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9.decision Theory
9.decision Theory
9.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.
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
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.
Since annual demand varies between 18 and 23 copies, there are six possible events.
Since annual demand varies between 18 and 23 copies, there are six possible events.
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
A1 18 A2 19 A3 20 A4 21 A5 22 A6 23
A1 18 A2 19 A3 20 A4 21 A5 22 A6 23
A1 18 A2 19 A3 20 A4 21 A5 22 A6 23
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.
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
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
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
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
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
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
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
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
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
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
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
= 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
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.
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
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
P 600,000