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Graphic Era University,Dehradun

Decision Making Theory

A decision is the conclusion of a process designed to weigh the relative utilities of a set
of available alternatives so that the most preferred course of action can be selected for
implementation.
Making of a decision requires a set of goals and objectives, a system of priorities, an
enumeration of alternatives of feasible and viable actions, the projection of consequences
associated with different alternatives, and a system of choice criteria by which the most
preferred course is identified.
It is possible to analyze the making of a special decision as an isolated phenomenon,
because in the inter-dependent world of today each decision has consequences the
implications far beyond its original boundaries drawn under simplified assumptions.
Decision theory (or decision analysis) provides an analytical and systematic approach to
depict the expected result of a situation when alternative managerial actions, and
outcomes are compared.
Decision theory is the combination of descriptive and prescriptive business modeling
approach to classify degree of knowledge. The degree of knowledge is usually divided
into four categories as shown below Complete knowledge (or certainty) is on the far right
and complete ignorance is on the far left. Between the two are risk and uncertainty.

Irrespective of the type of decision model, there are certain essential characteristics of
decision theory.
Decision alternatives: There is a finite number of decision alternatives available with the
decision-maker at each point in time when a decision is made. The number and type of
such alternatives may depend on the previous decisions made and on what has happened
subsequent to those decisions. These alternatives are also called courses of action
(actions, acts or strategies) and are under control and known to the decision-maker.
These may be described numerically such as, stocking 100 units of a particular item, or
non-numerically such as, conducting a market survey to know the likely demand of an
item.
States of nature: These are the future conditions (also called consequences, events or
scenarios) not under the control of decision-maker. A state of nature can be a state of
economy (e.g. inflation), a weather condition, a political development, etc. The states of
nature are usually not determined by the action of an individual or an organization. These
are the result of an act of God or result of many situations pushing in various directions.
Prepared by:-Sanjeev Arora
(Faculty of Management)

Graphic Era University,Dehradun

The most relevant states of nature may be identified through some technique such as
scenario analysis, i.e. there may be certain possible states of nature which may not have a
serious impact on the decision and other could be quite serious. In scenario analysis,
various knowledgeable section of people are interviewed stakeholders, long-time
managers, etc., to determine the most relevant states of nature to the decision.
The states of nature are mutually exclusive and collectively exhaustive with respect to
any decision problem. The states of nature may be described numerically such as,
demand of 100 units of an item or non-numerically such as, employees strike, etc.
Payoff: A numerical value (outcome) resulting from each possible combination of
alternatives and states of nature is called payoff. The payoff values are always conditional
values because of unknown states of nature.
The payoff is measured within a specified period (e.g. after one year) and is called the
decision horizon. Payoff can also be measured in terms of money market share, or other
measures. The payoffs considered in most decisions are monetary.
A tabular arrangement of these conditional outcome (payoff) values is known as payoff
matrix:
Courses of Action
(Alternatives)
States of Nature

Probability

S1

S2

...

Sn

N1

p1

p11

p12

...

p1n

N2

p2

p21

p22

...

p2n

...

Nm

pm

pm1

pm2

...

pmn

Types of Decision - Making Environments

To apply quantitative approach for decision-making, it is required to consider (a) all
available data, (b) an exhaustive list of alternatives, (c) knowledge of decision
environment, and (d) use of appropriate quantitative approach for decision-making.
There are four types of decision-making environments: Certainty, uncertainty, risk and
conflict.
Type 1: Decision-making under certainty
In this case the decision-maker has the complete knowledge (perfect information) of
consequence of every decision choice (course of action or alternative) with certainty.
Obviously, an alternative should be selected that yields the largest return (payoff) for the
known future (state of nature).
Prepared by:-Sanjeev Arora
(Faculty of Management)

Graphic Era University,Dehradun

For example, the decision to purchase either National Saving Certificate (NSS); Indira
Vikas Patra, or deposit in National Saving Scheme (NSS) is one in which it is reasonable
to assume complete information about the future because payment would be made when
it is due.
Type 2: Decision-making under risk
In this case the decision-maker has less than complete knowledge with certainty of the
consequence of every decision choice (course of action) because it is not definitely
known which outcome will occur. This means there is more than one state of nature
(future) and for which he makes an assumption of the probability with which each state
of nature will occur.
For example, probability of getting head in the toss of a coin is 0.5.
Type 3: Decision-making under uncertainty
In this case the decision-maker is unable to specify the probabilities with which the
various states of nature (futures) will occur. However, this is not the case of decisionmaking under ignorance, because possible states of nature are known. For example, the
probability that Mr X will be the prime minister of the country 15 years from now is not
known.

Decision-making under uncertainty

In the absence of knowledge about the probability of any state of nature (future)
occurring, the decision-maker must arrive at a decision only on actual conditional payoff
values, together with a policy (attitude). Several criteria of decision-making under
uncertainty are:
Optimism (Maximax or Minimin) criterion
Pessimism (Maximin or Minimax) criterion
Equal probabilities (Laplace) criterion
Coefficient of optimism (Hurwicz) criterion
Regret (salvage) criterion
Optimism (maximax or minimin) criterion: In this criterion the decision-maker ensures
that he should not miss the opportunity to achieve the largest possible profit (maximax)
or lowest possible cost (minimin). Thus, he selects the alternative (course of action) that
represents the maximum of the maxima (or minimum of the minima) payoffs
(consequences).
(a) Locate the maximum (or minimum) payoff values corresponding to each alternative,
and then
(b) Select an alternative with best anticipated payoff value (maximum for profit and
minimum for cost).

Prepared by:-Sanjeev Arora

(Faculty of Management)

Graphic Era University,Dehradun

Pessimism (maximin or minimax) criterion: In this criterion the decision-maker

ensures that he would earn no less (or pay no more) than some specified amount. Thus,
he selects the alternative that represents the maximum of the minima payoff in case of
profits or minimum of the maxima in case of loss.
a)
Locate the minimum (or maximum in case of profit) payoff value in case of loss
(or cost) data corresponding to each alternative, then
b)
Select an alternative with the best anticipated payoff value (maximum for profit
and mimimum for loss or cost).
Equal probabilities (laplace) criterion: Since the probabilities of states of nature are not
known, it is assumed that all states of nature will occur with equal probability. Since
states of nature are mutually exclusive and collectively exhaustive, probability of each of
these must be 1/(number of states of nature).
a) Assign equal probability value to each state of nature by using the formula:
1 (number of states of nature).
b) Compute the expected (or average) payoff for each alternative (course of action) by
adding all the payoffs and dividing by the number of possible states of nature or by
applying the formula:
(probability of state of nature j) (payoff value for the combination of
alternative, i and state of nature j.)
c) Select the best expected payoff value (maximum for profit and minimum for cost).
Coefficient of Optimism (Hurwicz) Criterion: This criterion suggests that a rational
decision-maker should be neither completely optimistic nor pessimistic and must display
a trade-off of both. Hurwicz, coefficient of optimism (denoted by ) measures the
decision-makers degree of optimism.
Value of a lies between 0 and 1, where 0 represents a complete pessimistic attitude about
the future and 1 a complete optimistic attitude about the future.
If a is the coefficient of optimism, then (1 ) will represent the coefficient of
pessimism.
Hurwicz approach suggests that the decision-maker must select an alternative that
maximizes
H (Criterion of realism) = a (Maximum in column) + (1 )
(Minimum in column)
a) Decide the coefficient of optimism a (alpha) and then coefficient of pessimism (1 ).
b) For each alternative select the largest and lowest payoff value and multiply these with
a and (1 ) values, respectively. Then calculate the weighted average, H.
c) Select an alternative with best anticipated weighted average payoff value.
Regret (savage) criterion: (Opportunity loss decision criterion or minimax regret
Decision criterion). In this case decision-maker feels regret after adopting a wrong
course of action (or alternative) resulting in an opportunity loss of payoff. Thus, he
always intends to minimize this regret.

Prepared by:-Sanjeev Arora

(Faculty of Management)

Graphic Era University,Dehradun

Decision-Making Under Risk

Decision-making under risk is a probabilistic decision situation, in which more than one
state of nature exists and the decision-maker has sufficient information to assign
probability values to the likely occurrence of each of these states. Knowing the
probability distribution of the states of nature, the best decision is to select that course of
action which has the largest expected payoff value. The expected (average) payoff of an
alternative is the sum of all possible payoffs of that alternative weighted by the
probabilities of those payoffs occurring.
Expected monetary value (EMV):The expected monetary value (EMV) for a given
course of action is the weighted sum of possible payoffs for each alternative. It is
obtained by summing the payoffs for each course of action multiplied by the probabilities
associated with each state of nature. The expected (or mean) value is the long-run
average value that would result if the decision were repeated a large number of times.
EMV is stated as follows:
m

EMV (Course of action, Sj) =

Where m
pi
pij

i=1

p ij p i

= number of possible states of nature

= probability of occurrence of state of nature, Ni
= payoff associated with state of nature Ni and course of action, Sj

Expected opportunity loss (EOL): The EOL approach is an alternative approach to

minimize the expected opportunity loss (EOL), also called expected value of regret. The
EOL is the difference between the highest profit (or payoff) for a state of nature and the
actual profit obtained for the particular course of action taken. In other words, EOL is the
amount of payoff that is lost by not selecting the course of action that has the greatest
payoff for the state of nature that actually occur. The course of action with minimum
EOL is recommended.
The result of EOL will always be the same as those obtained by EMV criterion.
Mathematically, it is stated as follows:
m
EOL (State of nature, Ni) =

i=1

where lij
pi

lij p i

= opportunity loss due to state of nature, Ni and course of action, Sj

= probability of occurrence of state of nature, Ni

Expected profit with perfect information:In decision-making under risk each state of
nature is associated with the probability of its occurrence. But, if the decision-maker can
acquire perfect (complete and accurate) information about the occurrence of various
Prepared by:-Sanjeev Arora
(Faculty of Management)

Graphic Era University,Dehradun

states of nature, then he will be able to select a course of action that yields the desired
payoff for whatever state of nature that actually occurs.
Since EMV or EOL criterion helps the decision-maker to select a particular course of
action that optimizes the expected payoff without any additional information.
Expected value of perfect information:(EVPI) is the maximum amount of money the
decision-maker has to pay to get an additional information about the occurrence of
various states of nature before a decision has to be made. Mathematically it is stated as:
EVPI =(Expected profit with perfect information) (Expected profit without perfect
information)

i =1

where pij
pi

p i m a x ( p ij )
j

EMV*

best payoff when action, Sj is taken in the presence of state of

nature, Ni
= probability of state of nature, Ni

EMV = maximum expected monetary value

Prepared by:-Sanjeev Arora

(Faculty of Management)