Chapter Five

Decision Theory Model

 Decision theory
• The decision making refers to the selection of an act
from amongst various alternatives, the one which is
judged to be the best under given circumstances.
• Decision theory is used to determine the best
alternative under incomplete and uncertain future
conditions.
• To analyze a set of complex situations with many
alternatives and many different possible
consequence
 Decision theory
Decision theory problems are characterized by the
following:
A list of alternatives
A list of possible future events (states of nature)
Payoffs associated with each combination of
alternatives and events (e.g. a payoff matrix)
The degree of certainty of possible future event
A decision criterion
 State of nature
• Are actual event that may occur in the future and
which are beyond the control of the decision maker
• State of nature are factors which influence a choice
of alternatives but their occurrences are knowing
during decision making
Example
• Demand level of a product
• Market condition
• Whether condition etc
 Pay off table
• A payoff table is a tool that provides information about
consequences associated with each alternative/state
of nature combination usually related to potential profit
or loss.
 Decision making environment/
Degree of certainty
1. Decision-making under certainty
•There is complete certainty about the future
•The decision-maker knows with certainty the
consequences of every alternative and Wich state of nature
will happen
2. Decision-making under uncertainty
The decision-maker does not know the probabilities of the
various outcomes and which state of nature will happen
3. Decision-making under risk (with probability)
The decision-maker does know the probabilities of the
various outcomes and state of nature
 Decision criteria

Criteria under complete uncertainty

1. Maximin
2. Maximax
3. Minimax regret
4. Hurwicz
5. Equal likelihood
Criteria under probability
1. Expected monitory value(EMV)
2. Expected opportunity Loss(EOL)
 Criteria..
Maximin: The maximin strategy is a conservative one; it consists of
identifying the worst (minimum) payoff for each alternative and then
selecting the alternative that has the best (maximum) of the worst
payoffs. In effect, the decision maker is setting a floor for the potential
payoff; the actual payoff cannot be less than this amount.
Maximax
The maximax approach is the opposite of the previous one: The best
payoff for each alternative is identified, and the alternative with the
maximum of these is the designated decision.
Minimax 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
The Hurwicz (Realism) Criterion (Weighted
Average or Realism 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 1.00.
– The closer the selected value of α is to 1.00, the more
optimistic the decision maker is, and the closer the value
of α is to 0, the more pessimistic the decision maker is.
Approaches to Incorporating Probabilities in
the Decision Making Process
• Expected Monetary Value (EMV) approach
– Provides the decision maker with a value that represents an
average payoff for each alternative.
• Expected Opportunity Loss (EOL)
– The opportunity losses for each alternative are weighted by the
probabilities of their respective states of nature to compute a
long-run average opportunity loss, and the alternative with the
smallest expected loss is selected as the best choice.
• Expected Value of Perfect Information (EVPI)
– A measure of the difference between the certain payoff that could
be realized under a condition of certainty and the expected payoff
under a condition involving risk.
 Decision Theory Solution steps

1. Identify all alternatives

2. Determine states of nature
3. Determine Payoffs table
4. Identify decision making environment
5. Choosing from among the various alternatives on
the basis of some criteria
Example 1
An investor called Naol is want to construct one of the
following a manufacturing plant. The investor’s decision
is mainly depend on a market demand wich could be
High or Low market demand. The alternatives are
constructing large plant, small plant or do nothing. Given
the following payoff table, determine the best alternatives
under uncertainty and risk environment. Assume, the
probability of high demand is 0.6 and low demand is 0.4.
further more, assume alpha value to be 0.7.
Alternative STATE OF NATURE
(Constructing plants ) High Demand (0.6) Low demand (0.4)

Large plant 200,000 -180,000

Small plant 100,000 -20,000
Do nothing 0 0
 Example 2
Suppose that a real estate developer must decide on a
plan for developing a certain piece of property. After
careful consideration, the developer has identified the
following list of acceptable alternatives:
1.Apartment building
2.Office building
3.Commercial building

Suppose that the developer identified the following state

of nature
1. Low demand
2. Moderate demand
3. High demand
 Payoff Table for Real Estate Developer
( Profit per year in Birr(000’s)

State Of Nature( Demand Level)

Alternatives
(Types of building) High Moderate Low
Apartment 500 320 200
Office 750 300 100
Commercial 400 150 -125