Decision Theory

and
Decision Tree
Represented By:
Laishram Priyadarshani Devi(Group Leader)
Aradhana Pathak.
Dhiraj Singh.
Gaurav Kumar Singh.
Gaurav Singh.
Jagat jat
Introduction
 Basic function of any manager in day-to –day
performance of his job are planning, organising,
monitoring and controlling .In all this function, he has to
take a number of decisions, small or big.
 Decisions are based on the criteria decided by the
organisational objectives of business like utility,
minimisation of cost or time, maximisation of profits.
 There are number of external factors responsible to
modify the decision and decision maker has to recognise
factors like attitude or interest of stock holders or
employees and unions.
Introduction Contd
Government policies or change in Regulatory
framework may be a major factor playing its cards in
major decision making processes.
Rationality of decision making and their improvement
bring out the best in a Decision Maker.
Hence, deep analysis of pervious decisions and that
of complexities of the given environment help the
process of coherent, and effective decision making.
Quality of decision making depends on the input
qualitatively and quantitatively.
Brief Contents
 DEFINE DECISION THEORY.
 APPLICATIONS OF DECISION THEORY.
 APPROACH'S OF DECISION THEORY.
 CATEGORIES OF DECISION THEORY.
 TYPES OF DECISION MAKING ENVIRONMENT.
 DECISION TREES.
 STEPS IN DECISION TREE ANALYSIS.
 ADVANTAGES AND DISADVANTAGES OF
DECISION TREE
 Important terminologies & concepts
Decision maker : The decision maker refers the individuals
or group of individuals responsible for making a choice of
an appropriate courses of action amongst the available
courses of action . For example , a CEO of a company may
be accounatable to the share holder .
Course of action :it sometimes called actions, decision
alternatives or strategies are the acts available to the
decision makert.
State of nature :it is an exhaustive list of possible future
events , i.e. ,a set of possible scenarios .
Payoff :it is the effectiveness associated with a particular
combination of a course of action and state of nature.It
measure the net benefit to the decision maker that accrues
from a given combination of decision alternatives and
events.
Assumption in formulation of payoff
matrix:
Both the number of feasible options and possible states
of nature is limited and finite.
Each state of nature is mutually exclusive ,i.e.,only one
event wil occur for any given option.
The results for each combination of an option and state of
nature are known and assumed to be stable and constant
for given decision making scenario.
The decision objective is singular in nature and clearly
identified .
There are no other constraints impose upon the decision
issue.
 Definition of
Decision Theory:
 A process which results in the selection from a
set of alternative courses,that course of action
which is considered to meet the objectives of
the decision problem more satisfactorily then
others as judged by the decision makers.
Or
 The process of logical and quantitative
analysis of all factors that influences the
decision problem,assits the decision maker in
analyzing these problems with several courses
of action and consequences.
 Steps in Decision Theory
Approach
For better understanding:

We are considering a manufacturing company that is thinking

of several alternatives method to increase its production to
meet the increasing market demand.

The decision theory approach generally involves four steps:

1.List all the viable alternatives.
2.Identify the expected future events.
3.Construct a payoff table.
4.Select optimum decision criterion.
Step 1:List all the viable alternatives
 The decision-maker list all the viable alternatives that can
be considered in the decision.

For the company considered above,it may be only

three options.
 Construct a new plant.
 Expand the present plant.
 Subcontract production for extra demand.
Step2:Identify the expected future events.
 The decision maker list all the future events that may
occur.Often it is possible to identify most of the events
that can occur,the difficulty is to identify which particular
event will occur.These future events are termed as states
of nature or outcomes in decision theory.
For the manufacturing company considered
above,the greatest uncertainity will be about
product demand.
 High demand.
 Moderate demand.
 Low demand.
 No demand.
Step 3:Construct a payoff table.

 The decision -maker now constructs a payoff table or

conditional gain or conditional profit for each possible
combination or alternatives course of action and states of
nature.
Table 1 represents 12 possible payoffs for the company’s expansion
decision.
Table 1
Alternatives States of nature(product demand)
High Moderate Low Nil
Expand Rs 50,000 Rs 25,000 -Rs 25,000 -Rs 45,000

Construct Rs 70,000 Rs 30,000 -Rs 40,000 -Rs 80,000

Subcontract Rs 30,000 Rs 15,000 -Rs 1,000 -Rs 10,000

Step 4:Select optimum decision criterion.

 Finally,the decision maker will choose criterion which

results in larger payoff.
Decision-Making Environment
Decision are made under fours types of
environments that differ according to the
degree of certainty.
1.Decision-making under conditions of certainty.
2.Decision-making under conditions of uncertainty.
3.Decision-making under condition of risk.
4.Decision-making under conditions of conflict.
 Decision-Making Under Conditions of
Certainty.
• In this environment,only one state of nature exists,the
decision-maker simply pickes up the best payoff in that
one column and chooses the associated alternative.
• Under the condition of certainty,the particular state of
nature is associated with probability.
• Though the state of nature is only one,possible
alternatives could be numerous.
Methods:
Linear programming.
Transportation and assignment technique.
Input-output analysis.
Activity analysis.
Economic order quantity.
Example:
Alternatives States of nature(product demand)

High Moderate Low Nil

Expand Rs 50,000 Rs 25,000 -Rs 25,000 -Rs 45,000

Construct Rs 70,000 Rs 30,000 -Rs 40,000 -Rs 80,000

Subcontract Rs 30,000 Rs 15,000 -Rs 1,000 -Rs 10,000

If the company knew that the demand would be high,it would choose the
alternative ’construct’ to get the highest payoff Rs 70,000,if it knew that the
demand would be low,
it would choose alternative ’subcontract’ to keep the losses lowest to Rs
1000.
 Decision-Making under condition of
uncertainty.
 Under the condition of uncertainty,the decision-maker has
a knowledge about the states that happens but lacks
the knowledge about the probablities of their occurrence.
 There are few decision criteria are available which could
be of help to the decision-maker.
They are as follows:
1.Maximax Criterion or Criterion of Optimism.
2.Maximin Criterion or Criterion of Pessimism.
3.Minimax Regret Criterion(Savage Criterion) .
4.Hurwicz Criterion(Criterion of Realism).
5.Laplace Criterion or Criterion of Rationality
(Bayes Criterion).
Minimax Criterion or Criterion of Optimism.

 This criterion provides the decision-maker with optimistic criterion.He finds

the maximum possible payoff for each possible alternative and then
chooses the alternative with payoff within the group.

Alternative States of nature(product demand)

s
High Moderate Low Nil Maximum
Rs Rs Rs Rs of row
Rs
Expand 50,000 25,000 -25,000 -45,000 50,000
Contract 70,000 30,000 -40,000 -80,000 70,000
Subcontract 30,000 15,000 -1,000 -10,000 30,000

Maximum payoff =70,000

Maximin Criterion or Criterion of Pessimism(Wald Criterion).

 This criterion provides the decision-maker with pessimistic

criterion.
 The decision-maker maximizes his minimum possible payoffs.
 He finds first the minimum possible payoff for each alternative
and then chooses the alternative with maximum payoff within
the group.
Alternatives States of nature(product demand)

High Moderate Low Nil Minimum

Rs Rs Rs Rs of row
Rs
Expand 50,000 25,000 -25,000 -45,000 -45,000

Contract 70,000 30,000 -40,000 -80,000 -80,000

Subcontract 30,000 15,000 -1000 -10,000 -10,000

Maximin=10,000
 Minimax Regret Criterion(Savage Criterion) .
This decision criterion was developed by L.J.Savage.

He pointed out that the decision-maker might experience
 regret after
the decision has been made and the states of nature i.e.events have
occurred.
Thus the decision-maker should attempt to minimize regret before

actually selecting a particular alternative.
The basic steps involved in this criterion are.
Determine the amount of regret corresponding to each event for every

alternative.The regret for jth event corresponding to ith alternative is
given by:
ith regret=(maximmum payoff-ith payoff)for jth event.

Determine the maximum

 regret amount for each alternative.
Choose the alternative
 which corresponds to the minimum of the
maximum regrets.
 This table shows that the company will minimize its
regret to Rs 35,000 by selecting alternative ‘Expand’.

Alternative States of nature(product demand)

High(Rs) Moderate Low Nil Maximum
Rs Rs Rs of row
Rs
Expand 20,000 5,000 24,000 35,000 35,000
Contract 0 0 39,000 70,000 70,000
Subcontract 40,000 15,000 0 0 40,000

Minimax=35,0000
Hurwicz Criterion(Criterion of Realism)/Weighted Average Criterion.
It
 is a compromise between the maximax and maximin decision
criteria.
It is based on Hurwicz’s concept of coefficient of optimism.

It allows the decision-maker to take into account both the maximum

and minimum for each alternative and assign them weights according
to its degree of optimism(or pessimism).The alternative which
maximizes the sum of weighted payoffs is then selected.
The basic steps involved in this criterion are.
Choose an appropriate degree of optimism α,so that(1-α) represents

the degree of pessimism.α is called coefficient or index of optimism.
Determine the maximum as well as minimum of each alternative and

obtain.
P=α.maximum +(1-α).minimum.
 Choose the alternative that yields the maximum value
of P.
Assume α=0.8
Alternative States of nature(product demand)
High Moderate Low Nil Maxim Minimu P=α.ma
Rs Rs Rs Rs um of m of x+(1-
row row α).min
Rs Rs
Expand 50,000 25,000 -25, -45, 50,000 -45,000 31,000
000 000
Contract 70,000 30,000 -40, -80, 70,000 -80,000 40,000
000 000
Sub 30,000 15,000 -1000 -10, 30,000 -10,000 22,000
contract 000
When α=0,the criterion is too pessimistic.
When α=1,it is too optimistic.
A value of α =1/2 seems to be a reasonable choice.
Laplace Criterion or Criterion of Rationality(Bayes’ Criterion).
It is based upon what is known as the principle of insufficient

reason.
Since the probabilities associated with the occurrence of

various events are unknown,there is not enough information
to conclude that these probabiliteis will be different.
This criterion assigns equal probabilities to all the events of

each alternative decisions and selects the alternative
associated with the maximum expected payoff
n denotes the number of events.
P’s denotes the payoffs.
Expected value is represented by:
1/n(P1+P2+…….+Pn)
Alternative States of nature(Product demand)
s
High Moderate Low Nil Expected payoff
Rs Rs Rs Rs Rs
Expand 50,000 25,000 -25,000 -45,000 1000/4[50+25-25-
45]=-1,200
Contract 70,000 30,000 -40,000 -80,000 1000/4[70+30-40-
80]=-5,000
Subcontract 30,000 15,000 -1000 -10,000 1000/4[30+15-1-
10]=8500

Thus the alternative ‘subcontract’ results in maximum

average payoff of Rs 8,500.
Decision Making Under Conditions of Risk
 Most business decisions may have to be made under
conditions of risk.
 More than one states of nature exist and the decision-
maker has sufficient information to assign probabilities to
each of these states.
 These probabilities could be obtained from the past
records or from simply the subjective judgement of the
decision-maker.
 Number of decision criteria are available,some are:
 Expected Value Criterion.
 Expected Opportunity Loss Criterion.
 Expected Value of Perfect Information.
Expected value criterion:
This criterion requires the calculation of the expected
value of each decision alternative which is the sum
of the weighted payoffs for that alternative, where the
weights are the probabilities assigned to the states
of the nature that can happen. Also called as
expected monetary value(EMV)criterion.
Expected opportunity loss(EOL) criterion:
an alternative approach is to minimize expected
 It is
opportunity loss.EOL represents the amount by
which maximum possible profit will be reduced under
various possible stock action. The course of action
that minimises this losses or reductions is the
optimal decision alternatives.
Expected value of perfect
information(EVPI): when the situation is
probabilistic, there is no control on the occurrences of
a given state of nature. If the decision maker had
exact information, the situation would be entirely
different i.e., with more authentic and exact
information available, the decision quality would
improve.
EVPI=Best outcome of first state of nature)x(Probability
of first state of nature)+………..+ (Best outcome of last
state of nature)x(Probability of last state of nature()
EVPI=EPPI – EMV
EPPI=Expected Profit with Perfect Information
EMV=Expected Monetary Value
Application of decision-making
Select the best from among several job offers.
Select the most profitable investment portfolio.
Select the best way to build a modern electronic
component.
Determine the number of personal computers(PCs)
to order for an office supply store.
Determine whether or not to expand a medical or
manufacturing facility.
Determine if a large plant, small plant, or no plant
should be built.
Decide if it is worthwhile to hire a marketing research
team to gather additional data.
Application of decision-making
 Decide whether to lease, sub-contract or manufacture
or select a quality control plan.
 Decide whether to invest in a new plant, equipment,
etc.
 Decide about the area of design and development of
new and improved product and equipment.
Decision Trees.

 A decision tree is a graphical representation of the

decision alternatives,states of nature,probabilities
attached to the states of nature and conditional benefits
and losses.
 It consist of a network of nodes and branches.
 Two types of nodes are used:
Decision node represented by a square.
State of nature node represented by a circle.
 Alternative courses of action originate from the decision
node as main branches.
Steps in Decision Tree Analysis.
 Identify the decision points and the alternative course of
action at each decision point systematically.
 At each decision point,determine the probability and payoff
associated with each course of action.
 Commencing from the extreme right end,compute the
expected payoffs(EMV)for each course of action.
 Choose the course of action that yields the best payoff for
each of the decisions.
 Proceed backwards to the next stage of decision points.
 Repeat above steps till the first decisions is reached.
 Finally,identify the courses of action to be adopted from the
beginning to the end under different possible outcomes for
the situation as a whole.
Advantages of the Decision tree approach.
 It structures the decision process and helps decision- making
in an orderly,systematic and sequential manner.
 It requires the decision-maker to examine all possible
outcomes,whether desirable or undesirable.
 It communicates the decision-making process to others in an
easy and clear manner,illustrating each assumption about the
future.
 It displays the logical relationship between the parts of a
complex decision and identifies the time sequence in which the
various actions and subsequent events would occur.
 It is especially useful in situations wherin the initial decision
and its outcome affects the subsequent decisions.
 It can be applied in various fields such as introduction of new
product,marketing,make or buy decisions,investment decision
etc.
Disadvantages of the Decision tree approach.
 Decision tree diagrams more complicated as the number
of the decisions alternatives increases and more
variables are introduced.
 It becomes highly complicated when interdependent
alternatives and dependent variables are present in the
problem.
 It assumes the utility of money is linear with money.
 It analyses the problem in terms of expected values and
thus yield an ‘average’ valued solution.
 There is often inconsistency in assigning probabilities for
different events.
THANK YOU