Decision Theory

DECISION UNDER UNCERTAINTY

Basic Concepts
This model satisfies the following conditions:
1. The payoff for each alternative is known.
2. There are a few states of nature.
3. Probability of occurrence of each state of nature is unknown.
5 Criteria
1) Criterion of Optimism (Maximax criterion & Minimin criterion)

2) Criterion of Pessimism | Wald Criterion (Maximin Criterion)

3) Hurwicz Criterion | Criterion of Realism (Maximization Problem & Minimization Problem)

4) Laplace Criterion | Equal Probability | Rationality | Bayes’ Criterion

5) Minimax Regret Criterion | Savage Criterion (Maximization Problem & Minimization Problem)
 Example: Nestle I
Mary is the Market Analyst of Nestle and she is asked to present an expansion plan for the
company to the senior managers, which is either to construct a plant, open a distribution
center, or do nothing. She was able to determine the expected payoff depending on the
decision and the type of market, which may be favorable, average, or unfavorable to the
business. If the decision is to construct a new plant, the company will gain $8000 if the market
turns out to be favorable, lose $1000 if the market turns out to be average and lose $5000 if
the market turns out to be unfavorable. If the decision is to open a distribution center, the
company will gain $4000 if the market is tuns out to be favorable, gain $2000 if the market
turns out to be average and lose $3000 if the market turns out to be unfavorable. If the
decision is to do nothing, the company will gain nothing whether the market turns out to be
favorable, average or unfavorable.
Mary noted that the decision of each manager is affected by bis or her personality. She
described each manager as follows:
Example: Nestle I
1. Edward is an optimistic person.
2. Agnes is very conservative.
3. William thinks there is 75% chance that the market is favorable.
4. Jane thinks that each type of market has an equal chance of occurring.
5. Joel does not want to regret making a wrong decision.

What would be the decision of each manager? How much gain or lose for the
company would each expect? Which alternative is most likely to be chosen by
most managers?
Example: Nestle I
Payoff Summary
Type of Market
Expansion Plan Payoff
($000) Favorable Average Unfavorable
Construct a Plant 8 -1 -5
Open a Distribution
4 2 -3
Center
Do nothing 0 0 0

Criterion of Realism 0.75