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Decision Theory

 Is defined the analysis of decision situations in which

certainty cannot be assumed.

 Most of the time decision makers must choose

among several different courses of action in an
attempt to optimize his decision process.
Steps in Decision Making

1. Clearly define the problem.

2. List all the possible alternative events that may
3. Determine all possible outcomes
4. Identify the profit/loss of each combination of
alternative events and outcomes.
5. Choose one mathematical decision theory model.
6. Apply the model and make the decision.
Decision Making Criteria

 Maximax Criterion
 Maximin Criterion
 Mimimax Regret Criterion
Maximax Criterion
(Optimistic Approach)

 The maximax criterion maximizes the maximum

payoffs for the different decisions starting with the
identification of the maximum payoffs of each
alternative decision.
Maximin Criterion
(Conservative Approach)

 The maximin criterion simply maximizes the

minimum payoffs given the various decisions that
are possible. It is a two step process once the payoff
table has been formulated.
 The first step is to identify the minimum payoff for
each decision.
 The second step is to select the largest minimum
Minimax Regret Criterion

 The minimax regret criterion involves the

construction of an opportunity loss or regret matrix
prior to applying the minimax rule. Construct an
opportunity loss table by transforming each element
in the payoff table to an opportunity loss. The degree
of the oportunity loss for a given element is the loss
incurred by not selecting the optimal alternative
decision given a state of nature.
 Converting a payoff table to an opportunity loss table is
composed of two step iterative process.

 The first step is to find the largest element in the first

column. The element represents the best decision given
a particular state of nature. The second step is to
subtract each element in the column from the largest
element to compute the opportunity loss.

 The minimax regret rule states to odentify the

maximum regret (opportunity loss) for each desion and
the choose that decision with the smallest maximum
Example 1:

 A farmer in Region 2 must decide which crop to

plant next year on his land: corn, wheat, or rice.
The return from each crop will be determined by
whether a new trade bill with Hongkong passes the
Senate. The profit the farmer will realize from each
crop given the two possible results on the trade bill
is shown in the following payoff table. Determine
the best crop to plant using the following decision
Crop Trade Bill
Pass fail
Corn 2,000,000 700,000

Wheat 1,100,000` 500,000

1,400,000 1,200,00
A. (Maximax Criterion)

 Step 1: select the column with maximum payoff

Crop Trade Bill

Pass fail
Corn 2,000,000 700,000

Wheat 1,100,000` 500,000

1,400,000 1,200,00

maximum payoff
 Step 2: identify the highest maximum payoff. The
minimum payoff can be found.

Crop Maximax Payoffs

Corn 2,000,000

Wheat 1,100,000 maximum

Rice 1,400,000

Thus, planting of corn will result in a maximax

payoff of 2,000,000
B. Maximin Criterion
 Step 1: Select the column with minimum payoff.

Crop Trade Bill

Pass fail
Corn 2,000,000 700,000

Wheat 1,100,000 500,000

1,400,000 1,200,00

Minimum payoff
Step 2: Identify the lowest minimum payoff.

Crop Trade Bill

Pass fail
Corn 2,000,000 700,000

Wheat 1,100,000 500,000

1,400,000 1,200,00 minimum


Thus, it will result in a minimum payoff of 500,000.

C. Minimax Regret Criterion

 Step 1: Determine the largest element in both


Crop Trade Bill

Pass fail
Corn 2,000,000 700,000

Wheat 1,100,000 500,000

1,400,000 1,200,00
Step 2: Subtract every element from the
largest payoff in both columns
Corn = 2,000,000 – 2,000,000 = 0
Wheat = 2,000,000 – 1,100,000= 900,000
Rice= 2,000,000 -1,400,000 = 600,000
Corn= 1,200,000 – 700,000 = 500,000
Wheat= 1,200,000 – 1,200,000 = 0
Step 3: select the largest amount in each
Crop Trade Bill Crop Minimax
Pass fail
Corn 0 500,000 Corn 500,000

Wheat 900,000 700,00 Wheat 900,000

600,000 0
Rice 600,000
Step 4: Identify the maximum regrets
Crop Minimax Payoffs

Corn 500,000

Wheat 900,000
Rice 600,000

Thus, planting of corn will result in, at most, 500,000

in regret
Expected Value/Mathematical Expectations

 The Expected Value, or Mean, sometimes called

Mathematical Expectation, of a discrete random
variable is very important ion characterizing its
probability distribution. Originally, the concept of
expected value was introduced with reference to
games of chance where, if a player stands to win an
amount k with probability P, his expected value or
expectation is defined as the k(P).
 The expected value of a discrete random variable of
probability distribution is the theoretical average of
the variable. The formula is

u= E(x) = E(x)= ∑[ x ● P(x)]

the symbol E(x) is used to expected value
Example 1

 If a man purchases a raffle ticket, he will win a first

prize of 500,000 or a second prize of 200,000 with
probabilities 0.0001 and 0.0005. what should be a
fair price to pay for the ticket?
E(x)= ∑[ x ● P(x)]
E(x)= (500,000)(0.0001) + (200,000)(0.0005)
E(x)= 50 + 100
E(x) = 150
The fair price of the ticket is 150
Example 2

 A gambler tosses a die. If 1,3 or 5 appears the

gambler will be paid php 9.00; if 2 or a 4 turns up he
will lose php 9.00; and if 6 is showing, he will win
12.00. Determine the expectation of the gambler.
 Take note that there are six faces of a regular die
which serves as the possible outcome, therefore the
probabilities of A, B, and C are as follows.

P(A)= 3/6 P(B)= 2/6 P(C)= 1/6

 E(x)= ∑[ x ● P(x)]
 E(x) = [9 ● P(A)] – [9 ● P(B)] + [ 12 ● P(C)]
 E(x) = 9 (3/6) – 9 (2/6) + 12(1/6)
 E(x) = 4.5 – 3+2
 E(x) = 3.50

 Thus, the gambler expects to win 3.50 per toss of a die.

Decision trees

 It is a graphical diagram consisting of nodes and

branches. Though, rather that determining the
probability of each branch (outcome) as a probability
tree in a decision tree, the user computes the
expected value of each outcome and makes a
decision based on these expected values.
 The circles and squares are referred as nodes. The
squares are decision nodes, and the braches
emanating from a decision node reflect the
alternative decisions possible at that point.
 The decision tree represents the sequence of events
in a decision situation.
 Decision variable- is a variable whose value
represents a potential decision on the part of the
decision maker.
Posterior probabilities

 the concept of conditional probability given

statistical dependence forms the necessary
foundation for an area of probability known as
Beyesian Analysis

 The basic principle of Bayesian Analysis is that the

additional information can sometimes enable one
to alter the marginal probabilities of the occurrence
of an event. The altered probabilities are reffered to
as Posterior Probabilities.
Example 1.

 The Manufacturing Company, A corporate raider, has

acquired a shoe company and is contemplating the
future one of its major plants located in Marikina.
Three alternative decisions are being considered: (1)
expand the plant and produce lightweight, durable
shoes for possible sales to the department store, a
market with little foreign competition: (2) maintain the
status quo at the plant, continuing production of shoes
that are subject to heavy foreign competition. (3) sell
the plant now. I
 If one of the first two alternatives is chosen, the
plant will still be sold at the end of the year. The
amount of profit that could be earned by selling the
plant in a year depends on foreign market
conditions, including the status of a trade embargo
bill in Congress. The following payoff table
describes this decision situation.
States of Nature
Decision Good foreign Competitive Bad foreign Competitive
Condition Condition
Expand 30,000,000 20,000,000
Maintain status quo 50,000,000 -7,500,000
Sell Now 15,000,000 15,000,000

B. Assume that it is now possible to estimate a

probability of 0.75 that good foreign competitive
conditions will exist and a probability of 0.25 that
bad conditions will exist. Determine the best
decision using expected value and expected
opportunity loss.

C. Compute the expected value of perfect

D. Develop a decision tree for this decision situation, with
expected values at the probability nodes.

 E. The company has hired a consulting firm to provide a

report on the political and market situation in the future.
The report will be either positive (P) or negative (N),
indicating either good (g) or bad (b) future foreign
competitive situation. The conditional probability of each
report outcome given each state of nature is as follows.

P(P/g)= 0.80 P(N/g) = 0.20 P(P/b) = 0.30 P(N/b) =


Determine the posterior probabilities using Bayes’s rule.

F. Perform a decision tree analysis using the posterior

probability obtained in part d.