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# Decision Theory

Decision Theory is a body of knowledge and related analytical techniques Decision is an action to be taken by the Decision Maker Decision maker is a person, a group of people or a committee who makes the final choice among the alternatives Alternative is one of the courses of action attaining the objectives States of Nature (mutually exclusive and exhaustive) are future events NOT under the control of the DM Consequence is an interaction between a decision and a state of nature (a result of a course of action or of a decision taken) Payoff is a benefit that accrues from a consequence

## Expected-Value Criterion = Sum of weighted pay-offs for that action

weight = probability assigned to a state of nature by DM

Under certainty DM completely certain as to which state of nature will occur Under uncertainty DM has no knowledge of the probabilities of the occurrences of the states of nature Under risk DM has knowledge about probabilities of the occurrences of the states of nature risk means uncertainty for which the probability distribution is known

Decision Making

## Under certainty DM completely certain as to which state of nature will occur

Pay-off Matrix Products GOOD A B C 10 20 22 Sates of nature MODERATE 1.5 10 7 POOR 0.4 -6 - 10

## Pay-off in crores of INR

Under uncertainty DM has no knowledge of the probabilities of the occurrences of the states of nature

## OPTIMIST (Aggressive) Maximax Criterion

Pay-off Matrix

Products
GOOD A B C 10 20 22

Sates of nature
MODERATE 1.5 10 7 POOR 0.4 -6 - 10

## PESSIMIST (Conservative) Maximin Criterion

Pay-off Matrix

Products
GOOD A 10

Sates of nature
MODERATE 1.5 POOR 0.4

## Min pay-off of each alternative 0.4

B
C

20
22

10
7

-6
- 10

-6
- 10

NEITHER AN OPTIMIST NOR A PESSIMIST (Middle of the road) Coefficient of Optimism (Hurwicz's Index, index of optimism) a) Choose an index of optimism a, 0 a 1 b) 1 means optimistic and 0 means pessimistic b) Multiply largest payoff (row-wise) by a and the smallest by (1 a) d) Pick action with largest sum.

Let a = 0.7
max min

Pay-off Matrix
Sates of nature GOOD MODERATE POOR Weighted pay-off 10 * 0.7 + 0.4 * 0.3 = 7.12 20 * 0.7 + (- 6) * 0.3 = - 0.4 22 * 0.7 + (- 10) * 0.3 = 12.4

A
B C

10
20 22

1.5
10 7

0.4
-6 - 10

REGRET CRITERION (Savage's Opportunity Loss) Regret = payoff of what would have minus the payoff for the actual decision in been the best decision in the circumstances the circumstances REGRET TABLE Sates of nature GOOD A B C 22 10 = 12 22 20 = 2 22 22 = 0 MODERATE 10 1.5 = 8.5 10 10 = 0 10 7 = 3 POOR 0.4 0.4 = 0 0.4 (- 6) = 6.4 0.4 (- 10) = 10.4 12 6.4 10.4 Minimise over all regrets

## Maximum Regret of each alternative

Under risk DM has knowledge about probabilities of the occurrences of the states of nature

Pay-off Matrix

GOOD

MODERATE

POOR

Probabilities

0.3

0.5

0.2

10

1.5

0.4

B
C

20
22

10
7

-6
- 10

## EV of Perfect Information = EV under certainty maximum EV under risk

Sates of nature GOOD Probabilities 0.3 MODERATE 0.5 POOR 0.2 EV under certainty

A B C

10 20 22

1.5 10 7

0.4 -6 - 10

## 0.4 * 0.2 = 0.08 10 * 0.5 = 5 22 * 0.3 = 6.6

Total = 11.68
EV of Perfect Information = 11.68 8.6 = 3.08

Pay-off Matrix
New scheme

## Pay-off in crores of INR

Sates of nature Market share 1% 3% 0.1 7% 0.4 19% ???

Probabilities

0.2

## Introduce Not introduce

-5 0

-3 0

22 0

40 0

Decision Tree
Decision node from which only one path of action may be taken

State of Nature node only one of the alternatives may happen in future