Statistical Decision Theory

B.Com (Hons.) Ist Year

Unit no: 1
Paper No:IV
(2.5): Statistical Decision Theory

Fellow
Dr.Kawal Gill, Associate Professor
Department/College: Shri Guru Gobind Singh College of Commerce

Author
Dr. Madhu Gupta, Associate Professor
College/Department: Janki devi Memorial College of Commerce,
University of Delhi

Reviewer
Dr. Bindra Prasad, Associate Professor
College/ Department: Department of Commerce, Shaheed Bhagat
Singh College, University of Delhi

1 
Institute of Lifelong Learning, University of Delhi.
 
 
 Statistical Decision Theory

Table of Contents
• (2.5): Statistical Decision Theory
o 5.1 Introduction
o 5.2 Decision Making Under Certainty
o 5.3 Decision Making Under Uncertainty (Without Probability)
o 5.4 Decision Making Under Risk (With Probabilities)
o Summary
o Exercise
o References
o Glossary

2 
Institute of Lifelong Learning, University of Delhi.
 
 
 Statistical Decision Theory

5.1 Introduction

Figure5.1: Organization of raw data

In any organization the main function of the managers is to take decisions. How many
units of the product should be manufactured? How many units of particular raw
materials should be bought? Whether we should go for the development project or not?
A business manager is faced with several such decision problems. Competence of a
manager is judged by his decision making capabilities. As future is unpredictable, most
business decisions have to be taken under conditions of uncertainty.

In earlier days decisions were taken purely on the basis of personal judgments, but now
the managers have been using newly developed statistical techniques to solve decision
problems for which information is incomplete, uncertain and in some cases completely
lacking. This new area of statistics is known as statistical decision theory (web link 5.1).

5.1.1 Meaning

Figure 5.2: Decision theory process

Statistical decision theory consists of a large number of quantitative techniques which

help us in analyzing a situation (logically and quantitatively) and enable us to arrive at a
decision, that is best under the given circumstances. In decision theory, we decide
among alternatives by taking into account the monetary repercussions of our actions.
A manager who has to select one act from among a number of available courses of
action should consider the profit or loss that might result from each alternative.

3 
Institute of Lifelong Learning, University of Delhi.
 
 
 Statistical Decision Theory

Figure 5.3: A baker

Consider the case of a baker who bakes cakes every day for sale on the next day. Any
cake not sold next day is to be discarded and is a waste. If exact demand of cake on the
next day can be predicted with certainty, there is no decision problem. He can bake that
many cakes. But since the consumer demand is unpredictable, he will have to decide
how many cakes should be baked each day. Statistical decision theory helps him take a
rational decision after considering all factors that are vital for the decision and taking
into account the profit and loss that might result from each alternative.

5.1.2 Decision Framework

Figure 5.4: Decision framework

Source-(modified)-http://www.bing.com/images/
search?q=decision+making+process&FORM=BIFD#

Statistical decision theory consists of a large number of quantitative techniques that help
us in analyzing a situation (logically and quantitatively) and enable us to arrive at a
decision, which is best under the given circumstances. Under decision theory each
problem is first put into suitable logical framework which includes:

1. Identifying the problem,

2. Generating alternative courses of action (called acts),

3. Stating the different possible events (called states of nature which are uncertain &
beyond the control of the decision maker) that may influence the decision,

4. Determining the result of each course of action with respect to different states of
nature,

4 
Institute of Lifelong Learning, University of Delhi.
 
 
 Statistical Decision Theory

5. Arriving at the best course of action so as to achieve the objective of decision making.

The various elements or ingredients of statistical decision theory are under:

1. Several courses of action– Decision is needed when more than one alternative
course of action are available and only one of them is to be selected. Obviously, if only
one course of action is available no decision is required since that action must be
adopted in order to solve the problem. These different alternatives are called “Acts” and
are generally represented as A1, A2, ...and so on. In matrix, they are indicated either as
a row or as a column.

Acts A1 A2 A3..............An

Figure 5.5: Decision maker with many alternative courses of action

Source - http://www.clipartof.com/gallery/clipart/confused_2.html

In our example, if the demand of cake varies from 15 to 20 cakes daily our action space
will have six alternative courses of action – to bake either 15 or 16 or 17 or 18 or 19 or
20 cakes daily.

2. States of nature - These are those possible events which are uncertain and beyond
the control of decision maker, but are vital for choice of any one of the alternative acts.
These are environmental factors like changes in technology, taste & preferences of the
consumers, war, political disturbances , decease or increase in the interest rates etc.
which are to be considered before taking any decision because they affect the payoff (
i.e. profit or loss ) arising out of different courses of action. The consumer demand of
cakes the next day in our example is beyond the control of our baker. It could be 15,
16,17,18,19 or 20 cakes. However, it is important factor in determining how many cakes
he should bake each day. Therefore, quantity demanded is the states of nature in our
case. These events or states of nature are generally represented as S1, S2.....and so on.
In matrix they are either written as a column or as a row.

5 
Institute of Lifelong Learning, University of Delhi.
 
 
 Statistical Decision Theory

3. Outcomes – The consequences of the combination of each alternative course of

action with different states of nature are called outcomes or conditional values. They are
indicated as O11, O12 ...Onn. They are shown in the middle of the matrix.

4. Pay Off - Pay off are the monetary gain or loss from each of the outcome. In other
words, they are quantitative measures of the benefit that accrues from a given
combination of a decision alternative and state of nature. It can also be in terms of
saving in cost, or saving in time but the expression of pay off should always be in
quantitative terms to help precise analysis.

Figure 5.6: pay-offs in terms of money

Source - http://www.iloveindia.com/finance/gifs/rupees.jpg

In our example, the profit or loss the baker will get by baking different number of
cakes under different consumer demand conditions will be called pay off.

5.Pay off table - It is a tabular presentation of a decision problem. All the elements of a
decision problem are summarized in it. Each of the set of possible actions chosen by the
decision maker for consideration is associated with a row (or column) of the pay off
table. Each state of nature is shown in the column (or row). The combination of each act
with different states of nature will result in certain pay off which is shown in the body of
the table. Thus if in our example the cost of one cake is Rs. 30 and selling price is Rs.
50, the pay off matrix will be as follows:

6 
Institute of Lifelong Learning, University of Delhi.
 
 
 Statistical Decision Theory

Here the baker’s action space will have five alternative courses of action- to bake 15,
16,17,18,19 or 20 cakes each day as consumer demand varies from 15 to 20 cakes each
day.

Profit per cake sold is Rs. 20 (Rs. 50- Rs.30) and cake not sold is a total loss (of Rs. 30).

Thus when baker bakes 15 cakes his profit will be

15 x 20 =Rs. 300, whatever is the demand as he cannot sell more than 15 cakes.

But if he bakes 16 cakes his profit will be

16 x 20 = Rs.320, If demand is 16 cakes or more.

However, if the demand is of 15 cakes only, his profit would be

Rs. 300 – Rs. 30 (loss for the one cake not sold) = Rs. 270.

Similarly, all other values of the pay off are calculated.

6.Opportunity loss ( or Regret)- The difference between profit actually derived from a
certain decision and that which would have been derived if the decision had been the
best for the state of nature that actually occurred is known as the Opportunity Loss.
Suppose baker bakes only 15 cakes for the next day, but cakes demanded turns out to
be 16.Then regret would be 320 – 300 = Rs 20.

7. Opportunity loss table - it shows the regrets of every action in different states of
nature. It will appear as follows in our example:

7 
Institute of Lifelong Learning, University of Delhi.
 
 
 Statistical Decision Theory

If 15 cakes are demanded the best Act would be to bake 15 cakes and maximum Pay
off in that case would be Rs. 300. Therefore, the opportunity loss of different acts for
this event will be 300 – Pay off of that act, which will be

300 - 300 = 0 for 15 baked cakes,

300 – 270 = 30 for 16 baked cakes,
300 - 240 = 60 for 17 baked cakes,
300 - 210 = 90 for 18 baked cakes,
300 - 180 = 120 for 19 baked cakes, and
300 - 150 = 150 for 20 baked cakes .
Similarly, opportunity loss of other events for different Acts is computed.

8. An Objective- Decision procedure involves selection a single course of action from

among various acts available. This choice depends upon the objective or purpose the
decision maker is trying to reach. He will select that action which achieves the pre-
designed objective which can either be maximization of profit or minimization of cost or
saving of time....... anything.

‘The scope of an objective is a key consideration in decision making. The objective-

setting technique points out the means-ends linkage among objectives in a hierarchical
relationship. Decision makers should select the broadest possible objective to avoid
unnecessarily restricting the search for responses in the form of alternatives. ‘(Web link
5.3)

In our example, baker’s objective is to maximize profit from the sale of cakes.

5.1.3 Types Of Decisions

Decision making may be classified in three categories:

1. Decision making under certainty where the decision makers knows with certainty the
consequences of every alternative.

2. Decision making under risk where probabilities are assigned to different states of
nature.

3. Decision making under uncertainty where the decision maker has no knowledge of the
events and there is no objective way of assigning probabilities.

8 
Institute of Lifelong Learning, University of Delhi.
 
 
 Statistical Decision Theory

Figure 5.7: Types of decisions

5.2 Decision Making Under Certainty

Here we deal with those problems where the result of each alternative course of action is
known with certainty. In such situations, decision making is limited to making
calculations only and the Act which gives the maximum payoff is chosen. For example,
suppose a businessman has to choose between market A and market B for selling his
product( he cannot choose both). It is known that in market A , he can cater to 4,00,000
customers with a margin of 20% on sales, while in market B, he can cater to 8,00,000
customers but the margin is only 15% on sales. Assuming market price to be Rs 100, his
profit In market A will be = 4,00,000 x 20 = Rs 80,00,000 and In market B will be =
8,00,000 x 15 = Rs 120,00,000 Since profit (payoff) will be more in market B, he will
choose market B instead of market A.

5.3 Decision Making Under Uncertainty (Without

Probability)
In decision making under pure uncertainty, the decision-maker has no knowledge
regarding any of the states of nature outcomes, and/or it is costly to obtain the needed
information. In such cases, the decision making depends merely on the decision-maker's
personality type. Some of these behaviors are optimistic, pessimistic, and least regret,
among others. (See web link 5.3). When objective probabilities are not known for
different events, the decision can be taken on the basis of following principles:

Figure 5.8: An optimist

Source-http://www.bing.com/images/search?
q=an+optimist&form=QBIR&qs=n&sk=#

This principle is applied when the decision maker takes the optimistic view of the
situation. According to him only good things happen to him, thus he must get the best.
The decision maker does not want to miss the opportunity to earn the maximum possible
profit (maximax) or minimum possible loss (minmin). He adopts the following procedure

9 
Institute of Lifelong Learning, University of Delhi.
 
 
 Statistical Decision Theory

for deciding the best course of action:

1. Determine maximum payoff (or minimum cost) associated with each act, and
2. Select the act that corresponds to the maximum of these maximum payoffs (or
minimum of these minimum costs).
The easiest way of applying the maximax criterion is to find the maximum payoff (or
minimum cost) in the Payoff table and choose the action corresponding to that payoff (or
minimum cost).
In our example of baker, for each act maximum payoff is

Acts 15 16 17 18 19 20
Maximum
payoffs(Rs)
300 320 340 360 380 400

The baker will select the Act to bake 20cakes as it gives the maximum payoff of Rs 400.

5.3.2 Maximin/Minimax Principle

Figure 5.9: A pessimist

Source -http://www.bing.com/images/search?
q=pessimist&form=QBIR&qs=n&sk=&sc=8-8#

This principle is followed by pessimist decision maker. The decision maker thinks always
bad things happen to him and thus anticipates the worst possible outcome.
In this case –
1. Determine the minimum payoff (or maximum cost) associated with each act, and
2. Select the act that corresponds to the maximum of these minimum payoffs (or
minimum of these maximum cost).
Applying maximin principle the baker will first select minimum pay off for each action
and then he will select the act of baking 15 cakes as the pay off of this Act is maximum
(Rs. 300) among these minimum pay offs as shown below:

Acts 15 16 17 18 19 20
Minimum
payoff(Rs)
300 270 240 210 180 150

10 
Institute of Lifelong Learning, University of Delhi.
 
 
 Statistical Decision Theory

Interesting quotes

Types of decision maker

Optimist: The glass is half-full.

Pessimist: The glass is half-empty.
Manager: The glass is twice as large as it needs to be.
Or, as in the follwoing metaphor of a captain in a rough sea:
The pessimist complains about the wind;
the optimist expects it to change;
the realist adjusts the sails.

Optimists are right; so are the pessimists. It is up to you to choose which you will be.
The optimist sees opportunity in every problem; the pessimist sees problem in

every opportunity.
Both optimists and pessimists contribute to our society. The optimist invents the airplane
and the pessimist the parachute.

Source: http://home.ubalt.edu/ntsbarsh/opre640a/partIX.htm#rintrodecisionanaly

5.3.3 Laplace Principle

This is applied in those cases where all events have equal opportunity (or where decision
maker thinks so). Equal probabilities are thus assigned to all the events. In this case -
1. Take average of all the pay off of all the acts and then
2. Select the act which corresponds to the maximum average pay off.

Acts 15 16 17 18 19 20
Average of
all the
payoff(Rs) 300 311.67 315 310 296.67 275

The maximum of average pay off of all the Acts is Rs. 315. Therefore, the baker will
select the Act of baking 17 cakes.

11 
Institute of Lifelong Learning, University of Delhi.
 
 
 Statistical Decision Theory

5.3.4 Minimax Regret (Savage) Principles

Figure 5.10: A disappointed or regretful person

The decision maker here hates regrets, therefore he wants to minimise it. He wants to
do only those things which he could repeat happily. This decision criterion reduces the
chance of making him regretful or disappointed.
For this Regret Table is used and an alternative is selected which offers the least among
the maximum of regrets in each act. In this case
(i) Determine maximum regrets associated with each Acts and
(ii) Selected from these the Act which corresponds to the minimum regret.
In our example, minimum regret of all the Acts is:

Acts 15 16 17 18 19 20
Maximum
regret (Rs)
100 80 60 90 120 150

The minimum regrets among these is Rs. 60 corresponding to the Act of baking 17
cakes. This one will be selected as best act.

Illustration: A businessman can adopt any of the two technologies A or B for

production. The corresponding cost of production under liberal & stringent Govt. policies
(to be followed next year) is given below.

Govt. policy Cost (Rs)

Liberal Stringent
Technology
A 500000 1500000
B 1000000 1000000

Which technology the businessman will adopt under

1. Minmin criterion
2. Minimax criterion
Solution: 1. Minmin criterion
The minimum cost of both the act are:
12 
Institute of Lifelong Learning, University of Delhi.
 
 
 Statistical Decision Theory

Minimum cost (Rs)

Act
A 500000
B 1000000

Minimum between these two is Rs 500000, which corresponds to technology A; therefore

businessman will select technology A under minmin criterion.
2. Minimax criterion
The maximum cost associated with each act is

Maximum cost (Rs)

Act
A 1500000
B 1000000

The minimum of these two is Rs 1000000, which corresponds to technology B; therefore

businessman will select technology B under minimax criterion.
Note: Act can be depicted either in the first row or in the first column in the question.
Students must be very careful in seeing which one is act and which one is event.

5.4 Decision Making Under Risk (With Probabilities)

Whenever the decision maker has some knowledge regarding the states of nature,
he/she may be able to assign subjective probability estimates for the occurrence of each
state. In such cases, the problem is classified as decision making under risk. The
decision-maker is able to assign probabilities based on the occurrence of the states of
nature(see web link 5.3).

In these cases two decision criteria are used:

1. Expected Monetary Value (EMV) criterion
2. Expected Opportunity Loss (EOL) criterion

Figure 5.11: A decision maker taking decision under risk

5.4.1 Expected Payoff Or Expected Monetary Value (EMV) Criterion

To use this criterion we use Pay off Table. EMV of a given act is the sum of products of
pay offs for each event and their corresponding probabilities of occurrence.
Expected monetary value (EMV) = Σ (payoff probability) for each act.
The act with maximum Expected Monetary Value (EMV) is selected.
13 
Institute of Lifelong Learning, University of Delhi.
 
 
 Statistical Decision Theory

In our example of baker, if the past records indicate the probability of demand for cake
as follows:

Demand (in
units)
15 16 17 18 19 20

probability .05 .10 .30 .40 .10 .05

The payoff table is:

\ Acts(A)
15 16 17 18 19 20

Events
(Demand)
15 300 270 240 210 180 150
16 300 320 290 260 230 200
17 300 320 340 310 280 250
18 300 320 340 360 330 300
19 300 320 340 360 380 350
20 300 320 340 360 380 400

Then the expected profits from different acts can be calculated as –

EMV (for A =15)
= (300 X .05) + (300 X .10) + (300 X .30) + (300 X .40) + (300 X .10) + (300 X.05)
= Rs 300
EMV (for A =16)

= (270 X .05) + (320 X .10) + (320 X .30) + (320 X .40) + (320 X.10) + (320 X .05)
= Rs 317.5
EMV (for A =17)
= (240 X .05) + (290 X .10) + (340 X .30) + (340 X .40) + (340 X .10) + (340 X .05)

= Rs 330
EMV (for A =18)
= (210 X .05) + (260 X .10) + (310 X .30) + (360 X .40) + (360 X .10) + (360 X .05)
= Rs 327.5
EMV (for A =19)
= (180 X.05) + (230 X .10) + (280 X .30) + (330 X .40) + (380 X .10) + (380 x .05)
= Rs 305
EMV (for A =20)
= (150 X .05) + (200 X .10) + (250 X .30) + (300 X .40) + (350 X .10) + (400 .05)
= Rs 277.5

The act which has maximum EMV is selected. Here maximum EMV is Rs. 330 when the
baker bakes 17 cakes. Therefore, the best act for the baker is to bake 17 cakes and
this Act should be selected.

14 
Institute of Lifelong Learning, University of Delhi.
 
 
 Statistical Decision Theory

5.4.2 Expected Opportunity Loss (EOL) Criterion

An alternative decision criterion is Expected Opportunity Loss. Here we use Regret or

Opportunity Loss Table. Expected Opportunity Loss (EOL) of each act is calculated by
multiplying the probabilities of different states of nature with the corresponding regrets
(opportunity loss) and adding them all.
Expected opportunity loss (EOL) = ∑ (opportunity loss X probability) for each act.
The act with minimum EOL is selected.
In our case the EOL table is

Acts

\
15 16 17 18 19 20
Events
(Demand)
15 0 30 60 90 120 150
16 20 0 30 60 90 120
17 40 20 0 30 60 90
18 60 40 20 0 30 60
19 80 60 40 20 0 30
20 100 80 60 40 20 0

Here
EOL (for A =15)
= (0 X .05) + (20 X .10) + (40 X .30) + (60 X .40) + (80 X .10) + (100 X .05)
= Rs 51
EOL (for A =16)
= (30 X .05) + (0 X .10) + (20 X .30) + (40 X .40) + (60 X .10) + (80 X .05)
= Rs 33.5
EOL (for A =17)
= (60 X .05) + (30 X .10) + (00 X .30) + (20 X .40) + (40 X .10) + (60 X .05)
= Rs 21
EOL (for A =18)
= (90 X .05) + (60 X .10) + (30 X .30) + (0 X .40) + (20 x .10) + (40 x .05)
= Rs 23.5
EOL (for A =19)
= (120 X .05) + (90 X .10) + (60 X .30) + (30 X .40) + (0 X .10) + (20 X .05)
= Rs 46
EOL (for A =20)
= (150 X .05) + (120 X .10) + (90 X .30) + (60 X .40) + (30 X .10) + (0 X .05)
= Rs 73.5
Here the baker will select the Act to bake 17 cakes as the EOL of this Act is minimum
(i.e. Rs.21).
Note: Whether we adopt EMV principle or EOL rule the decision will be the same. The
Act with maximum EMV will have minimum EOL.

15 
Institute of Lifelong Learning, University of Delhi.
 
 
 Statistical Decision Theory

Figure 5.12: baker with optimum decision

Source-http://www.bing.com/images/search?q=baker#
focal=7b95b4aef91793caae03ec2f0234d741&furl=http%3A%2F%2Fmel-
o.com%2FImages%2FBaker.jpg

5.4.3 Expected Profit With Perfect Information (EPPI)

Figure 5.13: EPPI

Source -http://www.crestock.com
/images/920000-929999/925705-xs.jpg

Expected profit with perfect information is defined as the maximum expected value of
profit, which can be earned knowing with certainty which state of nature is going to
occur in future. When the decision maker knows the states of nature with certainty he
can choose the action which will yield optimal results.
Suppose that the baker in our illustration could remove all uncertainties from his
problem by obtaining complete and accurate information about the future, referred to as
perfect information. The sales would still vary from 15 to 20 cakes per day. It would still
be 15 cakes per day 5 per cent of the time; 16 cakes 10 per cent of the time and so on.
However, with perfect information the baker would know in advance how many cakes
were going to be demanded each day. Under these circumstances, he would bake today
the exact number of cakes buyer will want tomorrow. In that case his conditional Pay off
Table will be:

16 
Institute of Lifelong Learning, University of Delhi.
 
 
 Statistical Decision Theory

Acts

\
15 16 17 18 19 20

Events
(Demand)
15 300 - - - - -
16 - 320 - - - -
17 - - 340 - - -
18 - - - 360 - -
19 - - - - 380 -
20 - - - - - 400

For a demand of 15 cakes, he will bake 15 cakes and realize a profit of Rs. 300. When
sales are going to be 16 cakes, he will bake 16 cakes and realize a profit of Rs. 320 and
so on. Thus knowing the size of the market in advance for a particular day, the baker
chooses that action which will maximize his profits. With this, we can calculate his
expected profit with perfect information.

Conditional profit with Expected profit with

perfect perfect
Demand (in units) Probability information(Rs) information(Rs)
C
B C
A B
15 .05 300 15
16 .10 320 32
17 .30 340 102
18 .40 360 144
19 .10 380 38
20 .05 400 20
Total = 351

EPPI = (300 X .05) + (320 X .10) + (340 X .30) + (360 X .40) + (380 X .10) + (400
X .05) = Rs 351
This (Rs. 351) is the maximum expected profit possible and is called expected profit
with perfect information (EPPI).

5.4.4 Expected Value of Perfect Information (EVPI)

Figure 5.14: EVPI

Source - http://www.siamman.com/images/finance.jpg

17 
Institute of Lifelong Learning, University of Delhi.
 
 
 Statistical Decision Theory

We have seen if the decision maker could predict the future states of nature he can raise
his volume of profit. The baker in our example can earn average daily profits of Rs.
351 if he has perfect information about the future but without such information his best
daily profits is only Rs. 330. However, to know the states of nature with certainty,
decision maker needs perfect information, which will certainly involve cost.

Now the question is whether he should first obtain perfect information and make the
optimal decision or he should take the decision on the basis of whatever information is
already available to him. Naturally, for this he will compare the cost of obtaining perfect
information with the additional profit he would realize as a result of that information. If
the cost is less than the additional profit he will obtain the information; if it is more, he
will not obtain the information.

In our example, the difference between EPPI and EP of best act i.e. Rs 21 ( Rs 351 – Rs
330 ) is the maximum amount the baker will be willing to pay per day to get this perfect
information about the future because, that is the maximum amount by which he can
increase his expected daily profit. This is called the Expected Value of Perfect
Information (EVPI).

The expected value of perfect information is thus the difference between expected profit
with perfect information (EPPI) and expected payoff (EP) of the optimal act when there is
no such perfect information. This will always be equal to the EOL of the optimal act since
the perfect prediction reduces the opportunity loss due to uncertainty to zero. Thus

EVPI = EPPI – EP
= EOL of optimal act
And,
EPPI = EVPI + EP

In our example
EVPI = EPPI – EP
= 351 – 330
= Rs 21
= EOL of the best act (i.e. to bake 17 cakes)

18 
Institute of Lifelong Learning, University of Delhi.
 
 
 Statistical Decision Theory

Summary
• Decision making is required whenever an individual or an organization (decision
maker) is faced with a situation of selecting an optimal(best) course of action
from among several available courses of action.
• There are 4 basic elements in decision theory: and. Acts are the actions being
considered by the decision maker; Events are occurrences taking place outside
the control of the decision maker; outcomes are the result of the occurrence of
acts and events; payoffs are the values the decision maker is placing on the
occurrences.acts, events, outcomes, payoffs
• Decision theory can apply to conditions of certainty, risk, or uncertainty.
• For making decision under uncertainty (without the use of probability), maximax,
maximin or Laplace criteria can be applied to payoff table.
• Decision under risk (with probability distribution) is done by adopting either EMV
criterion or by adopting EOL criterion.
• Both EMV and EOL criterion gives the same result.
• The expected value of perfect information is the difference between expected
profit with perfect information (EPPI) and expected payoff (EP) of the optimal act
. This will always be equal to the EOL of the optimal act. It is the maximum
amount the decision maker could pay to get the perfect information.

Exercise
1. What do you understand by statistical decision theory? List the different
ingredients of statistical decision
theory.
2. “Decision criterion under situation of uncertainty is governed by the
attitude of decision maker”. Explain.
3. Explain briefly the following terms:

a) Maximax criterion
b) Maximin criterion
c) Laplace criterion, and

1. Explain the concept of decision making under risk. Why is there is a need
for expected value of perfect information? How is it calculated?

Practical problems
5.1 Given the following payoff matrix

A1 A2 A3
Acts
States of nature
S1 70 50 30
S2 30 45 30
S3 15 10 30

1. Determine the best act to be chosen using the following criterion:

1. Maximax
2. Maximin
3. Laplace, and
4. Minimax regret
[A1, A3, A1, and A1]

19 
Institute of Lifelong Learning, University of Delhi.
 
 
 Statistical Decision Theory

5.2 A certain product is manufactured at Rs 200 and sold at Rs 400 per unit. The
product is such that if it is produced but not sold during a week’s time, it
becomes worthless. The weekly sales record in the past is as follows:
Demand: 20 25 40 60
No. of weeks: 5 15 25 5
Suggest the optimal act which should be taken by the manufacturer of the
product.
[40]
5.3 A newspaper distributor assigns probabilities to the demand for magazine as
follows:
Copies demanded: 1 2 3 4
Probability : .4 .3 .2 .1
A copy of magazine is sold for Rs 70 and it costs Rs 60. Distributor can return
unsold copies at Rs50 each. What is the maximum monetary value and the
minimum possible expected opportunity
loss? [12, 8, optimum number = 2]

5.4 consider the following payoff table:

Acts
States of nature A1 A2 A3
S1 -200 -500 2000
S2 2000 -1000 -500
S3 4000 6000 3000

The probabilities of the states of nature are 0.3, 0.4 and 0.3 respectively.
Calculate
1. The optimum act using the expectation principle.
2. EVPI.
[A1, 1260]

References

Essential Reading

1. Federrick S. Hillier & Gerald J. Lieberman “operations research – concept and

cases” Tata McGraw Hill Publishing Co. ltd.

2. Gupta, S.C., ‘‘Fundamentals of Statistics’’, Himalaya Publishing House.

3. Gupta, S.P., and Archana Gupta, ‘‘Statistical Methods’’, Sultan Chand and Sons,
New Delhi.

4. Kapoor V. K. ‘‘Fundamentals of Statistics – for business and economics’’, Sultan

Chand and Sons, New Delhi.

5. Levin, Richard and David S. Rubin, ‘‘Statistics for Management’’, 7th Edition,
Prentice Hall of India.

6. Sharma J.K., Business Statistics’ second edition ’pearsons education.

7. Srivastava T.N. & Shailja Rego, ‘‘Statistics for Management’’, Tata McGraw Hill
Publishing Co. ltd.

20 
Institute of Lifelong Learning, University of Delhi.
 
 
 Statistical Decision Theory

Glossary
Acts: - the courses of action or strategy being considered by the decision maker.

• a decision environment where the decision maker knows with certainty the
consequences of every alternative.Decision making under certainty –
• Decision making under risk – a decision environment where probabilities are
assigned to different states of nature.
• Decision making under uncertainty -a decision environment where the
decision maker has no knowledge of the events and there is no objective way of
assigning probabilities.
• Decision theory: a body of knowledge and related analytical techniques,
designed to help a decision maker to choose the best act from a set of available
alternatives in light of their possible co

• the sum of products of pay offs for each event and their corresponding
probabilities of occurrence.Expected monetary value (EMV) -
• Expected Opportunity Loss (EOL) – the sum of the products of probabilities of
different states of nature and their corresponding regrets (opportunity losses).
• Expected profit with perfect information - the maximum expected value of
profit which can be earned knowing with certainty which state of nature is going
to occur in future.
• Expected value of perfect information – the maximum amount the decision
maker could pay to get the perfect information.
• Opportunity loss table - - shows the regrets of every action in different states
of nature in tabular form.
• Opportunity loss (or Regret)- - The difference between profit actually derived
from a certain decision and that which would have been derived if the decision
had been the best for the states of nature that actually occurred .
• Pay Off - - the monetary gain or loss that accrues from a given combination of a
decision alternative and state of nature.
• Pay off table – - shows the payoffs of every action in different states of nature
in
• States of nature - - those possible events which are uncertain and beyond the
control of decision maker, but are vital for choice of any one of the alternative
acts.

21 
Institute of Lifelong Learning, University of Delhi.