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Decision theory commences with the assumption that regardless of the type of decision-whether it involves long-range or short-range consequences; whether it is finance, production 0r marketing, or someother area, whether it is at relatively high or low level managerial responsibility-certain common characteristics of the decision problem are to be discussed. In this section we will introduce the main concepts associated with the decision theory approach to problem solving. 1. The Decision Maker. The decision-maker refers to individual or a group of individual responsible for making the choice of an appropriate course of action amongst the available courses of action. 2. Courses of Action. The alterantive courses of action or strategies, are the I acts that are available to decision maker. The decision analysis involves a selection among two or more alternative courses of action and the problem is to choose the best of these alternatives, in order to achieve an objective. An example of an act or state of nature is the number of units of a particular item to be ordered for stock. 3. States of Nature. The events identify the occurrences which are outside of the decision maker's control and which determine the level of success for a given act. These events are often called 'states of nature, or outcomes'. [The decision maker has no control over which event will take place and can only attach a subjective probability or degree of belief of occurrence of each.) An example of an

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event or state of nature is the level of market demand for a particular item during a stipulatedtime period. 4. Payoff. Each combination of a course of action and a state of nature is associated with a payoff, which measures the net benefit to the decision maker that accrues from a given combination of decision alternatives and events. They are also known as conditional profit values or conditional economic consequences. For example, the conditional profit can be Rs. 50 associated with the action of stocking 15 units of an item when the outcome is a demand of 10 units of that item. Costs can be handled as negative profit. 5. Payoff Table. For a given problem, payoff table lists the states of nature (outcomes or events) which are mutually exclusive as well as collectively exhaustive and a set of given courses of action (strategies). For each combination of state of nature and course of action, the payoff is calculated Suppose the problem under consideration has m possible events or states of nature denoted by 51, 5 z, ..., Sm and n alternative courses of action (strategies) denoted by AI, Az, ..., An. Then the pay-off corresponding to strategy Aj of the decision maker under the state of nature 5j will be denoted by Pij (i = 1, 2,..., m i j = 1, 2, ..., n). The mn pay-offs can be conveniently arranged in a tabular form
known as a

.m x n payoff

table'.
Conditional Pay-off (Rs.) Courses of Action (Strategies) '" A2 ... P12 ... P22

TABLE 10.1. GENERAL FORM OF PAYOFF TABLE

States of Nature (Events) Al SI S2 Pn P21

An Pln P2n

Sm

Pml

Pm2

Ann

The weighted profit associated with a given combination of state of nature and course of action is obtained by multiplying the payoff for that state of nature and course of action by the probability of occurrence of the given state of nature (outcome). Although it is not universal, mostly payoff is measured in terms of monetary units. 6. Regret or Opportunity Loss Table. The opportunity loss has been defined to be the difference between the highest possible profit for a state of nature and the actual profit obtained for the particular action taken, i.e., an opportunity loss is the loss incurred due to failure of not adopting the best possible course of action or strategy. Opportunity losses are calculated separately for each state of nature that might occur. For a given state of nature the opportunity loss of possible course of action is the difference between the pay-off value for that course of action and the payoff for the best possible course of action that could have been selected. Consider a fixed state of nature S I. The pay-offs corresponding to the n strategies are given by Plh P12,..., Pin' Suppose MIis the maximum of these quantities. Then if Al is used by the decision maker there is loss of opportunity of M1- Plb and

so on. Then a table showingopportunityloss can be computedas follows:

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TABLE 10.2 : GENERALFORM OF REGRETTABLE

States of Nature 51 52 Sm Al Ml - Pn M2- P21 Mm-Pml

(Conditional Opportunity Loss Rs.) Course of Action (Strategies) ... A2 ... Ml - P12 ... M2-P22
Mm"'Pm2

An Ml - Pln M2- P2n Mm-Pmn

....

Illustration. Suppose an electrrital goods has a resource base to buy for resale purposes in a market, electric irons in the range of 0 to 4. His resource base permits him to buy nothing or 1 or 2 or 3 or 4 units. These are his alternative courses of action or strategies. The demand for electric irons in any month is something beyond his control and hence is a state of nature. Let us presume that the dealer does not know how many units will be bought from him by the customers. The demand could be anything from 0 to 4. The dealer can buy each unit of electric iron @ Rs. 40 and sell it a.t Rs. 45 each, his margin being Rs. 5 per unit. Assume the stock on hand is valueless. Portray in a payoff table and opportunity loss table the quantum of total margin (loss), that he gets in relation to various alternative strategies and states of nature. Conditional pay-off value = (Marginal Profit) (Units sold) - (Marginal Loss) (Units not sold) = (Rs. 45 - Rs. 40) (Units sold) - (Rs. 40) (Units not sold)
TABLE 10.3 : PAYOFF AND REGRET TABLE
State of Nature (Probable demand) Conditional Payoff (Rs. Course of Action (StrateglesPossIble Supply} CondItional OpportunIty Loss (Rs.) Course of Action (Strategies Possible Supply)

0 0

1 2 3 -40 -80 -120 5 5 10 10 -30 15

4 -160 -70 -25

0 0

1
2 3

0
0 0

1 0-(40)

2 0 - (-80)
5 - (- 35)

3
0 - (-120) 5 - (-75) 10 - (-30)

4
0-(-160)

5 -35 -75 -115 5 10 15 20

5-0
10-0 15-0

5-5
10-5 15-5

10-10 15-10

20-0

20-5

20-10

15- 15 20- 15

5-(-115) 10-(-70)
15 - (- 25)

20-20

10.5. TYPES OF DECISION-MAKING ENVIRONMENTS The main aim of decision theory is to help the decision-maker in selecting best course of action from amongst the available courses of action. Based upon the type of information that is available about the occurrence of the various states of nature the decision environment, the decision modal's have been classified into four types: certainty, risk, uncertainty, and conflict. Outcome Explanation State Certainty Complete and accurate knowledge of the outcome of each alternative.
Risk
Uncertainty'

There "isonly one outcome for each alternative. Multiplepossible outcomes of each alternative can be identified,and a probability of occurrence can be attached to each. Multipleoutcomes for each alternative can be identified,but there is no knowledge of the probability to be attached to 'each.