Decision Theory

IDS 355
FALL 2015
 Learning Objectives
 What is a Business Decision/
 Decisions and Lack of Knowledge
 Decision Theory Elements
 Decision Theory Problem Structure
 Decision Models
 Decision Models Under Uncertainty: maximax, maximin, Laplace, minimax regret
 Decision Models Under Risk
 Expected Monetary Value (EMV)
 Expected Value of Perfect Information (EVPI)
 Decision Trees
Business Decisions

 Business decision process:

 Propose set of potential actions
 Gather & process data:
 Internal
 External
 Identify variables affecting outcomes
 Estimate outcomes
 Pursue best course of action
 Businesses need:
 A framework for decision-making
 Estimation models
 Criteria for comparing outcomes

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Lack of Knowledge

 Businesses typically do not have all the information they need to make an
informed decision
 Purely rational evaluation under perfect knowledge doesn’t happen
 Diminishing marginal returns:
 More data = greater expenses
 Older data = less relevance
 Consequences: Bounded rationality, satisficing
 But, imperfect knowledge >> complete ignorance!
 Decision theory provides a structured approach for evaluating potential actions
under varying degrees of lack of knowledge

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Decision Theory Elements

 Decisions and alternatives:

 Each decision is a single (but often complex) variable
 Alternatives are mutually exclusive
 Events (states of nature)
 Each event is a single variable
 May include associated probabilities
 How much detail is enough?
 Payoffs (outcomes)
 One payoff per {decision alternative, state of nature} pair
 Represents expected value
 Discuss: Payoff estimation models

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Decision Theory Problem Structure

 Typical problems might involve:

 Decision to add capacity vs. future demand
 Product mix vs. factor affecting demand
 Our strategy vs. competitor’s strategy
 Two-variable problems produce a two-dimensional matrix
 Decision alternatives are the rows
 States of nature are the columns
 Discuss: Multi-variate states of nature

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Simplifying Assumptions

 Small set of alternatives

 Small set of states of nature
 All payoffs known
 Consequently, no scope for variance regarding:
 Variable success in strategy execution
 Variable effect of state of nature
 Effects from variables outside the model

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Decision Models

 Uncertainty:
 Probabilities of states of nature are unknown
 Discuss: Implications for building the decision model
 What states to include
 What states to exclude
 Risk:
 Probabilities of states of nature are known
 Obtained from:
 Historical data
 Predictive models

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Decisions Under Uncertainty

 Decision theory offers some bounds on decision outcomes even if the distribution of
states of nature are totally unknown, such as:
 Opaque competitor strategy
 Introduction of revolutionary products,
 Entering into different markets
 Four criteria:
 Maximax: MAXimize the MAXimum payoff
 Maximin: MAXimize the MINimum payoff
 Laplace: Maximize average payoff
 Minimax regret: MINimize the MAXimum regret
 Let’s consider a capacity problem:

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Example Problem

 We have options for changing capacity:

 Do nothing, add small facility, or add large facility
 More capacity = higher fixed costs
 Lower capacity = higher variable costs
 Compare production potential against possible demand

Capacity Low Demand Medium Demand High Demand

Don’t add $3m $4m $5m

Add small $1m $5m $8m

Add large ($3m) $3m $13m

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Maximax

 Rule: Choose alternative with the highest possible payoff

 Typically quite risky since all other payoffs are ignored!

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Maximin

 Rule: Choose alternative that maximizes the minimum payoff

 Process:
 For each alternative, identify its worst case
 Select the alternative with the best outcome for its worst case
 Risk-averse since it only considers the worst outcomes

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Laplace

 Rule: Choose alternative with highest outcome average

 Process:
 For each alternative, take the average of its outcomes
 Select alternative with highest average
 Shortcut: Select the alternative with the highest sum of outcomes
 Risk profile: Maximax > Laplace > Maximin

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Minimax Regret

 Rule: Choose alternative with lowest maximum regret

 Regret: The loss of payoff for not having chosen the best alternative when a
particular state of nature occurred
 Regret = zero if the best alternative was chosen
 Regret > zero otherwise
 Process:
 Construct “table of regrets” with one regret per payoff
 Find highest regret for each alternative
 Select alternative with the lowest value for its highest regret

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Example: Minimax Regret

Table of regrets: Find the worst regret for each alternative

For the minimax regret criterion, we would choose “add small”

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Decisions Under Risk

 Compared to uncertainty, knowing the outcome distribution for decision

alternatives enables more accurate estimation
 Most business decisions are made under risk
 Probabilities are considered known
 Yet, this knowledge may be outdated or otherwise inaccurate
 More accurate probability estimation is also valuable!
 We consider:
 Expected monetary value (EMV): The expected outcome for a particular decision
alternative
 Expected value of perfect information (EVPI): The extra value from knowing which
state of nature will actually occur

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Expected Monetary Value

 Rule: Choose the alternative with the highest expected value

 Process: Find the weighted average for each alternative and choose the highest
one.
 Assume probabilities: low = 30%, medium = 40%, high = 30%

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Expected Monetary Value
Expected Value of Perfect Information

 Core concept: Expected outcomes are bounded by distribution of states of nature

 Best possible outcome: We know the future state of nature and choose the best
alternative for it
 Then, expected outcome = weighted average of best outcomes for each state of nature
 Corollary: There exists some upper bound on the value of acquiring new information
about future states of nature
 The expected value of perfect information is that upper bound

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Expected Value of Perfect Information

 Mathematical Definition:
 Given e, expected monetary value knowing the distribution of future states of nature
 Given w, weighted sum of best outcomes for each state of nature
 Expected value of perfect information = w – e
 Bounds:
 Without knowing the future, e can be achieved
 Achieving better than w is not possible for a given distribution
 Better information about the future can push results above e toward w but no higher

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Example: Expected Value of Perfect
Information
 We already know the highest EMV is $4.7 for “add small”

Capacity Low Medium High Weighted Average

Demand Demand Demand
(30%) (40%) (30%)
Don’t add $3m $4m $5m
Add small $1m $5m $8m $4.7m
Add large ($3m) $3m $13m
Best possible $3m $5m $13m =0.3($3m) + 0.4($5m) + 0.3($13m)
= $0.9m + $2m + $3.9m = $6.8m

 Our best possible expected outcome is $6.8m

 Expected value of perfect information = $6.8m - $4.7m = $2.1m

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Decision Trees

 Decision trees:
 Present EMV problems in easily understood visual format, especially for multiple, sequential
decisions
 Facilitate checking for structural problem errors
 Elements of decision trees:
 Decisions: Where a decision alternative can be chosen
 Events: Where a random state of nature occurs
 Branches: Connect decisions and events
 Payoffs: Can be included at the end of a sequence as well as at intermediate steps
 Typical structure:
 Decision, then event (same as our EMV capacity example)
 Discuss: What happens if decisions & events are not ordered chronologically?

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Example: Decision Tree

 A manufacturer is considering switching vendors to get higher quality inputs.

After substantial research, we have gathered the following information:
 Cost of breaking contract with existing vendor is $1m
 Distribution of potential payoffs after switching:
 70%: $2.5m
 30%: $0.5m
 Alternately, we can ask the current vendor to improve quality, with distribution of
potential payoffs:
 50%: $0
 50%: $1.6m
 Based on expected payoffs, should the manufacturer switch?

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Example: Decision Tree (cont’d)

 At each decision, we select the alternative with the best expected outcome
 At each event, we find the weighted average of the payoffs

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