Decision theory

Decision theory
 The process of decision making consists of identifying alternatives, gathering all the
relevant information, and selecting the best alternative on the basis of a set criteria.
Ignorance Uncertainty Risk Certainty

Conflict

1. Decision making under certainty : Decision maker has complete knowledge (perfect
information) of outcome due to each decision alternative (course of action),
• Decision maker selects an alternative that yields the maximum return (payoff) under
know state of nature. (National saving certificate, Insurance policy, PPF etc.)

2. Decision making under un-certainty: This refers to the situation where more than one
outcome can result from any single decision.
• The decision maker lacks sufficient knowledge to allow him assign probabilities to
the various states of nature
Decision making environments - One-stage decision making
3. Decision making under risk : The decision maker chooses, from among several possible
outcomes where the probabilities of their occurrences can be determined objectively form
the past data.

4. Decision making under conflict: Here two or more opponents with conflicting objectives
try to make decisions to gain advantage over others (game theory).
Decision theory
 The process of decision making consists of identifying alternatives, gathering all the
relevant information, and selecting the best alternative on the basis of a set criteria.

Irrespective of the type of decision model, following components are common.

 Decision alternatives : There are finite number of decision alternatives available to the
decision maker at each point in time when decision is made.
 The number and type of such alternatives may depend on the previous decisions made
and their outcome.

 State of nature : A state of nature is an event or scenario that is not under the control of
decision maker (inflation, weather condition)
 State of nature may be identified through scenario analysis – focus group interview

 Pay-off : Is a numerical value, obtained due to the application of each possible

combination of decision alternatives and state of nature, displayed in payoff matrix.
 Decision theory
1. One Stage Decision Making - Decision making problems could be that of a news boy,
who has to decide how many news copies should he stock every day.

2. Multi-Stage Decision Making or Decision Tree - Decision making problem may need a
decision analysis – situation where the outcome of one decision has an influence on the
next decision.

3. Utility Theory - Decisions are based on the level of utility (worth or value) rather than
amount of money or monetary terms.

Steps in decision making

1. Identify and define the problem
2. List all possible future events (under the control of the decision maker) that are likely to
occur
3. Identify all courses of actions available to the decision maker
4. Express the pay-off resulting from each combination of course of action
5. Apply an appropriate decision theory model to select the best course of action.
Example 1 - Decision making environments

A bookstores sells books on Tax Law for Rs. 100 each.

He purchases the book for Rs.80 each
Since some of the Tax Laws change every year, the copies unsold would at the end of the
year becomes outdated and can be sold for Rs. 30 each.
According to past experience, the annual demand for this book is between 18 to 23 copies.
Assuming that the order for this book can be placed only once during the year,
the problem before the store’s manager is to decide how many copies of the book should
be purchased for the next year?.
Example 1 - Decision making environments

 Store keeper makes a profit of Rs 20 on every book sold 1st year

 Makes a loss of Rs. 50 on books sold in the next year

 Since annual demand varies between 18 and 23 copies, there are six possible events.

Steps in decision making

1. Identify and define the problem
2. List all possible future events (under the control of the decision maker) that are likely to
occur (event and its possibility)
3. Identify all courses of actions available to the decision maker (action and its possibility)
4. Express the pay-off resulting from each combination of course of action
5. Apply an appropriate decision theory model to select the best course of action.
Example 1 - Decision making environments

 Store keeper makes a profit of Rs 20 on every book sold 1st year

 Makes a loss of Rs. 50 on books sold in the next year

 Since annual demand varies between 18 and 23 copies, there are six possible events.

Event Possibility Action Possibility

E1 18 Copies are on demand A1 Buy 18 copies

E2 19 Copies are on demand A2 Buy 19 copies

E3 20 Copies are on demand A3 Buy 20 copies

E4 21 Copies are on demand A4 Buy 21 copies

E5 22 Copies are on demand A5 Buy 22 copies

E6 23 Copies are on demand A6 Buy 23 copies

Example 1 - Pay-off table 1.1 store keeper make Rs 20 per book sold
Events Actions

A1 18 A2 19 A3 20 A4 21 A5 22 A6 23

E1 18

E2 19

E3 20

E4 21

E5 22

E6 23
Example 1 - Pay-off table 1.1 store keeper makes a profit of Rs 20 per book sold
Events Actions

A1 18 A2 19 A3 20 A4 21 A5 22 A6 23

E1 18 360 310 260 210 160 110

E2 19 360 380 330 280 230 180

E3 20 360 400 350 300 250

380
E4 21 380 400 420 370 320
360
E5 22 360 380 400 420 440 390
E6 23 360 380 400 420 440 460
Example 1 - Pay-off table - store keeper makes a profit of Rs 20 per book sold
Events Actions

A1 18 A2 19 A3 20 A4 21 A5 22 A6 23

E1 18 360 310 260 210 160 110

E2 19 360 380 330 280 230 180

E3 20 360 380 400 350 300 250

E4 21 360 380 400 420 370 320

E5 22 360 380 400 420 440 390

E6 23 360 380 400 420 440 460

 Example 1 - Regret (opportunity loss) matrix -store keeper makes an opportunity loss of Rs
50
Events Actions

A1 18 A2 19 A3 20 A4 21 A5 22 A6 23

E1 18 0 50 100 150 200 250

E2 19 20 0 50 100 150 200
E3 20 40 20 0 50 100 150
E4 21 60 40 20 0 50 100
E5 22 80 60 40 20 0 50
E6 23 100 80 60 40 20 0
Example 1 - Regret Matrix - store keeper makes an opportunity loss of Rs 50
Events Actions

A1 18 A2 19 A3 20 A4 21 A5 22 A6 23

E1 18 0 50 100 150 200 250

E2 19 20 0 50 100 150 200

E3 20 40 20 0 50 100 150

E4 21 60 20 0 50 100
40
E5 22 80 60 40 20 0 50

E6 23 100 80 60 40 20 0
I - Steps in decision making under uncertainty
1. Identify and define the problem
2. List all possible future events (under the control of the decision maker) that are likely to
occur
3. Identify all courses of actions available to the decision maker
4. Express the pay-off resulting from each combination of course of action
5. Apply an appropriate decision theory model to select the best course of action.
a). Laplace Principle (Jacob Bernouli Method)
b). Maximin or Minimax Principle (Wald decision)
c). Maxmax or Minimin Principle
d). Hurwicz Principle
e). Savage Principle or principle of minimax regret
 Example 1.1 Laplace Principle (Jacob Bernouli Method)
If we are uncertain about various events then we may treat them as equally probable.
• Under this assumption, the expected (mean) value of pay-off for each strategy is
determined and the strategy with highest mean value is adopted.

Determine the strategy for pay-off

Events Actions
A1 18 A2 19 A3 20 A4 21 A5 22 A6 23
E1 18 360 310 260 210 160 110
E2 19 360 380 330 280 230 180
E3 20 360 380 400 350 300 250
E4 21 360 380 400 420 370 320
E5 22 360 380 400 420 440 390
E6 23 360 380 400 420 440 460
Mean 2,160/6 = 360 2,210/6 = 368.3 2,190/6=365 2,100/6=350 1,940/6=323.3 1,710/6=285
Note : If the pay-offs are in terms of costs, we choose the strategy with the lowest average cost
Example 1.2 Laplace Principle (Jacob Bernouli Method)
A research department of a consumer product division has recommended to the marketing
department to launch a soap with 3 different perfumes. The marketing manager has to
decide the type of perfume to launch under the following estimated payoffs. They have no
information of level of sales

Type of perfume Expected pay-offs from markets

1 (Hyderabad) 2 (Bengaluru) 3 (Chennai)
I 20 25 15
II 10 50 25
III 35 45 8

 determine the strategy for type of perfume

Example 1.2 Laplace Principle (Jacob Bernouli Method)

Type of Expected pay-offs from markets equal probability = 1/3

perfume 1 2 3
I 20 25 15 (20+25+15) / 3 = 60/3 = 20.00
II 10 50 25 (10+50+25) / 3 = 85/3 = 28.33
III 35 45 8 (35+45+8) / 3 = 88/3 = 29.33

Select type III perfume, which gives the maximum expected pay-off = 88/3 = 29.33
 example 1.3 Maximin or Minimax Principle (Wald decision)
• This principle is adopted by pessimistic decision makers who are conservative in their
approach.
• Using this approach, the minimum pay-offs resulting from adoption of various
strategies are considered and among these values the maximum is selected.
• Choosing the best (max.) profit from the set of worst profits(min)
Events Actions
A1 18 A2 19 A3 20 A4 21 A5 22 A6 23
E1 18 360 310 260 210 160 110
E2 19 360 380 330 280 230 180
E3 20 360 380 400 350 300 250
E4 21 360 380 400 420 370 320
E5 22 360 380 400 420 440 390
E6 23 360 380 400 420 440 460
Example 1.4 Maximin or Minimax Principle (Wald decision)
A research department of a consumer product division has recommended to the marketing
department to launch a soap with 3 different perfumes. The marketing manager has to
decide on maximin criteria to launch the perfume under the following estimated payoffs
and sales in each market.
Type of perfume Expected pay-offs for level of sales
20,000 10,000 2,000
I 25 15 10
II 40 20 5
III 60 25 3

 Lowest sales in three markets is 2,000

 Type I,II and III of perfumes sold in this market are 10, 5 and 3 respectively.
 Type I gives the maximum pay-off in the minimum sales is market -3
 Therefore launch type I perfume
Example 1.5 - Maxmax or Minimin Principle –
The maximax principle is optimist's principle of choice. It suggests that for each
strategy, the maximum profit should be considered and the strategy with which the
highest of the values is associated should be chosen.

Events Actions
A1 18 A2 19 A3 20 A4 21 A5 22 A6 23
E1 18 360 310 260 210 160 110
E2 19 360 380 330 280 230 180
E3 20 360 380 400 350 300 250
E4 21 360 380 400 420 370 320
E5 22 360 380 400 420 440 390
E6 23 360 380 400 420 440 460
d). Hurwicz Principle
• Hurwicz principle stipulates that a decision maker’s view may fall somewhere between
the extreme pessimism of the maximin principle and extreme optimism of maximax
principle.
• This principle provides a mechanism by which different levels of optimism and
pessimism may be shown.
• An index of optimism ⍺ is defined on scale 0 to 1, ⍺=0 pessimism and ⍺=1 optimism
• For making a decision first the decision maker’s degree optimism is assigned to ⍺,
• Multiply the maximum profit for each strategy Aj by ⍺ and minimum profit for by 1- ⍺
• The sum of these products is called Hurwics criterion
• Hurwics criterion is obtained for each strategy and select the alternative which
maximises the this value.
Example 1.6 Hurwicz Principle , An index of optimism ⍺ is defined as 0.60

Events Actions
Max Min Criterion (⍺ =0.60 max value and 1-⍺ is min. value)
A1 18 360 360 0.60 x 360 + 0.40 x 360 360
A2 19 380 310 0.60 x 380 + 0.40 x 310 352
A3 20 400 260 0.60 x 400 + 0.40 x 260 344
A4 21 420 210 0.60 x 420 + 0.40 x 210 336
A5 22 440 160 0.60 x 440 + 0.40 x 160 328
A6 23 460 110 0.60 x 460 + 0.40 x 110 320

Decision Index Di = ⍺Mmax + (1- ⍺)mmin

where Mmax = Maximum pay-off from any of the outcomes resulting resulting from ith strategy
mmin = minimum pay-off from any of the outcomes from resulting from ith strategy
 Example 1.7 Hurwicz Principle
A research department of a consumer product division has recommended to the marketing
department to launch a soap with 3 different perfumes. The marketing manager wants to be
optimistic of 0.6, ⍺ value from market -1 over market 3. He wants to decide which type of
perfume to launch
Type of perfume Expected pay-offs for level of sales
20,000 10,000 2,000
I 25 15 10
II 40 20 5
III 60 25 3

Decision Index - type I = (0.6 x 25) + (0.4) x 10 = 19.0 Decide to launch type III
perfume which has a greater
Decision Index - type II = (0.6 x 40) + (0.4) x 5 = 26.0
index for ⍺ = 0.6
Decision Index - type III = (0.6 x 60) + (0.4) x 3 = 37.2.0
 e). Savage Principle or principle of minimax regret–
• The savage principle is based on the concept of regret and calls for selecting course of
action that minimises the maximum regret.
• Developed by L.J.Savage
• As a first step a regret matrix is derived from the pay-off matrix
• Maximum regret value corresponding to each of the strategy is determined and strategy
which minimises the maximum regret is chosen.

 If the pay-off represents profit, then ith regret = max pay-off (–) jth pay-off for ith event

 Choose the minimum of the maximum regret

 If the pay-off represents the cost, then jth regret =ith pay-off (–) Maximum pay-off (i.e
minimum cost for the ith event )
Example 1.8 Savage Principle or principle of minimax regret–
• The savage principle is based on the concept of regret and calls for selecting course of
action that minimises the maximum regret.
• As a first step a regret matrix is derived from the pay-off matrix
• Maximum regret value corresponding to each of the strategy is determined and strategy
which minimises the maximum regret is chosen.

Events Actions
A1 18 A2 19 A3 20 A4 21 A5 22 A6 23
E1 18 0 50 100 150 200 250
E2 19 20 0 50 100 150 200
E3 20 40 20 0 50 100 150
E4 21 60 40 20 0 50 100
E5 22 80 60 40 20 0 50
E6 23 100 80 60 40 20 0
The maximum regret value for A2 being the least , it represents the optimum choice
example 1.9 - Savage Principle or principle of minimax regret
A businessman has 3 alternatives open to him each of which can be followed by any of the
four possible events. The conditional pay-offs (in Rs) for each action event combination are
given as

Type of Expected pay-offs for level of sales

perfume
1 2 3 4
A 7 0 -10 5
B -4 11 18 -2
C 13 5 0 7

Find out which alternative should be adopted, if the businessman adopts the minimax regret
criterion

 If the pay-off represents profit, then ith regret = max pay-off (–) ith pay-off for jth event
example 1.9 - Savage Principle or principle of minimax regret
Type of Expected pay-offs for level of sales
perfume 1 (j1) 2 (j2) 3 (j3) 4 (j4)
A (i1) 7 0 -10 5
B (i2) -4 11 18 -2
C (i3) 13 5 0 7
 If the pay-off represents profit, then ith regret = max pay-off (–) jth pay-off for ith event

Type of Expected pay-offs for level of sales Maximum

perfume regret
1 2 3 4
A 13-7 = 6 11- 0 = 11 18-(-10) = 28 7-5 = 2 28
B 13-(-4) = 17 11-11 = 0 18 – 18 = 0 7-(-2) = 9 17
C 13-13 = 0 11-5= 6 18 – 0 = 18 7-7 = 0 18
Since alternative B corresponds to minimum of the maximum possible regrets, the
businessman should chose this alternative
II - Decision under Risk - Maximum Likelihood Principle
 The decision maker chooses, from among several possible outcomes where the
probabilities of their occurrences can be determined objectively form the past data.

a) Maximum Likelihood Principle – In this principle, the decision maker first considers the
event that is most likely to occur.
b) Then decides for the course of action which has the maximum conditional pay-off,
corresponding to that event
example 2 - Decision under Risk
Supposing that the bookstores observes from the past sales data that the proportion of the
times number of books sold is given in the following table, determine how many copies
should he hold in stock No of books sold Proportion of time
18 0.05
19 0.10
20 0.3

Events Actions 21 0.4

22 0.1
A1 18 A2 19 A3 20 A4 21 A5 22 A6 23
23 0.05
E1 18 360 310 260 210 160 110
E2 19 360 380 330 280 230 180
Highest proportion of copies sold
E3 20 360 380 400 350 300 250
is 21 (i.e 0.40)
E4 21 360 380 400 420 370 320
E5 22 360 380 400 420 440 390 Pay-off for this probability is 420
E6 23 360 380 400 420 440 460
Decision under Risk - Expectation Principle
 Generally, the decision making in situations of risk is on the basis of the expectation
principle.
 With the event probabilities assigned, objectively or subjectively, the expected pay-off
for each strategy is calculated by multiplying the pay-off values with their respective
probabilities and then adding up these products.
 The strategy with highest expected pay-off represents the optimal choice.

 EPj = σ𝑛𝑖=1 𝑃𝑖 𝑎𝑖𝑗 j = 1,2,3,..n

𝑎𝑖𝑗 represents the pay-off resulting from the combination of ith event and jth action
Pi represents the probability of ith event
Example – 2 - Decision under Risk - Expectation Principle
Events Actions
Pi A1 18 A2 19 A3 20 A4 21 A5 22 A6 23
E1 18 0.05 360 310 260 210 160 110
E2 19 0.10 360 380 330 280 230 180
E3 20 0.30 360 380 400 350 300 250
E4 21 0.40 360 380 400 420 370 320
E5 22 0.10 360 380 400 420 440 390
E6 23 0.05 360 380 400 420 440 460

Expected pay-off values are

Ep1 = (0.05 x360) + (0.1x 360) + (0.3x360) + (0.4x360) + (0.1x360) + (0.05x360) = 360
Ep2 = (0.05 x310) + (0.1x 380) + (0.3x380) + (0.4x380) + (0.1x380) + (0.05x380) = 376.50
Ep3 = (0.05 x260) + (0.1x 330) + (0.3x400) + (0.4x400) + (0.1x400) + (0.0.5x400) = 386 (best course of action)
Ep4 = (0.05 x210) + (0.1x 280) + (0.3x350) + (0.4x420) + (0.1x420) + (0.0.5x420) = 374.50
Ep5 = (0.05 x160) + (0.1x 230) + (0.3x300) + (0.4x370) + (0.1x440) + (0.0.5x440) = 335
Ep6 = (0.05 x110) + (0.1x 180) + (0.3x250) + (0.4x320) + (0.1x390) + (0.05x460) = 288.50
Example –2.1 Decision under Risk - Expected opportunity loss or Expected regret

Events Actions
Pi A1 18 A2 19 A3 20 A4 21 A5 22 A6 23
E1 18 0.05 0 50 100 150 200 250
E2 19 0.10 20 0 50 100 150 200
E3 20 0.30 40 20 0 50 100 150
E4 21 0.40 60 40 20 0 50 100
E5 22 0.10 80 60 40 20 0 50
E6 23 0.05 100 80 60 40 20 0
Expected regret values are
Ep1 = (0.05 x0) + (0.1x 20) + (0.3x40) + (0.4x60) + (0.1x80) + (0.05x100) = 51
Ep2 = (0.05 x50) + (0.1x 0) + (0.3x20) + (0.4x40) + (0.1x60) + (0.05x80) = 34.5
Ep3 = (0.05 x100) + (0.1x 50) + (0.3x0) + (0.4x20) + (0.1x40) + (0.0.5x60) = 25 (best course of action)
Ep4 = (0.05 x150) + (0.1x 100) + (0.3x50) + (0.4x0) + (0.1x20) + (0.0.5x40) = 36.5
Ep5 = (0.05 x200) + (0.1x 150) + (0.3x100) + (0.4x50) + (0.1x0) + (0.0.5x20) = 76
Ep6 = (0.05 x250) + (0.1x 200) + (0.3x150) + (0.4x100) + (0.1x50) + (0.0.5x0) = 122.5

The optimum strategy is the one which minimises the expected regret
Example –2.2 Decision under Risk - Expected value
An auto parts manufacturer is deciding about the size of the plant to be built. Three
alternatives of annual capacities are i). 10,000 units, ii). 20,000 units and iii). 30,000 units.
Demand for the parts is not known but management has estimated the probabilities for 5
different levels of demand. The profit for each size of the plant at different levels of
demand is as follows,
Levels of Probability Profit in lakhs for different actions
demand 10,000 units 20,000 units 30,000 units
Very high 0.15 - 4.0 -6 -8
High 0.30 1 0 -2
Moderate 0.25 1 7 5
Low 0.20 1 7 11
very low 0.10 1 7 11
What plant capacity would you suggest to the management
Example – 2.2 Decision under Risk - Expected value

Levels of Probability Expected Profit in lakhs

demand 10,000 units 20,000 units 30,000 units
Very high 0.15 - 4.0 x 0.15 = - 0.60 - 6x0.15= -0.90 - 8x0.15 = -1.20
High 0.30 1 x 0.3 = 0.3 0 x 0.30 = 0 - 2x0.30 = -0.60
Moderate 0.25 1 x 0.25 = 0.25 7x 0.25 = 1.75 5x0.25 = 1.25
Low 0.20 1 x 0.20 = 0.20 7x0.20 = 1.40 11x0.20 = 2.20
very low 0.10 1 x 0.10 = 0.10 7x0.1 = 0.70 11x0.10 =1.10
End Market Value (EMV) 0.25 2.95 2.75

Since plant with capacity of 20,000 units is likely to yield high EMV of Rs 2.95 lakhs
build this capacity
Example – 2.3 Decision under Risk - Expected pay-off

A small perishable goods making company finds from the past data that the cost of
making an item is Rs.25, the selling price of the item is Rs. 30, if it is sold within a week ,
and unsold items can be disposed off at Rs 20 per item at the end of the week. Frequency
of weekly sales is given below
Weekly <3 4 5 6 7 >8
sales
No of 0 10 20 40 30 0
weeks

Find the optimal number of items to be produced per week by the company
Example – 2.3 Decision under Risk - Expected pay-off

Cost of production = Rs. 25

Selling price = Rs. 30
Profit if it is sold the same week = 30-25 Rs. 5
Disposal price if unsold = Rs.20
Loss if an item is unsold = 25-20 = Rs. 5

Conditional loss (Regret) table

Strategy make
Sales Probability 4 5 6 7
4 0.1 Rs. 4x5 = 20 15 10 5
5 0.2 20 25 20 15
6 0.4 20 25 30 25
7 0.3 20 25 30 35
Example – 2.3 Decision under Risk - Expected pay-off
Strategy make
Sales Probability 4 5 6 7
4 0.1 Rs. 4x5 = 20 15 10 5
5 0.2 20 25 20 15
6 0.4 20 25 30 25
7 0.3 20 25 30 35
Strategy and Expected Profit
Sales Probability 4 5 6 7
4 0.1 20x0.1= 2 15x0.1= 1.5 10x0.1= 1 5x0.1= 0.5
5 0.2 20x0.2= 4 25 x0.2= 5 20x0.2= 4 15x0.2= 3
6 0.4 20x0.4= 8 25x04= 10 30x0.4 =12 25x0.4= 10
7 0.3 20x0.3 = 6 25x0.3= 7.5 30x0.3= 9 35x0.3=10.5
20 24 26 24
Maximum items to be produced are 6
Example – 2.4 Decision under Risk - Expected Opportunity Loss (EOL)

A small perishable goods making company finds from the past data that the cost of
making an item is Rs.25, the selling price of the item is Rs. 30, if it is sold within a week ,
and unsold items can be disposed off at Rs 20 per item at the end of the week. Frequency
of weekly sales is given below
Weekly <3 4 5 6 7 >8
sales
No of 0 10 20 40 30 0
weeks

Find how many items should be produced to minimise the expected opportunity loss
for the company
Conditional (opportunity) loss table
Strategy and Expected Profit
Sales Probability 4 5 6 7
4 0.1 20-20 =0 20 -15 = 5 20-10 = 10 20 - 5= 15
5 0.2 25-20= 5 25-25= 0 25-20= 5 25 - 15= 10
6 0.4 30-20 =10 30 -25 = 5 30 -30 = 0 30 - 25= 5
7 0.3 35-20 = 15 35 - 25= 10 35 – 30 = 5 35 - 35= 0
Expected loss table
Strategy and Expected Profit
Sales Probability 4 5 6 7
4 0.1 0x0.1 = 0 5x0.1= 0.50 10x0.1 =1 15x0.1=1.5
5 0.2 5x0.2 = 1 0x0.2 = 0 5x0.2 =1 10x0.2 = 2
6 0.4 10x0.4 = 4 5x0.4 = 2 0x0.4 =0 5x4 =2
7 0.3 15x0.3 = 4.5 10x0.3 = 3 5x0.3= 1.5 0x0.3
EOL 9.50 5.5 3.50 5.5
The optimum stock position that minimises the opportunity loss 3.50 is making 6 items
Incremental or Marginal Analysis
 For every additional unit purchased will be either sold or remain unsold.
 If p is probability of selling the additional unit and then (1-p) will be the probability of
not selling
 If an additional unit is sold, the conditional profit (CP) will increase and this is termed
as incremental profit (IP) or marginal profit
 If additional unit is not sold CP reduces this is termed as Incremental Loss (IL)

 Additional unit should be put in stock if IP from stocking each item is > IL
 Thus a unit should be stocked to the limit where probability
• p x IP = (1-p) IL
𝐼𝑃 1−𝑝
• =
𝐼𝐿 𝑝
𝐼𝑃 1
• = - 1
𝐼𝐿 𝑝
𝐼𝑃 1
• 1+ =
𝐼𝐿 𝑝
𝐼𝐿
• p =
𝐼𝐿+𝐼𝑃
Incremental or Marginal Analysis
𝐼𝐿
p =
𝐼𝐿+𝐼𝑃
• P is minimum required probability of selling at least one additional unit to justify the
stocking.
• So additional unit should be stocked to the point the probability of selling at-least one
additional unit is greater than p
example 2.4 - Daily demand for multi grain bread at a grocery shop is given by the
following probability distribution

Daily 100 150 200 250 300 350 400

demand
probability 0.2 0.25 0.30 0.1 0.05 0.05 0.05

If a piece of bread is not sold the same day, it becomes useless. The shop is selling the
bread at Rs 31 and the purchase cost of the bread is Rs.25 If each day’s demand is
independent of previous day’s demand, how many breads should be ordered everyday.
Incremental or Marginal Analysis
example 2.4 - Daily demand for multi grain bread at a grocery shop is given by the
following probability distribution
Daily 100 150 200 250 300 350 400
demand
probability 0.2 0.25 0.30 0.1 0.05 0.05 0.05

IP = (31 – 25) = Rs. 6 p =

𝐼𝐿
IL = (25 – 0) = 25 𝐼𝐿+𝐼𝑃

= 25 / 25 + 6 = 0.8
It implies that to justify the stocking of one additional bread, there must be at least 0.8
cumulative probability of selling that unit.
Incremental or Marginal Analysis
Daily 100 150 200 250 300 350 400
demand
probability 0.2 0.25 0.30 0.1 0.05 0.05 0.05
It implies that to justify the stocking of one additional bread, there must be at least 0.8
cumulative probability of selling that unit.
Sales units Probability of sales Cumulative probability that sales will be at the level or higher
100 0.2 1.00
150 0.25 0.80
200 0.30 0.55
250 0.1 .25
300 0.05 0.15
350 0.05 0.10
400 0.05 0.05
The shop keeper should keep 150 pieces of bread. This is the optimum number
Multi-Stage or Sequential Decision Making Problems (Decision Tree)
 Decision tree or the decision flow diagram is the most effective tool for multistage
decision making

 In analysis of multiple stage decision situations, we have to evaluate the decision

proceeding in backward manner to evaluate the best course of action at the later stage to
decide the best action at the earlier stage.
Spoiled refreshments, Damp guests, unhappiness

Very pleasant party, Distinct comfort

Birthday
Party
Crowded but dry, happy feeling,

= Decision Point
Crowded, hot, un-happy feeling,
regret decision = Chance even
Example 3 Multi-Stage or Sequential Decision Making Problems (Decision Tree)
It is 9.30 am Anil has just missed the bus for his 10.00 am test.
the next bus is scheduled to arrive in 10 minutes and it takes exactly 20 minutes to the
destination. However there is 0.20 chance that the bus will be 5mts early and 0.30 chance that
it will be late by 5 minutes.

If he walks, there is 0.8 chance that he will get to the test in 30 minutes and 0.2 chance to
reach in 35 minutes

If he takes his bike he will reach in 25 minutes with probability of 0.50 and 30 minutes with
probability of 0.40 and with a 0.1 probability of having flat tyre and reaching in 45 minutes

If Anil drives his car it will take 15 minutes to reach but time needed to park his car and get
to the test has the probability of 0.3 for 10 minutes, 0.45 for 15 minutes and 0.15 for 20
minutes and 0.10 for 25 minutes

Determine his best option assuming that his house is in front of the bus stop.
Example 3 Multi-Stage or Sequential Decision Making Problems (Decision Tree)

Expected time
a). 0.2 x 25 +0.3 x35 + 0.5 x30 = 30.50 min.

a 0.5 b). 0.8 x30 + 0.2x 35 = 31 minutes

c). 0.5 x 25 + 0.4x 30 + 0.1 x 45 = 29

Reach for walk d). 0.3x 25+0.45 x 30+ 0.15 x 35 + 0.1 x 40
test b = 30.25

c 0.4
d
Example 4 Decision Analysis

A businessman has two independent investments A and B available to him but he lacks the
capital to undertake both of them simultaneously.
He can chose to take A first then stop or if A is successful then take B or vice versa. The
probability of success of A is 0.7 while for B it is 0.4.
Both investments need an initial capital of Rs.200,000 both return nothing if the venture is
unsuccessful.
On successful completion of A will return 300,000 lakhs and successful completion of B
will return 500,00
Draw the decision tree and determine the best strategy.
 Example 4 Multi-Stage or Sequential Decision Making Problems (Decision Tree)
200,000
Fail 0.6
Z - 200,000
200,000
Success 0.7 Stop
X Y
300,000

two independent investments A and B available to him but he lacks the

Investments capital to undertake both of them simultaneously.
He can chose to take A first then stop or if A is successful then take B or
vice versa. The probability of success of A is 0.7 while for B it is 0.4
Both investments need an initial capital of Rs.200,000 both return
nothing if the venture is unsuccessful.
P
On successful completion of A will return 300,000 lakhs and successful
completion of B will return 500,00
Draw the decision tree and determine the best strategy.
 Example 4 Multi-Stage or Sequential Decision Making Problems (Decision Tree)
80,000
Fail 0.6
Z - 200,000
200,000
Success 0.7 Stop
X Y
300,000
(300,000 + 80,000)
= 380,000
Investments

Roll Back or Fold back

End of Market Value (EMV) / Residual Value
(0.4 X 500,000) (-) (0.6 X 200,000) = 80,000
P
80,000 Plus 300,000 on successful completion of A
Y = 380,000
Net EMV = (0.7 x 380,000) (–) (0.3x200,000) = 206,000
 Example 4 Multi-Stage or Sequential Decision Making Problems (Decision Tree)
80,000
Fail 0.6
Z - 200,000
200,000
Success 0.7 Stop
X Y
300,000
380,000
Q
Investments
Q

P (500,000 + 150,000)
= 650,000
Roll Back or Fold back B
200,000
End of Market Value (EMV) / Residual Value
(0.7 X 300,000) - (0.3 X 200,000) = 150,000

150,000 Plus 500,000 on successful completion of b

= 650,000
Net EMV = (0.4 x 650,000) – (0.6x200,000)
= 140,000
 Example 4 Multi-Stage or Sequential Decision Making Problems (Decision Tree)
80,000
Solution :Start with A Fail 0.6
and Proceed to B Z - 200,000
200,000
Success 0.7 Stop
X Y
300,000
380,000
Q
Investments
Q

P 600,000

200,000 Roll Back or Fold back B

Roll Back or Fold back A
End of Market Value (EMV) / Residual Value
(0.4 X 500,000) + (0.6 X 200,000) = 80,000
80,000 Plus 300,000 on successful completion of A = 380,000
Net EMV = (0.7 x 380,000) – (0.3x200,000) = 206,000
End of Market Value (EMV) / Residual Value
(0.7 X 300,000) - (0.3 X 200,000) = 150,000
150,000 Plus 500,000 on successful completion of B
Q = 650,000
Net EMV = (0.4 x 650,000) – (0.6x200,000)
= 140,000