DECISION THEORY & DECISION TREE

•Components of Decision Making

•Decision Making Under Uncertainty (Without Probabilities)
•Decision Making Under Risk (With Probabilities)
•Decision Analysis with Additional Information
 The Six Steps in Decision Theory
• Clearly define the problem at hand.

• Identify the possible outcomes or events or states of nature.

• List the possible decision alternatives or course of actions or

strategies.

• Evaluate the payoff or profit or utility of each combination

of decision alternatives and states of nature.

• Select one of the mathematical decision theory models.

• Apply the model and make your decision

 Decision Analysis
Components of Decision Making
• A state of nature is an actual event that may occur in the future.
• A payoff table is a means of organizing a decision situation,
presenting the payoffs from different decisions given the various
states of nature.

Payoff Table
 Types of Decision-Making Environments

• Type 1: Decision-making under certainty

– decision-maker knows with certainty the consequences of
every alternative or decision choice
• Type 2: Decision-making under uncertainty
(without probability)
– The decision-maker does not know the probabilities of the
various outcomes
• Type 3: Decision-making under risk
(with probability)
– The decision-maker does know the probabilities of the
various outcomes
 Decision-Making under uncertainty
• A newspaper salesman has forecasted the minimum and
maximum demands of selling a magazine in a month. The
minimum and maximum demand of the magazine will be 10
copies and 14 copies respectively. Procurement Cost of one
copy of magazine is Rs. 30 and sale price is Rs. 50. He cannot
return unsold copies. How many copies can he order?

What are the possible events or states of nature involved in the

above problem?

What are the possible decision alternatives or strategies the

newspaper salesman should make?
 Decision-Making under uncertainty
Next, evaluate the payoff or profit of each combination of
decision alternatives and the states of nature.
Demands or States of Nature
10 11 12 13 14
copies copies copies copies copies
10
200 200
copies
11
170
Decision copies
alternatives 12
or copies
strategies 13
copies
14
copies
 Decision-Making under uncertainty
Payoff Matrix

Demands or States of Nature

10 11 12 13 14
copies copies copies copies copies
10
200 200 200 200 200
copies
11
170 220 220 220 220
Decision copies
alternatives 12
140 190 240 240 240
or copies
strategies 13
110 160 210 260 260
copies
14
80 130 180 230 280
copies
Principles of Decision Making Under Uncertainty
• Several criteria exist for making decisions under these
conditions. The principles are as follows:

1. Optimistic (maximax) principle

2. Pessimistic (maximin) principle
3. Criterion of realism (Hurwicz) principle
4. Equally likely (Laplace) principle
5. Minimax regret (Savage) principle
 Optimistic (maximax) principle
• In using the optimistic criterion, the best (maximum) payoff
for each alternative is considered and the alternative with the
best (maximum) of these is selected. Hence, the optimistic
criterion is sometimes called the maximax criterion.

Pessimistic (maximin) principle

• In using the pessimistic criterion, the worst (minimum) payoff
for each alternative is considered and the alternative with the
best (maximum) of these is selected. Hence, the pessimistic
criterion is sometimes called the maximin criterion. This
criterion guarantees the payoff will be at least the maximin
value (the best of the worst values). Choosing any other
alternative may allow a worse (lower) payoff to occur.
 Criterion of Realism (Hurwicz principle)
• Often called the weighted average, the criterion of realism
(Hurwicz principle) is a compromise between an optimistic
and a pessimistic decision. To begin with, a coefficient of
realism, is selected; this measures the degree of optimism of
the decision maker. This coefficient is between 0 and 1.
• When it is 1, the decision maker is optimistic about the future.
When it is 0, the decision maker is pessimistic about the future.
The advantage of this approach is that it allows the decision
maker to build in personal feelings about relative optimism and
pessimism. The weighted average is computed as follows:
Weighted average = α (best in alternative) + (1- α) (worst in alternative)

• This weighted average value is computed for each alternative,

and the alternative with the highest value is then chosen.
 Equally likely (Laplace) principle
• One criterion that uses all the payoffs for each alternative is the
equally likely, also called Laplace decision criterion. This
involves finding the average payoff for each alternative, and
selecting the alternative with the best or highest average. The
equally likely approach assumes that all probabilities of
occurrence for the states of nature are equal, and thus each
state of nature is equally likely.
• The next decision criterion that we discuss is based on
opportunity loss or regret.

• Opportunity loss or regret refers to the difference between

the optimal profit or payoff for a given state of nature and the
actual payoff received for a particular decision. In other
words, it’s the amount lost by not picking the best alternative
in a given state of nature.
 Minimax regret (Savage) principle
Regret Matrix

Demands or States of Nature

11 12 13 14
10 copies
copies copies copies copies
10 200 – 200
20
copies = 0
11 200 – 170
0
Decision copies = 30
alternatives 12 200- 140
or 30
copies = 60
strategies 13 200 – 110
60
copies = 90
14 200 – 80
90
copies = 120
 Minimax regret (Savage) principle
Regret Matrix

Demands or States of Nature

10 11 12 13 14 Maximum
copies copies copies copies copies Regret
Decision alternatives or

10 copies 0 20 40 60 80 80

11 copies 30 0 20 40 60 60
strategies

12 copies 60 30 0 20 40 60

13 copies 90 60 30 0 20 90

14 copies 120 90 60 30 0 120

 Minimax regret (Savage) principle

• Using the opportunity loss (regret) table, the Savage criterion

finds the alternative that minimizes the maximum opportunity
loss within each alternative. You first find the maxi-mum
(worst) opportunity loss for each alternative. Next, looking at
these maximum values, pick that alternative with the minimum
(or best) number.

Minimax
Decision making under Optimum Decision
Regret
uncertainty on Regret Matrix Alternative
value
Purchase 11 or 12
1 Savage Criterion 60
copies magazines
 Decision-Making under uncertainty
The salesman’s decision-Making under uncertainty based on
different Principles or Criterion are as follows

Decision making under Optimum

Payoff Degree of
uncertainty on Payoff (or Decision
value Optimism
Regret) matrix Alternative
Maximax or Optimistic Purchase 14
1 280 α= 1
decision copies magazines
Maximin or Pessimistic Purchase 10
2 200 α= 0
decision copies magazines
Laplace or Most Likely Purchase 11 or 12
3 210.00
Decision copies magazines
Herwicz (Decision based on Purchase 10
4 200 α= 0.41
degree of Optimism i.e. α) copies magazines
 Decision-Making under Risk
• Decision making under risk is a decision situation in which several
possible states of nature may occur, and the probabilities of these states of
nature are known.
• Most popular methods of making decisions under risk:
– Expected Monetary Value (EMV) Criterion
– Expected Opportunity Loss value (EOL) Criterion

• Expected Monetary Value

Given a matrix with conditional values (payoffs) that are monetary
values, and probability assessments for all states of nature, it is possible to
determine the expected monetary value (EMV) for each alternative
decisions.
• The EMV for an alternative is just the sum of possible payoffs of the
alternative, each weighted by the probability of that payoff occurring.
• Decision making under EMV criterion is selecting the alternative
with the highest expected monetary value (EMV).
• Expected Opportunity Loss (EOL)
Given a matrix with conditional values (regrets) that are opportunity loss
values, and probability assessments for all states of nature, it is possible to
determine the expected opportunity loss value (EOL) for each alternative
decisions.
• The EOL for an alternative is just the sum of possible regrets of the
alternative, each weighted by the probability of that regret occurring.
• Decision making under EOL criterion is selecting the alternative with
the lowest expected opportunity loss value (EOL).
n
EMV (Each alternative decision) = X
i 1
i P(Xi )

OR
n
EOL (Each alternative decision) = O P(X
i 1
i i )

where
X i  payoff for the alternative in state of nature i
Oi  Opportunity Loss or Regret for the alternative in state of nature i
P ( X i )  probability of getting X i (i.e. probability of state of nature i )
 Decision-Making under Risk
• A newspaper salesman has forecasted the minimum and
maximum demands of selling a magazine in a month. The
minimum and maximum demand of the magazine will be 10
copies and 14 copies respectively. Procurement Cost of one
copy of magazine is Rs. 30 and sale price is Rs. 50. He cannot
return unsold copies. The probabilities of selling magazines
are given below. How many copies can he order to maximize
his expected payoff?
No of copies sold 10 11 12 13 14
Probability 0.10 0.15 0.20 0.25 0.3

What is the optimal decision alternative or strategy the

newspaper salesman should make based on Expected
Opportunity Loss (EOL) criterion?
 Decision-Making under Risk based on EMV Criterion
Demands or States of Nature

Probability 0.10 0.15 0.20 0.25 0.3 EMV

Decision alternatives or strategies

10 11 12 13 14 
i 1
Xi P( Xi )
copies copies copies copies copies

10 copies 200 200 200 200 200 200

11 copies 170 220 220 220 220 215

12 copies 140 190 240 240 240 222.5

13 copies 110 160 210 260 260 220

14 copies 80 130 180 230 280 205

 Decision-Making under Risk based on EOL Criterion
Demands or States of Nature

Probability 0.10 0.15 0.20 0.25 0.3 EOL

Decision alternatives or strategies

10 11 12 13 14 5

 Oi P ( X i )
copies copies copies copies copies i 1

10 copies 0 20 40 60 80 50

11 copies 30 0 20 40 60 35

12 copies 60 30 0 20 40 27.5

13 copies 90 60 30 0 20 30

14 copies 120 90 60 30 0 45
 Decision-Making under Risk

The salesman’s decision-Making under Risk based on EMV

and EOL Criterion are as follows

Expected
Decision making under Risk Optimum
Payoff /
on Decision
Opportunity
Payoff (or Opportunity Loss) matrix Alternative
Loss Value
Purchase 12
Expected Monetary Value (EMV)
1 copies 222.5
Criterion
magazines
Purchase 12
Expected Opportunity Loss (EOL)
2 copies 27.5
Criterion
magazines
 Decision-Making under Risk
Expected Value of Perfect Information

• The Expected Payoff with Perfect Information (EPPI) is the

expected or average return, in the long run, if we have perfect
information before a decision has to be made. To calculate this
value, we choose the best alternative for each state of nature and
multiply its payoff with the probability of occurrence of that state of
nature.
• The Expected Value of Perfect Information (EVPI) is the
maximum amount a decision maker would pay for additional
information.
• EVPI equals the expected payoff with perfect information
minus the expected payoff without perfect information.
• EVPI equals the Expected Opportunity Loss (EOL) for the best
decision.
 EVPI, EPPI AND EMV
Demands or States of Nature

Probability 0.10 0.15 0.20 0.25 0.3 EMV

Decision alternatives or strategies

10 11 12 13 14 
i 1
Xi P( Xi )
copies copies copies copies copies

10 copies 200 200 200 200 200 200

11 copies 170 220 220 220 220 215

12 copies 140 190 240 240 240 222.5

13 copies 110 160 210 260 260 220

14 copies 80 130 180 230 280 205

 Decision-Making under Risk
Expected Value of Perfect Information

10 11 12 13 14
Events
copies copies copies copies copies
Max Payoff
200 220 240 260 280
with PI
Probability 0.10 0.15 0.20 0.25 0.30 TOTAL
EPPI 20.00 33.00 48.00 65.00 84.00 250.00
Expected Payoff of Perfect Information (EPPI) 250.00
Maximum of EMV 222.50
Expected Value of Perfect Information (EVPI)
27.50
= EPPI - Max(EMV)
 Decision Analysis
Decision Making without Probabilities
Decision situation: An investor wants to decide which of the three property to buy.

Payoff Table for the Real Estate Investments

Decision-Making Criteria:
Maximax, Maximin, Minimax Regret, Hurwicz, Equal Likelihood
(Laplace)
 Decision Making without Probabilities
The Maximax Criterion

In the maximax criterion the decision maker selects the decision that
will result in the maximum of maximum payoffs; an optimistic
criterion.

Payoff Table Illustrating a Maximax Decision

 Decision Making without Probabilities
The Maximin Criterion

In the maximin criterion the decision maker selects the decision that
will reflect the maximum of the minimum payoffs; a pessimistic
criterion.

Payoff Table Illustrating a Maximin Decision

 Decision Making without Probabilities
The Minimax Regret Criterion

Regret is the difference between the payoff from the best decision and all
other decision payoffs.
The decision maker attempts to avoid regret by selecting the decision
alternative that minimizes the maximum regret.

Regret Table Illustrating the Minimax Regret Decision

 Decision Making without Probabilities

The Hurwicz Criterion

- The Hurwicz criterion is a compromise between the maximax and maximin criterion.
- A coefficient of optimism, , is a measure of the decision maker’s optimism.
- The Hurwicz criterion multiplies the best payoff by  and the worst payoff by 1- .,
for each decision, and the best result is selected.

Decision Values
Apartment building $50,000(.4) + 30,000(.6) = 38,000
Office building $100,000(.4) - 40,000(.6) = 16,000
Warehouse $30,000(.4) + 10,000(.6) = 18,000
 Decision Making without Probabilities

The Equal Likelihood Criterion

- The equal likelihood ( or Laplace) criterion multiplies the decision payoff for each
state of nature by an equal weight, thus assuming that the states of nature are equally
likely to occur.

Decision Values
Apartment building $50,000(.5) + 30,000(.5) = 40,000
Office building $100,000(.5) - 40,000(.5) = 30,000
Warehouse $30,000(.5) + 10,000(.5) = 20,000
 Decision Making under uncertainty

Summary of Criteria Results

- A dominant decision is one that has a better payoff than another decision under each
state of nature.
- The appropriate criterion is dependent on the “risk” personality and philosophy of the
decision maker.
Criterion Decision (Purchase)
Maximax Office building
Maximin Apartment building
Minimax regret Apartment building
Hurwicz Apartment building
Equal liklihood Apartment building
 Decision Making under Risk
Expected value is computed by multiplying each decision outcome under
each state of nature by the probability of its occurrence.

EV(Apartment) = $50,000(.6) + 30,000(.4) = 42,000

EV(Office) = $100,000(.6) - 40,000(.4) = 44,000
EV(Warehouse) = $30,000(.6) + 10,000(.4) = 22,000
 Decision Making with Probabilities
Expected Opportunity Loss
The expected opportunity loss is the expected value of the regret for
each decision.
The expected value and expected opportunity loss criterion result in the
same decision.

EOL(Apartment) = $50,000(.6) + 0(.4) = 30,000

EOL(Office) = $0(.6) + 70,000(.4) = 28,000
EOL(Warehouse) = $70,000(.6) + 20,000(.4) = 50,000
 Decision Making with Probabilities
EVPI Example

Decision with perfect information: $100,000(.60) + 30,000(.40) = $72,000

Decision without perfect information: EV(office) = $100,000(.60) - 40,000(.40) = $44,000
EVPI = $72,000 - 44,000 = $28,000
EOL(office) = $0(.60) + 70,000(.4) = $28,000
 Decision Making with Probabilities
Decision Trees

A decision tree is a diagram consisting of decision nodes

(represented as squares), probability nodes (circles), and decision
alternatives (branches).