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Decision Theory: IDS 355 FALL 2015
Decision Theory: IDS 355 FALL 2015
Decision Theory: IDS 355 FALL 2015
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
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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
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Decision Theory Problem Structure
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Simplifying Assumptions
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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
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Maximax
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Maximin
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Laplace
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Minimax Regret
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Example: Minimax Regret
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Decisions Under Risk
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Expected Monetary Value
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Expected Monetary Value
Expected Value of Perfect Information
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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”
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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
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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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