Decision theory: is an analytic and systematic approach to the study of

decision making.

A good decision is one that is based on logic, considers all available data and
possible alternatives, and the quantitative approach described here.

A good decision results in an unexpected or unfavorable outcome. But if it is

made properly, it is still a good decision & vise versa.

Six Steps in Decision Making

1. Clearly define the problem at hand.
2. List the possible alternatives.
3. Identify the possible outcomes or states of nature.
4. List the payoff (typically profit) of each combination of alternatives and
outcomes.
5. Select one of the mathematical decision theory models.
6. Apply the model and make your decision.
One of the biggest mistakes that decision makers make is to leave out some
important alternatives. Although a particular alternative may seem to be
inappropriate or of little value, it might turn out to be the best choice.
Optimistic decision makers tend to ignore bad outcomes.
Pessimistic managers may discount a favorable outcome.
If you don’t consider all possibilities, you will not be making a logical decision,
and the results may be undesirable.
States of nature: those outcomes over which the decision maker has little or
no control.
we call such payoffs or profits conditional values

Types of Decision-Making Environments

The types of decisions people make depend on how much knowledge or
information they have about the situation. There are three decision-making
environments:
●● Decision making under certainty
●● Decision making under uncertainty
●● Decision making under risk
Type 1: Decision making under certainty
• Decision maker knows with certainty the consequences of every alternative
or decision choice
• Naturally, they will choose the alternative that will maximize their well-being
or will result in the best outcome.

Type 2: Decision making under uncertainty

• There are several possible outcomes for each alternative, and the decision
maker does not know the probabilities of the various outcomes

Type 3: Decision making under risk

• there are several possible outcomes for each alternative, and the decision
maker knows the probability of occurrence of each outcome

There are several criteria for making decisions under uncertainty

• 1. Optimistic (Maximax)
• 2. Pessimistic (Maximin)
• 3. Criterion of realism (Hurwicz)
• 4. Equally likely (Laplace)
• 5. Minimax regret

The first four criteria can be computed directly from the decision (payoff)
table, whereas the minimax regret criterion requires use of an opportunity
loss table

Optimistic (Maximax)
Used to find the alternative that maximizes the maximum payoff
n Locate the maximum payoff for each alternative
n Select the alternative with the maximum number
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Pessimistic (Maximin)

Used to find the alternative that maximizes the minimum payoff

n Locate the minimum payoff for each alternative
n Select the alternative with the maximum number
n The best of the worst values

Criterion of Realism (Hurwicz)

Weighted Average
A weighted average compromise between optimistic and pessimistic
n Select a coefficient of realism
n Coefficient is between 0 and 1
n Compute the weighted averages for each alternative
n Select the alternative with the highest value

Weighted average = a (maximum in row) + (1 –a)(minimum in row)

n This measures the degree of optimism of the decision maker and is

between 0 and 1.
n When a is 1, the decision maker is 100% optimistic about the future.
n When a is 0, the decision maker is 100% pessimistic about the future.
n The advantage of this approach is that it allows the decision maker to
build in personal feelings about relative optimism and pessimism.

If we assume that John Thompson sets his coefficient of realism, a, to be

0.80, the best decision would be to construct a large plant. As seen in Table
3.4, this alternative has the highest weighted average:

n For the large plant alternative using a = 0.8

(0.8)(200,000) + (1 – 0.8)(–180,000) = 124,000

n For the small plant alternative using a = 0.8

(0.8)(100,000) + (1 – 0.8)(–20,000) = 76,000

Equally Likely (La place)

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.

MiniMax Regret
 Minimax regret criterion is based on opportunity loss or regret.
 Opportunity loss 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 for that state of nature.
o In other words, it’s the amount lost by not picking the best
alternative in a given state of nature.
 The first step is to create the opportunity loss table by determining the
opportunity loss for not choosing the best alternative for each state of
nature.
 Opportunity loss for any state of nature, or any column, is calculated
by subtracting each payoff in the column from the best payoff in the
same column.
 Using the opportunity loss (regret) table, the minimax regret criterion
first considers the maximum (worst) opportunity loss for each
alternative. Next, looking at these maximum values, pick the
alternative with the minimum (or best) number.
 Decision Making Under Risk
• Decision making when there are several possible states of nature and we
know the probabilities associated with each possible state

• Most popular method is to choose the alternative with the highest expected
monetary value (EMV)

• The expected value, or the mean value, is the long-run average value of
that decision.

• The EMV for an alternative is just the sum of possible payoffs of the
alternative, each weighted by the probability of that payoff occurring.
 EMV for Thompson Lumber

n Each market has a probability of 0.50

n Which alternative would give the highest EMV?
n The calculations are
EMV (large plant) = (0.50)($200,000) + (0.50)(–$180,000) = $10,000
EMV (small plant) = (0.50)($100,000) + (0.50)(–$20,000) = $40,000
EMV (do nothing) = (0.50)($0) + (0.50)($0) = $0

Expected Value of Perfect Information

• The expected value of perfect information (EVPI)
• The expected value with perfect information (EVwPI).
• The expected value with perfect information 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 times the probability of occurrence of that
state of nature.
The expected value with perfect information is
EVwPI = EVwPI = $200,000*0.50 + $0*0.50= $100,000
Thus, if we had perfect information, the payoff would average $100,000.

• The EVPI is the expected value with perfect information minus the
expected value without perfect information (i.e., the best or maximum
EMV). Thus, the EVPI is the improvement in EMV that results from having
perfect information.
EVPI = EVwPI - Best EMV
• The maximum EMV without additional information is $40,000. Therefore
the increase in EMV is EVPI = EVwPI - Maximum EMV
= $100,000 - $40,000 = $60,000
• Thus, the most Thompson would be willing to pay for perfect information
is $60,000. This, of course, is again based on the assumption that the
probability of each state of nature is 0.50.

Expected Opportunity Loss

An alternative approach to maximizing EMV is to minimize expected
opportunity loss (EOL). First, an opportunity loss table is constructed.

Then the EOL is computed for each alternative by multiplying the

opportunity loss by the probability and adding these together.

Using minimum EOL as the decision criterion, the best decision would be
the second alternative, “construct a small plant.” It is important to note that
minimum EOL will always result in the same decision as maximum EMV
and that the EVPI will always equal the minimum EOL.

Referring to the Thompson case, we used the payoff table to compute the
EVPI to be $60,000. Note that this is the minimum EOL we just computed.
EOL (construct large plant) = 0.5*0 + 0.5*180,000 = $90,000
EOL (construct small plant) = 0.5*100,000 + 0.5*20,000 = $60,000
EOL (do nothing) = 0.5*200,000 + 0.5*0 = $100,000
Decision Trees
• Any problem that can be presented in a decision table can also be
graphically represented in a decision tree
• Decision trees are most beneficial when a sequence of decisions
must be made
• All decision trees contain decision points or nodes and state-of
nature points or nodes
• A decision node from which one of several alternatives may be
chosen
• A state-of-nature node out of which one state of nature will occur
1. In decision theory terminology, a course of action or a strategy that may be chosen by a decision maker is called
a. a payoff.
b. an alternative.
c. a state of nature.
d. none of the above.

2. In decision theory, we call the payoffs resulting from each possible combination of alternatives and outcomes
a. marginal values.
b. conditional values.
c. conditional probabilities.
d. Bayesian values.

3. The three types of decision-making environments are

a. utility, risk, and certainty.
b. utility, certainty, and uncertainty.
c. utility, equity, and certainty.
d. risk, certainty, and uncertainty.

4. Which of the following is not considered a criterion for decision making under uncertainty?
a. optimistic
b. pessimistic
c. equally likely
d. random selection

5. A pessimistic decision making criterion is sometimes called

a. the maximax criterion.
b. the equally likely criterion.
c. the maximin criterion.
d. decision making under certainty.

6. In using the criterion of realism (Hurwicz criterion), the coefficient of realism (a)
a. is the probability of a good state of nature.
b. describes the degree of optimism of the decision maker.
c. describes the degree of pessimism of the decision maker.
d. is usually less than zero.

7. The most that a person should pay for perfect information is

a. the EVPI.
b. the maximum EMV minus the minimum EMV.
c. the maximum EOL.
d. the maximum EMV.

8. The minimum EOL criterion will always result in the same decision as
a. the maximax criterion.
b. the minimax regret criterion.
c. the maximum EMV criterion.
d. the equally likely criterion.

9. A decision tree is preferable to a decision table when

a. a number of sequential decisions are to be made.
b. probabilities are available.
c. the maximax criterion is used.
d. the objective is to maximize regret.

10. Bayes’ Theorem is used to revise probabilities. The new (revised) probabilities are called
a. prior probabilities.
b. sample probabilities.
c. survey probabilities.
d. posterior probabilities.

11. On a decision tree, at each state-of-nature node,

a. the alternative with the greatest EMV is selected.
b. an EMV is calculated.
c. all probabilities are added together.
d. the branch with the highest probability is selected.
12. The EVSI
a. is found by subtracting the EMV without sample information from the EMV with sample information.
b. is always equal to the expected value of perfect information.
c. equals the EMV with sample information assuming no cost for the information minus the EMV without sample
information.
d. is usually negative.

13. The efficiency of sample information

a. is the EVSI/(maximum EMV without SI) expressed as a percentage.
b. is the EVPI/EVSI expressed as a percentage.
c. would be 100% if the sample information were perfect.
d. is computed using only the EVPI and the maximum

EMV.
14. On a decision tree, once the tree has been drawn and the payoffs and probabilities have been placed on the tree, the
analysis (computing EMVs and selecting the best alternative) is done by
a. working backward (starting on the right and moving to the left).
b. working forward (starting on the left and moving to the right).
c. starting at the top of the tree and moving down.
d. starting at the bottom of the tree and moving up.

15. Utility values typically range from

a. -1 to 1.
b. 1 to 10.
c. 0 to 1.
d. 1 to 100.

16. It is sometimes said that those who gamble the most are the ones who can least afford to lose. These people gamble
because
a. the EMV is positive.
b. the EMV is negative.
c. there is utility other than monetary to consider.
d. none of the above.