UNIT FOUR

Decision theory/analysis
Introduction
The success or failure that an individual or organization experiences, depends to a large extent on the
ability of making appropriate decisions. Making of a decision requires an enumeration of feasible and
viable alternatives (courses of action or strategies), the projection of consequences associated with
different alternatives and a measure of effectiveness (or an objective) by which the most preferred
alternative is identified.
4.1. Characteristics of Decision Theory
Decision theory problems are characterized by the following:
1. List of alternatives: are a set of mutually exclusive and collectively exhaustive decisions that are
available to the decision maker (sometimes, not always, one of these alternatives will be to “do
nothing”.)
2. States of nature: - the set of possible future conditions, or events, beyond the control of the
decision maker, that will be the primary determinants of the eventual consequence of the
decision. The states of nature, like the list of alternatives, must be mutually exclusive and
collectively exhaustive.
3. Payoffs: - the payoffs might be profits, revenues, costs, or other measures of value. Usually the
measures are financial. Usually payoffs are estimated values. The more accurate these estimates,
the more useful they will be for decision making purposes and the more likely, it is that the
decision maker will choose an appropriate alternative. The number of payoffs depends on the
number of alternative/state of nature combination.
4. Degree of certainty: - the approach often used by a decision maker depends on the degree of
certainty that exists. There can be different degrees of certainty. One extreme is complete
certainty and the other is complete uncertainty. The later exists when the likelihood of the various
states of nature are unknown. Between these two extremes is risk (probabilities are unknown for
the states of nature). Knowledge of the likelihood of each of the states of nature can play an
important role in selecting a course of active.
5. Decision criteria: - the decision maker’s attitudes toward the decision as well as the degree of
certainty that surrounds a decision. Example; maximize the expected payoffs.

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 4.2 TYPES OF DECISION MAKING ENVIRONMENTS
Decisions are made based upon the data available about the occurrence of events as well as the decision
situation (or environment). There are three types of decision-making environment: Certainty, uncertainty
and risk
4.2.1 DECISION MAKING UNDER CERTAINTY
In this case, the decision-maker has the complete knowledge (perfect information) of consequence of
every decision choice (course of action or alternative) with certainty. Obviously, he will select an
alternative that yields the largest return (payoff) for the known future (state of nature).
The simplest of all circumstances occurs when decision making takes place in an environment of
complete certainty. When a decision is made under conditions of complete certainty, the attention of the
decision maker is focused on the column in the payoff table that corresponds to the state of nature that
will occur. The decision maker then selects the alternative that would yield the best payoff, given that
state of nature.
EXAMPLE
The following payoff table provides data about profits of the various states of nature/alternative
combination.
S1 S2 S3
A1 4 16 12
A2 5 6 10
A3 -1 4 15

If we know that S2 will occur, the decision maker then can focus on the first row of the payoff table.
Because alternative A1 has the largest profit (16), it would be selected. If we know that S1 will occur, the
decision maker then can focus on the second row of the payoff table. Because alternative A2 has the
largest profit (5), it would be selected. If we know that S3 will occur, the decision maker then can focus
on the third row of the payoff table. Because alternative A3 has the largest profit (15), it would be
selected.
4.2.2 DECISION MAKING UNDER UNCERTAINTY.
Under complete uncertainty, the decision maker either is unable to estimate the probabilities for the
occurrence of the different state of nature, or else he or she lacks confidence in available estimates of
probabilities, and for that reason, probabilities are not included in the analysis.
A decision making situation includes several components- the decision themselves and the actual event
that may occur future, known as state of nature. At the time the decision is made, the decision maker is
uncertain which state of nature will occur in the future, and has no control over them.

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Decisions made under these circumstances are at the opposite end of the spectrum from the certainty case
just mentioned. Once the decision has been organized in to a payoff table, several criteria are available
making the actual decision. There are several approaches (criteria) to decision making under complete
uncertainty. Some of these discussed in this section include: maximax, maximin,minimax regret, and
equal likelihood.
MAXIMAX
With the maiximax criterion, the decision maker selects the decision that will result in the maximum of
the maximum payoffs. (In fact this is how this criterion derives its name- maximum of maximum). The
maximax is very optimistic. The decision maker assumes that the most favorable state of nature for each
decision alternative will occur. For example, the investor would optimistically assume that good
economic conditions will prevail in the future. The best payoff for each alternative is identified, and the
alternative with the maximum of these is the designated decision.
For the previous problem:
S1 S2 S3 Row Maximum
A1 4 16 12 16*maximum
A2 5 6 10 10
A3 -1 4 15 15

Decision: A1 will be chosen.

Note: If the payoff table consists of costs instead of profits, the opposite selection would be indicated:
The minimum of minimum costs. For the subsequent decision criteria we encounter, the same logic in the
case of costs can be used.
Maximin Criteria
This approach is the opposite of the previous one, i.e. it is pessimistic. This strategy is a conservative one;
it consists of identifying the worst (minimum) payoff for each alternative, and, then, selecting the
alternative that has the best (maximum) of the worst payoffs. In effect, the decision maker is setting a
floor on the potential payoff by selecting maximum of the minimum; the actual payoff cannot be less than
this amount. It involves selecting best of the worst.
For the previous problem:
S1 S2 S3 Row minimum
A1 4 16 12 4
A2 5 6 10 5*maximum
-1 4 15 -1

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 A3
Decision: A2 will be chosen.
Note: If it were cost, the conservative approach would be to select the maximum cost for each decision
and select the minimum of these costs.
MINIMAX REGRET
Both the maximax and maximin strategies can be criticized because they focus only on a single, extreme
payoff and exclude the other payoffs. Thus, the maximax strategy ignores the possibility that an
alternative with a slightly smaller payoff might offer a better overall choice. For example, consider this
payoff table: A similar example could be constructed to demonstrate comparable weaknesses of the
maximin criterion, which is also due to the failure to consider all payoffs.
An approach that does take all payoffs in to consideration is minimax regret. In order to use this
approach, it is necessary to develop an opportunity loss table. The opportunity loss reflects the difference
between each payoff and the best possible payoff in a column (i.e., given a state of nature). Hence,
opportunity loss amounts are found by identifying the best payoff in a column and, then, subtracting each
of the other values in the column from that payoff. Therefore, this decision avoids the greatest regret by
selecting the decision alternative that minimizes the maximum regret.
EXAMPLE:
S1 S2 S3
A1 4 16 12
A2 5 6 10
A3 -1 4 15

opportunity loss table:

S1 S2 S3
A1 5-4=1 16-16=0 15-12=3
A2 5-5=0 16-6=10 15-10=5
A3 5-(-1)=6 16-4=12 15-15=0

The values in an opportunity loss table can be viewed as potential “regrets” that might be suffered as
the result of choosing various alternatives. A decision maker could select an alternative in such a way
as to minimize the maximum possible regret. This requires identifying the maximum opportunity loss
in each row and, then, choosing the alternative that would yield the best (minimum) of those regrets.
S1 S2 S3 Max. Loss
A1 5-4=1 16-16=0 15-12=3 3*minimum
A2 5-5=0 16-6=10 15-10=5 10
5-(-1)=6 16-4=12 15-15=0 12
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 A3

Decision: A1 will be chosen

PRINCIPLE OF INSUFFICIENT REASON/ Equal likelihood/ average
The Minimax regret criterion’s weakness is the inability to factor row differences. Hence, sometimes the
minimax regret strategy will lead to a poor decision because it ignores certain information.
The principle of insufficient reason offers a method that incorporates more of the information. It treats the
states of nature as if each were equally likely, and it focuses on the average payoff for each row, selecting
the alternative that has the highest row average.
EXAMPLE
S1 S2 S3 S4 S5 Row Average
A1 28 28 28 2 4 23.2*maximum
A2 8
A3 5 5 5 5 28 9.6
5 5 5 5 28 9.6

Decision: A1 is selected
The basis for the criterion of insufficient reason is that under complete uncertainty, the decision maker
should not focus on either high or low payoffs, but should treat all payoffs (actually, all states of nature),
as if they were equally likely.
Example two
A food products company is contemplating the introduction of a revolutionary new product with new
packaging or replace the existing product at much higher price (S 1) or a moderate change in the
composition of the existing product with a new packaging at a small increase in price (S 2) or a small
change in the composition of the existing product except the word “New” with a negligible increase in
price (S3). The three possible states of nature or events are: (i) high increase in sales (N1), (ii) no change
in sales (N2) and (iii) decrease in sales (N3). The marketing department of the company worked out the
payoffs in terms of yearly net profits for each of the strategies of three events (expected sales). This is
represented in the following table:

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Avarage approach

4.2.3 DECISION MAKING UNDER RISK

Decision making under risk is a probabilistic decision situation, in which more than one state of nature
exists and the decision-maker has sufficient information to assign probability values to the likely
occurrence of each of these states. Knowing the probability distribution of the sates of nature, the best
decision is to select that course of action which has the largest expected payoff value.
It is often possible for the decision maker to know enough about the future state of nature to assign
probabilities to their occurrences. The term risk is often used in conjunction with partial uncertainty,
presence of probabilities for the occurrence of various states of nature. The probabilities may be
subjective estimates from managers or from experts in a particular field, or they may reflect historical
frequencies. If they are reasonably correct, they provide the decision maker with additional information
that can dramatically improve the decision making process.
Given that probabilities can be assigned, several decision criteria are available to aid the decision maker.
Some of these are discussed below.
EXPECTED MONETARY VALUE (EMV)
The EMV approach provides the decision maker with a value which represents an average payoff for each
alternative. The best alternative is, then, the one that has the highest EMV. To calculate the EMV for each

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course of action by multiplying the conditional payoff by the associated probabilities and add these
weighted values for each course of action.
The average or expected payoff of each alternative is a weighted average:
k
EMVi = Σ Pj.Vij
i=1
Where:
EMVi = the EMV for the ith alternative
Pi = the probability of the ith state of nature
Vij = the estimated payoff for alternative i under state of nature j.
Note: the sum of the probabilities for all states of nature must be 1.
EXAMPLE:
Probability 0.20 0.50 0.30
S1 S2 S3 Expected payoff
A1 4 16 12 4x0.2+16x0.5+12x0.3=12.40*maximum
A2 5 6 10 5x0.2+6x0.5+10x0.3= 7
A3 -1 4 15 -1x0.2+4x0.5+15x0.3= 6.30

Decision: A1 will be chosen.

EXPECTED OPPORTUNITY LOSS (EOL)
The table of opportunity loss is used rather than a table of payoffs. Hence, the opportunity losses for each
alternative are weighted by the probabilities of their respective state of nature to compute a long run
average opportunity loss, and the alternative with the smallest expected loss is selected as the best choice.
The opportunity lost for the above table will
Probability 0.20 0.50 0.30
S1 S2 S3
A1 5-4=1 16-16=0 15-12=3

A2 5-5=0 16-6=10 15-10=5

5- (-1)=0 16-4=12 15-15=0

EOL (A1) = 0.20(1) + 0.50(0) + 0.30(3) = 1.10 *minimum

EOL (A2) = 0.20(0) + 0.50(10) + 0.30(5) = 6.50
EOL (A3) = 0.20(6) + 0.5+ 0.30(0) = 7.20

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Note: The EOL approach resulted in the same alternative as the EMV approach
(Maximizing the payoffs is equivalent to minimizing the opportunity losses).
EXPECTED VALUE OF PERFECT INFORMATION (EVPI)
It can sometimes be useful for a decision maker to determine the potential benefit of knowing for certain
information which state of nature is going to prevail. The EVPI is the measure of the difference between
the certain payoffs that could be realized under a condition involving risk.
If the decision maker knows that S1 will occur, A2 would be chosen with a payoff of $5. Similarly for S2
$16 (for A1) and for S3, $15 (with A3) would be chosen.
Hence, the expected payoff under certainty (EPC) would be:
EPC = 0.20(5) + 0.50(16) + 0.30(15) = 13.50
The difference between this figure and the expected payoff under risk (i.e., the EMV) is the expected
value of perfect information. Thus:
EVPI = EPC – EMV
= 13.50 – 12.40 = 1.10
Note: The EVPI is exactly equal to the EOL. The EOL indicates the expected opportunity loss due to
imperfect information, which is another way of saying the expected payoff that could be achieved by
having perfect information.

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