Decision Theory

Statistics for
Business and Economics

6th Edition
Chapter 21
Statistical Decision Theory
Statistics for Business and Economics, 6e 2007 Pearson Education, Inc. Chap 21-1
Chapter Goals
After completing this chapter, you should be
able to:
Describe basic features of decision making
Construct a payoff table and an opportunity-loss table
Define and apply the expected monetary value criterion for
decision making
Compute the value of sample information
Describe utility and attitudes toward risk
Steps in Decision Making
List Alternative Courses of Action

Choices or actions
List States of Nature
Possible events or outcomes
Determine Payoffs
Associate a Payoff with Each Event/Outcome
combination
Adopt Decision Criteria
Evaluate Criteria for Selecting the Best Course
of Action
List Possible Actions or Events
Two Methods
of Listing
Payoff Table Decision Tree
Payoff Table
Form of a payoff table
Mij is the payoff that corresponds to action ai and
state of nature sj
States of nature
Actions s1 s2 ... sH
a1 M11 M12 ... M1H
a2 M21 M22 ... M2H
. . . . .
. . . . .
. . . . .
aK MK1 MK2 ... MKH
Payoff Table Example
A payoff table shows actions (alternatives),
states of nature, and payoffs
Profit in $1,000s
Investment (States of nature)
Choice Strong Stable Weak
(Action) Economy Economy Economy
Large factory 200 50 -120
Average factory 90 120 -30
Small factory 40 30 20
Decision Tree Example
Strong Economy 200
Large factory Stable Economy 50
Weak Economy -120
Strong Economy 90
Average factory Stable Economy 120
Weak Economy -30
Strong Economy 40
Small factory Stable Economy 30
Weak Economy 20
Payoffs
Decision Making Overview
Decision Criteria
No probabilities
known * Nonprobabilistic Decision Criteria:
Decision rules that can be applied
if the probabilities of uncertain
Probabilities events are not known
are known
maximin criterion
minimax regret criterion
The Maximin Criterion
Consider K actions a1, a2, . . ., aK and H possible states of nature
s1, s2, . . ., sH
Let Mij denote the payoff corresponding to the ith action and jth state
of nature
For each action, find the smallest possible payoff and denote the
minimum M1* where
M1* Min(M11,M12 ,,M1H )
More generally, the smallest possible payoff for action ai is given by
Mi* (M11,M12 ,,M1H )

Maximin criterion: select the action ai for which the
corresponding Mi* is largest (that is, the action with the
greatest minimum payoff)
Maximin Example
The maximin criterion
1. For each option, find the minimum payoff
Profit in $1,000s
1.
Investment (States of Nature)
Choice Strong Stable Weak Minimum
(Alternatives) Economy Economy Economy Profit
Large factory 200 50 -120 -120
Average factory 90 120 -30 -30
Small factory 40 30 20 20
Maximin Solution
(continued)
The maximin criterion

1. For each option, find the minimum payoff
2. Choose the option with the greatest minimum payoff
Profit in $1,000s 2.
1.
Choice Strong Stable Weak Minimum
(Alternatives) Economy Economy Economy Profit Greatest
Large factory 200 50 -120 minimum
-120
Average factory 90 120 -30 is to
-30 choose
Small factory 40 30 20 20 Small
factory
Regret or Opportunity Loss
Suppose that a payoff table is arranged as a

rectangular array, with rows corresponding to
actions and columns to states of nature
If each payoff in the table is subtracted from the
largest payoff in its column . . .
. . . the resulting array is called a regret table, or
opportunity loss table
Minimax Regret Criterion
Consider the regret table

For each row (action), find the maximum
regret
Minimax regret criterion: Choose the action
corresponding to the minimum of the
maximum regrets (i.e., the action that
produces the smallest possible opportunity
loss)
Opportunity Loss Example
Opportunity loss (regret) is the difference between an
actual payoff for a decision and the optimal payoff for
that state of nature
Profit in $1,000s Payoff
Investment (States of Nature) Table
Choice Strong Stable Weak
(Alternatives) Economy Economy Economy
The choice Average factory has payoff 90 for Strong Economy. Given
Strong Economy, the choice of Large factory would have given a
payoff of 200, or 110 higher. Opportunity loss = 110 for this cell.
Opportunity Loss
(continued)
Profit in $1,000s Payoff
Choice
Table
Strong Stable Weak
Opportunity Loss in $1,000s

Opportunity Investment (States of Nature)
Choice
Loss Table Strong Stable Weak
Large factory 0 70 140
Average factory 110 0 50
Minimax Regret Example
The minimax regret criterion:
1. For each alternative, find the maximum opportunity
loss (or regret)
Opportunity Loss Table

Opportunity Loss in $1,000s 1.
Choice Maximum
Strong Stable Weak
Op. Loss
Large factory 0 70 140 140

Average factory 110 0 50 110
Small factory 160 90 0 160
Minimax Regret Example
(continued)
The minimax regret criterion:

1. For each alternative, find the maximum opportunity
loss (or regret)
2. Choose the option with the smallest maximum loss
Opportunity Loss Table
Opportunity Loss in $1,000s 1. 2.
Choice Maximum Smallest
Strong Stable Weak
Op. Loss maximum
loss is to
Large factory 0 70 140 140 choose
Average factory 110 0 50 110 Average
Small factory 160 90 0 160 factory
Decision Making Overview
Decision Criteria
No probabilities
known Probabilistic Decision Criteria:
Consider the probabilities of
Probabilities
are known * uncertain events and select an
alternative to maximize the
expected payoff of minimize the
expected loss
maximize expected monetary value
Payoff Table
Form of a payoff table with probabilities
Each state of nature sj has an associated
probability Pi
States of nature
Actions s1 s2 ... sH
(P1) (P2) (PH)
a1 M11 M12 ... M1H
a2 M21 M22 ... M2H
. . . . .
. . . . .
. . . . .
aK MK1 MK2 ... MKH
Expected Monetary Value (EMV)
Criterion
Consider possible actions a1, a2, . . ., aK and H states
of nature
Let Mij denote the payoff corresponding to the ith action
and jth state and Pj the probability of occurrence of the
jth state of nature with H
P 1
j1
j
The expected monetary value of action ai is

H
EMV(ai ) P1Mi1 P2Mi2 PHMiH PjMij
j1
The Expected Monetary Value Criterion: adopt the

action with the largest expected monetary value
Expected Monetary
Value Example
The expected monetary value is the weighted
average payoff, given specified probabilities for
each state of nature
Profit in $1,000s
(States of Nature)
Investment Strong Stable Weak
Choice Economy Economy Economy
(Alternatives) (.3) (.5) (.2) Suppose these
Large factory 200 50 -120 probabilities
have been
assessed for
Small factory 40 30 20 these states of
nature
Expected Monetary Value
Solution
(continued)
Goal: Maximize expected monetary value
Payoff Table:
Profit in $1,000s
(States of nature)
Expected
Choice Values Maximize
Economy Economy Economy
(Action) expected
(.3) (.5) (.2) (EMV)
value by
Large factory 200 50 -120 61 choosing
Average factory 90 120 -30 81 Average
Small factory 40 30 20 31 factory
Example: EMV (Average factory) = 90(.3) + 120(.5) + (-30)(.2)

= 81
Decision Tree Analysis
A Decision tree shows a decision problem,

beginning with the initial decision and ending
will all possible outcomes and payoffs
Use a square to denote decision nodes
Use a circle to denote uncertain events
Add Probabilities and Payoffs
(continued)
Strong Economy (.3) 200
Large factory Stable Economy (.5) 50
Weak Economy (.2) -120
Strong Economy (.3) 90

Average factory Stable Economy (.5) 120
Weak Economy (.2)
-30
Decision Strong Economy (.3) 40

Small factory Stable Economy (.5) 30
Weak Economy (.2)
20
States of nature
Probabilities Payoffs
Fold Back the Tree
EMV=200(.3)+50(.5)+(-120)(.2)=61 Strong Economy (.3) 200
EMV=90(.3)+120(.5)+(-30)(.2)=81 Strong Economy (.3) 90

Weak Economy (.2)
-30
EMV=40(.3)+30(.5)+20(.2)=31 Strong Economy (.3) 40

Weak Economy (.2)
20
Make the Decision
EV=61 Strong Economy (.3) 200

Maximum
EMV=81
Weak Economy (.2)
-30

Weak Economy (.2)
20
Bayes Theorem
Let s1, s2, . . ., sH be H mutually exclusive and collectively
exhaustive events, corresponding to the H states of nature of a
decision problem
Let A be some other event. Denote the conditional probability that
si will occur, given that A occurs, by P(si|A) , and the probability
of A , given si , by P(A|si)
Bayes Theorem states that the conditional probability of si, given
A, can be expressed as
P(A | si )P(si ) P(A | si )P(si )

P(si | A)
P(A) P(A | s1 )P(s1 ) P(A | s2 )P(s 2 ) P(A | sH )P(sH )
In the terminology of this section, P(si) is the prior probability of si

and is modified to the posterior probability, P(si|A), given the
sample information that event A has occurred
Expected Value of
Perfect Information, EVPI
Perfect information corresponds to knowledge of which
state of nature will arise
To determine the expected value of perfect
information:
Determine which action will be chosen if only the prior
probabilities P(s1), P(s2), . . ., P(sH) are used
For each possible state of nature, si, find the
difference, Wi, between the payoff for the best choice
of action, if it were known that state would arise, and
the payoff for the action chosen if only prior
probabilities are used
This is the value of perfect information, when it is
known that si will occur
Expected Value of
Perfect Information, EVPI
(continued)
The expected value of perfect information (EVPI) is
EVPI P(s1)W1 P(s2 )W2 P(sH )WH
Another way to view the expected value of perfect

information
Expected Value of Perfect Information
EVPI = Expected monetary value under certainty
expected monetary value of the best alternative
Expected Value Under Certainty
Profit in $1,000s
Expected (Events)
value under Investment Strong Stable Weak
certainty Choice Economy Economy Economy
(Action) (.3) (.5) (.2)
= expected
value of the
best Small factory 40 30 20
decision,
given perfect Value of best decision
200 120 20
information for each event:
Example: Best decision

given Strong Economy is
Large factory
Expected Value Under Certainty
(continued)
Profit in $1,000s
(Events)
Choice Economy Economy Economy
(Action) (.3) (.5) (.2)
Now weight Average factory 90 120 -30
these outcomes
with their
probabilities to 200 120 20
find the
expected value: 200(.3)+120(.5)+20(.2) Expected
= 124 value under
certainty
Expected Value of
Perfect Information
Expected Value of Perfect Information (EVPI)
EVPI = Expected profit under certainty
Expected monetary value of the best decision
Recall: Expected profit under certainty = 124
EMV is maximized by choosing Average factory,

where EMV = 81
so: EVPI = 124 81

= 43
(EVPI is the maximum you would be willing to spend to obtain
perfect information)
Bayes Theorem Example
Consider the choice of Stock A vs. Stock B

Percent Return
(Events)
Stock Choice Strong Weak Expected
(Action) Economy Economy
Return:
(.7) (.3)
Stock A has a
Stock A 30 -10 18.0
higher EMV
Stock B 14 8 12.2
(continued)
Prior
Probability
Permits revising old
New
probabilities based on new Information
information
Revised
Probability
(continued)
Additional Information: Economic forecast is strong economy

When the economy was strong, the forecaster was correct
90% of the time.
When the economy was weak, the forecaster was correct 70%
of the time.
F1 = strong forecast
F2 = weak forecast Prior probabilities
from stock choice
E1 = strong economy = 0.70 example
E2 = weak economy = 0.30
P(F1 | E1) = 0.90 P(F1 | E2) = 0.30
(continued)
P(F1 | E1) .9 , P(F1 | E2 ) .3

P(E1) .7 , P(E2 ) .3
Revised Probabilities (Bayes Theorem)
P(E1 )P(F1 | E1 ) (.7)(. 9)
P(E1 | F1 ) .875
P(F1 ) (.7)(. 9) (.3)(. 3)
P(E2 )P(F1 | E2 )
P(E2 | F1 ) .125
P(F1 )
EMV with
Revised Probabilities
Pi Event Stock A xijPi Stock B xijPi
.875 strong 30 26.25 14 12.25
.125 weak -10 -1.25 8 1.00
= 25.0 = 11.25
Revised
probabilities
EMV Stock B = 11.25
EMV Stock A = 25.0
Maximum
EMV
Expected Value of
Sample Information, EVSI
Suppose there are K possible actions and H
states of nature, s1, s2, . . ., sH
The decision-maker may obtain sample information.
Let there be M possible sample results,
A1, A2, . . . , AM
The expected value of sample information is
obtained as follows:
Determine which action will be chosen if only the prior
probabilities were used
Determine the probabilities of obtaining each sample
result:
P( Ai ) P( Ai | s1 ) P(s1 ) P( Ai | s2 ) P(s2 ) P( Ai | sH ) P(sH )
Expected Value of
Sample Information, EVSI
(continued)
For each possible sample result, Ai, find the

difference, Vi, between the expected monetary value
for the optimal action and that for the action chosen if
only the prior probabilities are used.
This is the value of the sample information, given that
Ai was observed
EVSI P(A1)V1 P(A 2 )V2 P(AM )VM
Utility
Utility is the pleasure or satisfaction

obtained from an action
The utility of an outcome may not be the same for
each individual
Utility units are arbitrary
Utility
(continued)
Example: each incremental $1 of profit does not

have the same value to every individual:
A risk averse person, once reaching a goal,

assigns less utility to each incremental $1
A risk seeker assigns more utility to each
incremental $1
A risk neutral person assigns the same utility to
each extra $1
Three Types of Utility Curves
$ $ $
Risk Aversion Risk Seeker Risk-Neutral
Maximizing Expected Utility
Making decisions in terms of utility, not $
Translate $ outcomes into utility outcomes

Calculate expected utilities for each action
Choose the action to maximize expected utility
The Expected Utility Criterion
Consider K possible actions, a1, a2, . . ., aK and H states
of nature.
Let Uij denote the utility corresponding to the ith action and
jth state and Pj the probability of occurrence of the jth state
of nature
Then the expected utility, EU(ai), of the action ai is
H
EU(a i ) P1Ui1 P2Ui2 PHUiH PjUij
j1
The expected utility criterion: choose the action to maximize

expected utility
If the decision-maker is indifferent to risk, the expected utility
criterion and expected monetary value criterion are equivalent
Chapter Summary
Described the payoff table and decision trees
Defined opportunity loss (regret)
Provided criteria for decision making
If no probabilities are known: maximin, minimax regret
When probabilities are known: expected monetary
value
Introduced expected profit under certainty and the
value of perfect information
Discussed decision making with sample
information and Bayes theorem
Addressed the concept of utility

Decision Theory

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Decision Theory

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Statistics for

Business and Economics

Statistical Decision Theory

List Alternative Courses of Action

Payoff Table Decision Tree

Mi* (M11,M12 ,,M1H )

The maximin criterion

Suppose that a payoff table is arranged as a

Consider the regret table

Opportunity Loss in $1,000s

Opportunity Loss Table

Large factory 0 70 140 140

The minimax regret criterion:

The expected monetary value of action ai is

The Expected Monetary Value Criterion: adopt the

Example: EMV (Average factory) = 90(.3) + 120(.5) + (-30)(.2)

A Decision tree shows a decision problem,

Use a square to denote decision nodes

Use a circle to denote uncertain events

Strong Economy (.3) 90

Decision Strong Economy (.3) 40

EMV=90(.3)+120(.5)+(-30)(.2)=81 Strong Economy (.3) 90

EMV=40(.3)+30(.5)+20(.2)=31 Strong Economy (.3) 40

EV=81 Strong Economy (.3) 90

EV=31 Strong Economy (.3) 40

P(A | si )P(si ) P(A | si )P(si )

In the terminology of this section, P(si) is the prior probability of si

The expected value of perfect information (EVPI) is

EVPI P(s1)W1 P(s2 )W2 P(sH )WH

Another way to view the expected value of perfect

Example: Best decision

Recall: Expected profit under certainty = 124

EMV is maximized by choosing Average factory,

so: EVPI = 124 81

Consider the choice of Stock A vs. Stock B

Additional Information: Economic forecast is strong economy

P(F1 | E1) .9 , P(F1 | E2 ) .3

EMV Stock A = 25.0

For each possible sample result, Ai, find the

EVSI P(A1)V1 P(A 2 )V2 P(AM )VM

Utility is the pleasure or satisfaction

Example: each incremental $1 of profit does not

A risk averse person, once reaching a goal,

Risk Aversion Risk Seeker Risk-Neutral

Making decisions in terms of utility, not $

Translate $ outcomes into utility outcomes

The expected utility criterion: choose the action to maximize

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