Chapter 5. Decision Theory.

5. DECISION THEORY.

5.1. INTRODUCTION OF THE DECISION THEORY.

5.1.1. DEFINITIONS. Decision Theory is an analytic and systematic approach to studying decision making. What Makes the Differences between BAD & GOOD DECISION? A GOOD DECISION is one that is based on logic, considers on available data and possible alternatives, and applied the quatitative approach. Occasionally, a good decision results is an unexpected or unfavorable outcome. A BAD DECISION is one that is not based on logic, does not use all available information, does not consider all alternatives , and does not employ appropriate quantitative techniques. If you make a bad decision, but are lucky and a favorable outcome occurs, you still have l make a bad decision. Managers make many decisions. Although occasionally good decisions yield bad results, in the long run, using decision theory will result in successful outcomes. 5.1.2. 1. 2. 3. 4. THE SIX STEPS IN DECISION THEORY.

Clearly Define The Problem. List The Possible Alternatives. Indentify The Possible Outcomes. List The Payoff or profit of each combination of Alternatives & Outcomes. 5. Select one of The Mathematical Decision Theory Models. 6. Apply The Model and Make your Decision.

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Chapter 5. Decision Theory.

5.1.3.

TYPES OF DECISION MAKING ENVIRONMENTS.

Type 1. Decision making under Certainty. Type 2. Decision making under Risk. Type 3. Decision making under Uncertainty.

5.1.4. DECISION MAKING UNDER RISK. Decision Making under risk is a probability decision situation. Several possible states of nature may occur, each with a given probability. In this section, we consider one of the most popular methods of making decisions under risk, namely, selecting the alternative with the highest expected monetary value. EXPECTED MONETARY VALUE (EMV). FORMULAE.
EMV(Alternative i) =

(Payoff(state

j) * Prob(X=xj)

EXEMPLE 1. We have the following Decision Table:

ALTERNATIVES STATES OF FAVORABLES MARKET NATURE UNFAVORABLE MARKET

A1. Large facility A2. Small facility A3. Do nothing

PROBABILITIES

200 100 0
0.5

-180 - 20 0
0.5

EMV 10 40 0

Select decision = A 2 DEFINITION. EVPI (Expected Value of Perfect Information) is defined as following: EVPI = Best Outcome for State i* P[X=xi] - EMV From the above example, we have: EVPI = 200/2 +0/2 - 40 = 60. Thus the most Thompson would be willing to pay for perfect information is 60$.

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Chapter 5. Decision Theory.

OPPORTUNITY LOSS. An alternative approach to maximizing expected monetary value (EMV) is to minimize EXPECTED OPPORTUNITY LOSS (EOL). Opportunity loss, sometimes called regret, refers to the difference between the optimal profit or payoff and the actual payoff received. METHOD FOR CALCULATING THE EOL. STEP 1. Create the Opportunity Loss Table (OL). FORMULAE. OL(Alter. j, State i) = Best Outcome of State i - Actual Outcomes STEP 2. Compute The EOL by the following Formulae: EOL(Alternative j) = OL(Alternative j,State i)* P[X=xj] For the above example, we have The OL Table as follows:
ALTERNATIVES STATES OF FAVORABLES MARKET NATURE UNFAVORABLE MARKET

A1. Large facility A2. Small facility A3. Do nothing

PROBABILITIES

200 200 =

200 - 100 = 100 200 0.5

0 = 200

0 - (-180) = 180 0 - (- 20) = 20 0 - 0 = 0

0.5

EOL 90 60 100

Select decision = A 2 NOTE. Minimum EOL will always result in the same decision as Maximum EMV, and that The following relationship always hold: EVPI = Min EOL.

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Chapter 5. Decision Theory.

5.1.5. DECISION MAKING UNDER UNCERTAINTY.

When the probability of occurrence of each state of nature cannot be assessed, we can use the following criteria for making the decision: Maximax. Maximin. Minimax. Equally likely. Criterion realism. 5.1.5.1. MAXIMAX. The Maximax Criterion finds the Alternative that maximizes the maximum outcomes or consequence for every alternative. For the above example, we have:
ALTERNATIVES STATES OF FAVORABLES MARKET NATURE UNFAVORABLE MARKET MAX in Row

A1. Large facility A2. Small facility A3. Do nothing

PROBABILITIES

200 100 0
0.5

-180 - 20 0
0.5

200 100 0

Select decision = A 1 5.1.5.2. MAXIMIN. The Maximin Criterion finds the Alternative that maximizes the minimum outcomes or consequence for every alternative. For the above example, we have:
ALTERNATIVES STATES OF FAVORABLES MARKET NATURE UNFAVORABLE MARKET MIN in Row

A1. Large facility A2. Small facility A3. Do nothing

PROBABILITIES

200 100 0
0.5

-180 - 20 0
0.5

-180 - 20 0

Select decision = A 3

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Chapter 5. Decision Theory.

5.1.5.3. MINMAX. The Mimax Criterion based on opportunity loss. Minmax finds the Alternative that minimizes the maximum opportunity loss within each alternative. For the above example, we have:
ALTERNATIVES STATES OF FAVORABLES MARKET NATURE UNFAVORABLE MARKET MAX in Row

A1. Large facility A2. Small facility A3. Do nothing

PROBABILITIES

0 100 200
0.5

180 20 0
0.5

180 100 200

Select decision = A 2 5.1.5.4. EQUALLY LIKELY.

The Equally Criterion finds that Alternative with the highest average outcomes.

For the above example, we have:

ALTERNATIVES STATES OF FAVORABLES MARKET NATURE UNFAVORABLE MARKET AVERAGE

A1. Large facility A2. Small facility A3. Do nothing

PROBABILITIES

200 100 0
0.5

- 180 20 0
0.5

10 40 0

Select decision = A 2

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Chapter 5. Decision Theory.

5.1.5.5. CRITERION REALISM (WEIGHTED AVERAGE = W.A). The criterion is a compromise between an optimistic and a pessimistic decision, with a coefficient of realism a. FORMULAE. W.A = a(Max in Row) + (1-a)(Min in Row) For the above example, we have:
ALTERNATIVES STATES OF FAVORABLES MARKET NATURE UNFAVORABLE MARKET W.A , a=.8

A1. Large facility A2. Small facility A3. Do nothing

PROBABILITIES

200 100 0
0.5

- 180 20 0
0.5

124. 76 0

Select decision = A 1

5.2. TREE DECISION.

5.2.1. DEFINITION.
Any Problem that can be presented in a decision Table can also be graphically illustrated in a decision tree. NOTION: a Decision Node. a State Node. Analyzing Problems with Decision Tree involves five Steps. STEP 1. Define the Problem. STEP 2. Structure or Draw the Decision Tree. STEP 3. Assign Probabilities to the States of Nature. STEP 4. Estimate Payoffs for each Possible combination of alternatives and the States of nature. STEP 5. Calculate EMV for each state.

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Chapter 5. Decision Theory.

For The above example, we have: State of Nature Node Favorable Market EMV(1)=10 Plant
Large

$ PAYOFF 200 - 180

1 Unfavorable Market Favorable Market Unfavorable Market Do Nothing 100 - 20

Small Plant 2 EMV(2)=40

Decision Node

5.2.2.

BAYES S FORMULAE

BAYES S FORMULAE
P P(A\B) = P( B \ A )P(( B \) A )P((BA\)A )P( A ) P A +

where A, B = 2 events, A = the complement of A

EXEMPLE 1. Do not Conduct Survey.

ALTERNATIVES A1. Large facility A2. Small facility A3. Do nothing PROBABILITIES STATES OF NATURE FAVORABLES UNFAVORABLE MARKET (FM) MARKET (UM) 190 -190 90 - 30 0 0 0.5 0.5

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Chapter 5. Decision Theory.

Conduct Market Survey.

STATES OF FAVORABLES MARKET (FM) 190 90 -10 0.7 0.3 NATURE UNFAVORABLE MARKET (UM) -190 - 30 -10 0.2 0.8

ALTERNATIVES A1. Large facility A2. Small facility A3. Do nothing Survey Positive (SP) Survey Negative (SN)

Apply the Bayess formulae, we have: P(FM\Survey positve) =

P( SurveyPositive \ FM )P( FM ) = 0.78 P( S .P \ FM )P( FM ) + P( SP \ UM )P( UM ) P( SurveyPositive \ UM )P( UM ) = 0.22 P( S .P \ FM )P( FM ) + P( SP \ UM )P( UM ) P( SurveyNegative \ FM )P( FM ) = 0.27 P( S .N \ FM )P( FM ) + P( SN \ UM )P( UM ) P( SurveyNegative \ UM )P( UM ) = 0.73 P( S .N \ FM )P( FM ) + P( SN \ UM )P( UM )

P(UM\Survey positve) =

P(FM\Survey negative) =

P(UM\Survey negative) =

P(Survey Result Positive) = P(SP\FM)P(FM) + P(SP\UM)P(UM) =0.45 P(Survey Result Negative)=P(SN\FM)P(FM) + P(SN\UM)P(UM) =0.55

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Chapter 5. Decision Theory.

5.3. EXERCISES.
1. Consider the following profit table, where I.. V are Alternatives, S1, ..,S5 are states of nature. The prior probabilities associated with S1 to S5 are .3, .2, .1, .15 and .25 respectively.
I II III IV V S1 10 17 05 35 45 S2 31 67 45 19 51 S3 11 13 13 09 08 S4 39 22 18 29 40 S5 54 43 32 35 45

Which Alternative maximizes expected monetary value? Which is the best decision if you use the opportunity loss. 2. Suppose the probabilities of occurrence of each state not be assessed. Which is the best decision if you use the following criteria: Maxmax, Maxmin, MinMax, Average. For the above Table. 3. The following payoff matrix indicates the monetary values that would be realized for each of the three alternatives (A 1, A 2, A 3 ) and three states of nature (S1, S2, S3).
A1 A2 A3 Prob, S1 1000 0 -400 .3 S2 -100 0 100 .5 S3 -2000 100 500 .2

3.1. Which Alternative maximizes expected monetary value? 3.2. A market analyst offers to conduct a survey to determine which state of nature migh occur. The result of survey as follows:
Result of Survey Positive Negative S1 .7 .3 S1 900 -100 -500 .3 S2 .2 .8 S2 -200 -100 0 .5 S3 .2 .8 S3 -2100 0 400 .2

A1 A2 A3 Prob,

Determine The Posterior probabilities. Draw a decision tree to represent these situations and find the best strategy.

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