analyzing the model like an air plane
designer who might test a new air plane model in a wind tunnel to learn about
the potential flying characteristics of a full size plane.
DECISION THEORY – BASIC ELEMENTS

Decision Theory comprises of two basic elements:

1. States of Nature (Future Events)
2. Strategies (Course of Action)

State of Nature: refers to that element of the decision making process which is not in
the control of decision maker; example demand of a product. We use the term state of
nature because the decision maker is an “innocent bystander” in the determination of
which state of nature occurs

Strategy: refers to that element of the decision making process which is in the control
of the decision maker, example Product mix strategy, Investment strategy, Marketing
mix strategy
DECISION THEORY – BASIC ELEMENTS

Payoff: is a monetary value associated with an outcome corresponding to a

combination of a possible state of nature that occurs and the strategy the decision
maker selects. Since this value is condition to (depends on) the state of nature that
occurs, it is referred as conditional payoff.

Payoff Matrix: is a tabular compilation of the payoffs for all the possible
combinations of state of nature that occurs and the strategies the decision maker
selects
CONDITIONAL PAYOFF MATRIX

Strategy (Course of Action)

State of Nature (Future Events)

Pij is the conditional payoff corresponding

to the ith state of Nature that occurs and jth

strategy the decision maker selects.

If this value is positive, it means the
decision maker is the gainer and the
Pij
outcome is favorable to the decision maker.
However, if this value is negative, it means
the decision maker is a loser and the
outcome is unfavorable to the decision
maker.
SELECTION OF AN OPTIMUM STRATEGY

Selection of an Optimum strategy depends on the environments or situations of Decision

making.
Decision – making environment signifies a condition or a situation of decision-making
based on the knowledge or information the decision maker has on the possible States of
Nature that occurs.
There are three important environments defined in decision-making:
1. Decision making under Certainty (Perfect Information)
2. Decision making under Risk (Less than Perfect Information)
3. Decision making under Uncertainty (No Information
DECISION MAKING UNDER CERTAINTY

Decision making under Certainty: signifies a situation of decision-making where a

decision maker has perfect information or complete knowledge on the possible
States of Nature that occurs.
The decision-making in this situation is to select a strategy that offers maximum
conditional payoff.
In practical situations of Decision making it is difficult (almost impossible) to
obtain perfect information on the possible states of nature that occurs
DECISION MAKING UNDER RISK

Decision making under risk: signifies a situation of decision making where a

decision maker has less than perfect information on the possible states of nature
that occurs. In this situation, the decision maker is able to associate probability
values for the States of Nature that occurs based on the past data using relative
frequency theory.
The decision making in this situation is to select a strategy that maximizes
weighted payoff (EMV or Expected Monetary Value) or minimizes weighted
opportunity loss (EOL or Expected Opportunity Loss)
EMV CRITERION

EMV is an acronym for Expected Monetary Value. It is mathematically defined as

follows:

EMV = Pij pi

Where Pij is the conditional payoff corresponding to State of Nature N i & Strategy Sj & pi

is the probability of obtaining the State of Nature N i

The following is the procedure for EMV Criterion:

1. Compile the Conditional Payoff Matrix
2. Calculate EMV corresponding to each strategy
3. Select the optimum strategy corresponding to the maximum value of EMV
EMV CRITERION

The decision maker selects the optimum strategy that maximizes the expected
payoff, which gives importance to both conditional payoff and the values of
probability. The values of probability are the weights. The higher the value of
probability, the more the weightage for that state of nature. EMV therefore
signifies weighted payoff.

Distinction between a good decision and good outcome is important. Decision

analysis is a logical framework for obtaining good decisions, but does not
guarantee good outcomes. Even after a good decision has been made, state of
nature will play a role in determining whether the decision results in a good or
bad outcome.

There are many examples in real life situations where the decisions have been
good but the outcome was not good & similarly there are examples where
decision were not good but the outcome was good
EMV CRITERION

Expected Payoff for Perfect Information = EPPI = Pijmax pi

where Pijmax is the maximum value of payoff corresponding to State of Nature N i & pi is the

probability of obtaining the State of Nature Ni

EPPI signifies the theoretical maximum average payoff the decision maker can obtain
assuming that he has perfect information on the possible states of nature that occurs

Expected Value of Perfect Information = EVPI = EPPI – EMVmax

EVPI signifies the cost of uncertainty. It signifies the maximum average cost a decision
maker may not mind incurring to obtain perfect information on the possible state of nature
that occurs

Alternately, EVPI signifies the loss to the decision maker for not having perfect information
on the possible states of nature that occurs
EXPECTED VALUE OF PERFECT INFORMATION

The expected value of perfect information (EVPI) can also be computed

as follows:
EVPI =
(EVPI = EPPI – EMVmax )
where,
EVPI= expected value of perfect information
expected value with perfect information about the states of nature
= expected value without perfect information about the states of nature
EOL CRITERION

Expected Opportunity Loss = EOL = lij pi

Where lij is the conditional opportunity loss corresponding to State of Nature N i &

Strategy Sj and is defined as lij = Pijmax – Pij

The procedure for EOL calculation is as follows:

1. Compile Conditional Opportunity Loss Matrix (Regret Matrix) from

Conditional Payoff Matrix

2. Calculate EOL for each strategy

3. Select an optimum strategy corresponding to minimum value of EOL

EOL CRITERION

Interpretation of COL Matrix:

1. COL signifies the loss in payoff for selecting a particular strategy in
preference to the best available strategy for a particular state of nature. The
higher the value of COL, the more the regret of the decision maker for
selecting that strategy over the best available strategy
2.  COL Matrix signifies a compilation of all the possible values of COL for all
the possible States of Nature that occurs and Strategy the decision maker
selects.
3. COL matrix is also referred as regret matrix as it indicates the regret of the
decision maker for not selecting the best strategy for a particular state of
nature that occurs
EOL CRITERION

1. EOL signifies the average opportunity loss. It is also the weighted opportunity loss.
Importance is given to both COL and the value of probability which signify the
weights

2.  EOL min = EVPI; EOL / EVPI signifies the expected opportunity loss for selecting a
particular strategy in preference to the best available strategy for that State of Nature

3. The optimum strategy for both EMV & EOL criterion are the same. In practical
application of Management, it is sufficient to apply any one of the two criterion. Of
the two criterion, EMV criterion is more popular
DECISION MAKING UNDER UNCERTAINTY

Decision making under Uncertainty: signifies a situation of decision-making

where a decision maker has no knowledge on the possible state of nature that
occurs, for example launching a new product in the market.

Since there is no past data available, probability values cannot be obtained. EMV
criterion cannot be applied for selecting the optimum strategies
DECISION MAKING UNDER UNCERTAINTY

The decision-making in this situation is to select a strategy based on conditional payoff

together with one or more of the following criterion or principle.

1. Criterion of Optimism (Maximax)

2. Criterion of Pessimism (Maximin)
3. Hurwicz Criterion (Max H)
4. Laplace Criterion (Max Average)
5. Criterion of Regret (Minimax)
DECISION MAKING UNDER UNCERTAINTY

Criterion Principle Meaning Underlying Concepts

Optimistic Maximax Max from amongst the The best from amongst
Max possible payoff the best

Pessimistic Maximin Max from amongst the The best from amongst
(Conservative) Min possible payoff the worst

Hurwicz Max H Combination of Optimistic & Pessimistic criterion

Laplace Max Avg Max from amongst the All the states of nature
Average payoff are equally likely

Regret Minimax Minimum from amongst The best from amongst

the max opportunity loss the worst
WHAT IS A DECISION TREE?

DTR1 0.1
Low
10
10 10

Decision Tree is a pictorial 0.5

S1 Medium
50
0 46 50 50

representation of the High

0.4

50
50 50

decision process. Low

0.1

-20
-20 -20

0.5
S2 Medium
3 60
75 0 68 60 60

It represents the State of High

0.4

100
100 100

nature with the associated

0.1
Low
-150
-150 -150

0.5

probability and strategies S3 Medium

20
0 75 20 20

0.4

with the associated payoff. High

200
200 200
HOW TO DRAW A DECISION TREE?

Decision Tree comprises of two basic elements

1. Nodes
2. Branches.

Nodes: There are two types of nodes:

3. The Decision node is represented by a square D

4. The Chance node is represented by a circle C

HOW TO DRAW A DECISION TREE?

The decision node D represents a point on the decision tree where a

decision maker takes a decision.

The chance node C represents a point on the decision tree where a

decision maker evaluates the outcome of his decision.
HOW TO DRAW A DECISION TREE?

Branches: are lines or segments that connect the nodes.

D C

There are three types of branches:

(i) Decision branch D Decision Branch

signifies the branch that commences from the decision node.
It signifies the strategy the decision maker selects at that
point.
HOW TO DRAW A DECISION TREE?

(ii) Chance branch C Chance Branch

signifies the branch that commences from the chance
node. It signifies the state of nature that occurs at that
point.

(iii) Terminal branch signifies the last branch of the decision

tree. It is not followed by either decision or chance node.
The terminal branches are mutually exclusive &
collectively exhaustive at that point.
DIAGRAM OF A REPRESENTATIVE DECISION TREE

ce
h a n ch
C an
Br
h
nc
B ra
on
cisi
De

Terminal Branch
OBJECTIVE OF DRAWING A DECISION TREE

The objective of drawing a decision tree is multiple stage decision

analysis.

The calculation starts with the terminal branch. Starting from the
terminal branch we calculate the position value progressively at
each node & roll back to the earlier node till we reach the initial
node.
DECISION TREE - ROLL BACK TECHNIQUE

The position value at the chance node is the EMV at that point.
The position value at the decision node is the maximum payoff
amongst the branches at that point.

In the process of rolling back to the initial node, we identify a

series or sequence of optimum strategies that maximizes the
payoff at the initial node.
DECISION TREE - ROLL BACK TECHNIQUE

Roll back

max
payoff
EMV

EMV

max
payoff

EMV
EMV

max
payoff
USE OF TREEPLAN (EXCEL ADD-INS)
DTR2 0.4
Oil
700
1000 700

0.2
Drill Gas
200
-200 200 500 200

0.4 0.4
Type A Dry
1 -300
0 200 0 -300

Do Not Drill
-100
0 -100

0.1
Purchase Oil
700
-100 20 1000 700

0.1
Drill Gas
200
-200 -150 500 200

0.6 0.8
Type B Dry
1 2 -300
20 0 -100 0 -300

Do Not Drill
-100
0 -100

Do Not Purchase
0
0 0