Decision Theory

Decision Theory
BY HARSH VARDHAN

Decision Theory provide a method of decision-making wherein data concerning the occurrence of different outcomes (consequences) may be evaluated to enable the decision- maker to identify suitable alternative (or course of action) Decision Models provides frame work to make best possible decision. Decision Alternatives are different possible strategies(course of actions) the decision maker can employ.
Decision Theory/OR/Harsh/11 2

State of Nature A possible future condition event, not under control of decision maker, which may occur. State of nature are mutually exclusive and collectively exhaustive. Payoff The consequence resulting from specific combination of a decision alternative and a state of nature is called payoff. It could be in terms of profit, cost ,time ,distance etc. Payoff Table A table showing pay offs for all combination of decision alternative and 3 states on nature. Decision Theory/OR/Harsh/11

Pay off Table

DECISION Carry an Umbrella Not carry an Umbrella

STATE OF NATURE

RAIN DOES NOT RAIN

NOT WET NOT WET

WET NOT WET

CONSEQUENCE
Decision Theory/OR/Harsh/11 4

Steps in Decision Theory Approach

Decision Making Environments

Step 1 Determine the various alternative courses of action (or choice of strategies) from which the final decision is to be made. Step 2 Identify the possible outcomes, called the states of nature or events for the decision problem. Step 3 Construct a payoff table for each possible combination of alternative course of action and state of nature. Step 4 Choose the criterion which results in largest payoff. The criterion may be economic, quantitative or qualitative(market share, profit)
Decision Theory/OR/Harsh/11

Decision analysis is used to determine optimum strategies amongst several decision alternatives. There are four types of decision environments: 1. 2. 3. 4. Decision under Decision under Decision under Decision under Certainty Uncertainty Risk Conflict

Decision Theory/OR/Harsh/11

Decision Making Environments

1. Decision under certainty Whenever there exists only one outcome for a decision, we are dealing with this category. The decision maker has complete knowledge (perfect information) of consequences of every decision (course of action or alternative). Pick up an alternative that yields largest payoff for known future(state of nature)-Investment in PPF , Infrastructure Bond. 2. Decision under uncertainty These refer to situations where more than one outcome can result from any single decision. The decision maker is unable to assign probabilities with which each state of nature will occur. Mr. Y will be PM in the next election. Decision Theory/OR/Harsh/11 7

3. Decision under risk These refer to decision situations

wherein the decision-maker chooses from several possible outcomes where the probability of occurrence can be stated objectively from the past data.

The decision maker has less than complete knowledge of consequences of each decision choice and is unsure of which outcome will occur. Thus there may be more than on state of nature for which me makes assumption about its probability. P(head) =0.5 4. Decision under conflict In many situations, neither states of nature are completely known nor are they completely uncertain. Partial knowledge is available and therefore, it is termed as decision-making under partial uncertainty or conflict.

Decision Theory/OR/Harsh/11

Problem-1
Decision Making Under Uncertainty

Under condition of uncertainty, the decision-maker has a knowledge about the states of nature that happen but lacks the knowledge about the probabilities of their occurrence. ( example LAUNCHING A NEW PRODUCT). There are several criteria of decision-making in this situations which includes: 1. 2. 3. 4. 5. Criterion of Optimism (Maximax or Minimin) Criterion of Pessimism (Minimax or Maximin ) Equally Likely Decision (Laplace) Criterion Criterion of Realism (Hurwicz Criterion) Criterion of Regret (Savage Criterion) or Minimax Regret Criterion
Decision Theory/OR/Harsh/11

A farmer wants to decide which of the three crops he should plant on his 100 acre farm. The profit from each is dependent on the rainfall during the growing season. The farmer has categorized the amount of rainfall as high, medium and low. His estimated profit for each is shown in the table in the next slide:
Decision Theory/OR/Harsh/11 10

Problem-1
Rainfall High Medium Low Estimated conditional profit (Rs) Crop A 8000 4500 2000 Crop B 3500 4500 5000 Crop C 5000 5000 4000

Problem -2
States nature S1 S2 S3 of A1 200 160 120 Courses of Action A2 210 170 130 A3 230 190 140

If the farmer wishes to plant only one crop, decide which should be his best crop using : 1. Maximax Criterion(Optimism) 2. Maximin Criterion(Pessimism) 3. Hurwicz Criterion (farmers degree of optimism being 0.6) 4. Laplace Criterion(Equally likely criterion) 5. Minimax regret Criterion
Decision Theory/OR/Harsh/11 11

Evaluate the above pay off table and determine suitable course of action by following methods 1. Criterion of Pessimism, 2.Criterion of Optimism, 3.Equally Likely Decision Criterion, 4.Hurwitz Criterion [ degree of optimism, being 0.6] and 5. Criterion of Regret(Minimax Regret) Decision Theory/OR/Harsh/11 12

Problems Problems
1. A company wishes to decide which of the three components A,B and C they should manufacture. The profit from each is dependent on the power consumption. The power consumption for each type of component has been categorized low, medium and high . His estimated profit for each is shown below:
Estimated conditional profit (Rs) A Low Medium High 200 450 B 500 450 C 400 500

2.

A food products company is contemplating the introduction of a revolutionary new product with three strategies S1, S2 and S3. The three possible states of nature or events (expected sales) are N1, N2, and N3. The marketing department of the company worked out the payoffs in terms of yearly profits for each of the strategies of three events (expected sales). This is represented in the following table:
Strategies S1 S2 S3 States of Nature N1 7,00,000 5,00,000 3,00,000 N2 3,00,000 4,50,000 3,00,000 N3 1,50,000 0 3,00,000

80

350

500

If the company wishes to manufacture one component , decide the best a) Maximax Criterion b) Maximin Criterion c) Laplace Criterion d) Minimax Regret Criterion e) Hurwicz Criterion (degree of pessimism being 0.4)
Decision Theory/OR/Harsh/11 13

Which strategy should the concerned executive choose on the basis of a) Maximax Criterion(Optimism ) b) Maximin Criterion(Pessimism) c) Realism Criterion (alpha being 0.7)(Hurwicz) d)Equally Likely Criterion (Laplace) , e)Criterion of Regret or Savage Criterion or Minimax Regret.
Decision Theory/OR/Harsh/11 14

Problem
Mr. Ashok has Rs. 10,000 to invest in one of the three options A, B or C. the return on his investment depend on weather the economy experiences inflation recession or no change at all. His possible returns under each economic condition are given below: Strategy A B C States of Nature Inflation Recession No Change 2000 1200 1500 3000 800 1000 2500 1000 1800

Decision Under Risk

Decision Maker has sufficient information to assign probabilities to each state. These probabilities could be obtained from past record or from simply the subjective judgment of decision maker. Some criterion under condition of risk for evaluating alternatives are:

What is the best strategy under : (i) Laplace criterian (ii) Maximax,(iii) Minimax ,(iv)Hurwitz criterian (alpha = 0.5), (v) Equally likely
Decision Theory/OR/Harsh/11 15

Expected Monetary Value (EMV) Criterion Expected Opportunity Loss (EOL)

Decision Theory/OR/Harsh/11 16

Expected Monetary Value (EMV) Criterion

The Expected Monetary Value(EMV) for a given course of action is the expected value of conditional payoff for that action. EMV for a given course of action is the weighted average pay off, which is sum of payoffs for each course of action multiplied by probabilities associated with each state of nature.

A person has choice of running a hot snack stall or an ice cream /cold drink stall at Amritsar. If the weather is cool and rainy ,he can expect to make a profit of Rs 15,000 and if it is warm he can expect to make a profit of Rs 3,000 by running a hot snack stall. On the hand if his choice is to run an ice cream and cold drink stall ,he can expect to make a profit of Rs 18,000 if the weather is warm ,and Rs 3000 ,if the weather is cool and rainy. There is 40% chance of weather being warm in the coming season. Should he opt for running the hot snack stall or an ice cream stall?
Decision Theory/OR/Harsh/11 18

Problem

Decision Theory/OR/Harsh/11

17

Thank You