DECISION THEORY:

DECESION THEORY PROVIDES A RATIONAL

APPROACH IN DEALING PROBLEMS CONFRONTED
WITH THE PARTIAL , IMPERFECT OR UNCERTAIN
FUTURE CONDITION
STEPS IN DECESION THEORY
APPROACH:

LIST ALL THE VIABLE

ALTERNATIVES

IDENTIFY THE EXPECTED

FUTURE EVENTS

CONSTRUCT A PAY-OFF
TABLE

SELECT OPTIMUM
DECESION CRITERION
DECESION MAKING ENVIRONMENT:
DECESIONS ARE MADE UNDER THREE TYPES OF
ENVIRONMENT:

CERTAINITY UNCERTAINITY RISK

HERE MORE THAN HERE ALSO MORE

IN THIS , ONLY ONE ONE S.O.N. EXISTS THAN ONE S.O.N.
STATE OF NATURE BUT D. MAKER EXISTS BUT THE D.
EXISTS i.e. THERE IS LACKS SUFFICIENT MAKER HAS
COMPLETE KNOWLEDGE TO SUFFICIENT INFO TO
CERTAINITY ABOUT ALLOW HIM ASSIGN ALLOW HIM ASSIGN
THE FUTURE PROB TO VARIOUS PROB TO EACH OF
S.O.N. THESE STATES
 D.M. UNDER UNCERTAINITY:
Under condition of uncertainty, the decision maker has
knowledge about states of nature that happens but lacks the
knowledge about the probabilities of their occurrence.
Under conditions of uncertainty, a few decision criterions are
available which could be of help to the decision maker.
D.M. UNDER UNCERTAINITY

Maximax Maximin Minimax Hurwicz Laplace

Criterion or Criterion or Criterion or Criterion or Criterion or
Criterion of Criterion of Regret Criterion of Criterion of
optimism pessimism Criterion Realism Rationality
ILLUSTRATION: CONSIDERING A MANUFACTURING
COMPANY THAT IS THINKING OF VARIOUS
ALTERNATIVES TO INCREASE ITS PRODUCTION TO
MEET THE INCREASING MARKET DEMAND.
STATE OF NATURE (PRODUCT DEMAND)
ALTERNATIVES
HIGH MODERATE LOW NIL

EXPAND 50,000 25,000 - 25,000 - 45,000

CONSTRUCT 70,000 30,000 - 40,000 - 80,000

SUBCONTRACT 30,000 15,000 - 1,000 - 10,000

WHICH STRATEGY OR ALTERNATIVE WILL THE CO.

EMPLOY ON THE BASIS OF VARIOUS METHODS.
(I) MAXIMAX CRITERION OR CRITERION OF
OPTIMISM:
 This criterion provides the decision maker with optimistic
criterion. The working method is summarizing as follow.
Locate the maximum payoff values corresponding to each
alternative (or course of action or strategy), then
Select an alternative with maximum payoff value.
STATE OF NATURE (PRODUCT DEMAND)
ALTERNATI
VES HIGH MODERATE LOW NIL

EXPAND 50,000 25,000 - 25,000 - 45,000

CONSTRUC 70,000 30,000 - 40,000 - 80,000

T
SUBCONTR 30,000 15,000 - 1,000 - 10,000
ACT

THUS THE MAXIMAX PAYOFF IS Rs. 70,000 CORRESPONDING TO

THE ALTERNATIVE “CONSTRUCT”.
(II) MAXIMIN CRITERION OR CRITERION OF
PESSIMISM:
This criterion provides the decision maker with pessimistic
criterion. The working method is summarizing as follow.
Locate the minimum payoff values corresponding to each
alternative (or course of action or strategy), then
Select an alternative with maximum payoff value.

STATE OF NATURE (PRODUCT DEMAND)

ALTERNATI HIGH MODERATE LOW NIL
VES
EXPAND 50,000 25,000 - 25,000 - 45,000

CONSTRUC 70,000 30,000 - 40,000 - 80,000

T
SUBCONTR 30,000 15,000 - 1,000 - 10,000
ACT
THUS THE MINIMAX PAYOFF IS Rs. – 10,000 CORRESPONDING TO THE
ALTERNATIVE - “SUBCONTRACT”
(III) MINIMAX CRITERION OR MINIMUM REGRET
CRITERION:
This criterion is also known as opportunity loss decision
criterion or minimax regret criterion. The working method is
summarizing as follow.

Determine the amount of regret corresponding to each

alternative for each state of nature. The regret for jth
event corresponding to ith alternative is given by
ith regret = (maximum payoff – ith payoff) for the jth
event
Determine the maximum regret amount for each
alternative.

Choose the alternative which corresponds to the

minimum of the maximum regrets.
 STATE OF NATURE (PRODUCT DEMAND)
ALTERNATIVES HIGH MODERATE LOW NIL

EXPAND 50,000 25,000 - 25,000 - 45,000

CONSTRUCT 70,000 30,000 - 40,000 - 80,000
SUBCONTRACT 30,000 15,000 - 1,000 - 10,000

CALCULATION OF REGRET
ALTERNATIVE HIGH MODERATE LOW NIL
S
EXPAND 20000 5000 24000 35000

CONSTRUCT 0 0 39000 70000

SUBCONTRA 40000 15,000 0 0
CT

THIS TABLE SHOWS THAT THE COMPANY WILL MINIMIZE ITS REGRET TO
RS 35,000 BY SELECTING ALTERNATIVE- “EXPANSION”
 (IV) HURWICZ CRITERION OR CRITERION OF
REALISM:
Also called weighted average criterion, it is a compromise
between the maximax (optimistic) and minimax
(pessimistic) decision criterion. This concept allows the
decision maker to take into account both maximum and
minimum for each alternative and assign them weights
according to his degree of optimism (or pessimism). The
working method is summarizing as follow:
Choose an appropriate degree of optimism, α so that (1-α)
represents degree of pessimism.
Determine the maximum as well as minimum of each
alternative and obtain
P = α. Maximum + (1-α). Minimum
for each alternative.
Choose the alternative that yields the maximum value of P.
 HERE LET α = 0.8
ALTERN STATE OF NATURE
ATIVES
HIGH MOD LOW NIL

EXP 50,000 25,000 - 25,000 - 45,000

CONST 70,000 30,000 - 40,000 - 80,000

SUBCON 30,000 15,000 - 1,000 - 10,000

TRACT

WORKING NOTES:
H1 = 0.8 * 50000 + 0.2 * -45000 = 31000
H2 = 0.8 * 70000 + 0.2 * -80000 = 40000
H3 = 0.8 * 30000 + 0.2 * -10000 = 22000
THUS ACCORDING TO HURWICZ CRITERION , COMPANY WILL CHOOSE
ALTERNATIVE – “CONSTRUCT”
(V) LAPLACE CRITERION OR CRITERION OF RATIONALITY:
Also known as equal probabilities criterion or criterion of
rationality. Since the probability of states of nature are not
known, it is assumed that all states of nature will occur with
equal probability, i.e. assign an equal probability. The
working method is summarizing as follow:
Determine expected value for each alternative; if n denotes
the number of events and P’s denote the payoffs, then
expected value is given by 1\n[P1+P2+….+Pn]
Choose the alternative that yields the maximum value of P.
 STATE OF NATURE EXPECTED
ALTERNATI MODERATE LOW PAYOFF
HIGH NIL
VES
EXPAND 50,000 25,000 - 25,000 - 45,000

CONSTRUC 70,000 30,000 - 40,000 - 80,000

T
SUBCONTR 30,000 15,000 - 1,000 - 10,000
ACT

WORKING NOTES:
(E.P.)1 = ¼(50000 + 25000 - 25000 – 45000) = 1250
(E.P.)2 = ¼(70000 + 30000 – 40000 – 80000)= - 5000
(E.P.)3 = ¼(30000 + 15000 – 1000 – 10000 ) = 8500

THUS ACCORDING TO LAPLACE CRITERION , COMPANY WILL CHOOSE

ALTERNATIVE – “SUBCONTRACT”
ILLUSTRATION: THE FOLLOWING MATRIX GIVES THE
PAYOFF OF DIFFERENT STRATEGIES S1, S2, S3 AGAINST
CONDITIONS N1, N2, N3 AND N4.
STRATEGY CONDITIONS
N1 N2 N3 N4
(Rs) (Rs) (Rs) (Rs)
S1 4000 -100 6000 18000
S2 20000 5000 400 0
S3 20000 15000 - 2000 1000

INDICATE THE DECESION TAKEN UNDER THE FOLLOWING

APPROACH:
OPTIMISTIC
PESSIMISTIC
REGRET
HURWICZ, THE DEGREE OF OPTIMISM BEING 0.7
EQUAL PROBABILITY
 SOLUTION
(I) OPTIMISTIC CRITERION:
CONDITIONS MAX
STRATEGY N1 N2 N3 N4 OF
(Rs) (Rs) (Rs) (Rs) ROW
S1 4000 -100 6000 18000 18000
S2 20000 5000 400 0 20000
S3 20000 15000 - 2000 1000 20000
SO, ACCORDING TO O.C., MAXIMAX PAYOFF IS Rs. 20000
CORRESPONDING TO THE STRATEGY – “S2” AND “S3” .
(II) PESSIMISTIC CRITERION:
CONDITIONS MIN
STRATEGY N1 N2 N3 N4 OF
(Rs) (Rs) (Rs) (Rs) ROW
S1 4000 -100 6000 18000 - 100
S2 20000 5000 400 0 0
S3 20000 15000 - 2000 1000 - 2000

SO, ACCORDING TO P.C., MAXIMIN PAYOFF IS Rs. 0 CORRESPONDING

TO THE STRATEGY – “S2”
(III) REGRET (SAVAGE CRITERION):
THE BEST PAY OFFS FOR EACH STATE OF NATURE N1, N2,
N3 & N4 ARE Rs. 20000, Rs. 15000, Rs. 6000 & RS. 18000
RESPECTIVELY.
SUBSTRACTING FROM THESE THE PAYOFFS OF
CORRESPONDING COLUMN WE GET
CONDITION MAX
STRATEGY N1 N2 N3 N4 OF
(Rs) (Rs) (Rs) (Rs) ROW
S1 16000 15100 0 0 16000
S2 0 10000 5600 18000 18000
S3 0 0 8000 17000 17000

THE MINIMAX REGRET CORRESPONDS TO STRATEGY

“S1”.
(IV) HURWICZ CRITERION:
CONDITION MAX MIN H=
STRATE N1 N2 N3 N4 OF OF .max +
GY (Rs) (Rs) (Rs) (Rs) ROW ROW (1- )
min
S1 4000 -100 6000 18000 18000 - 100 12570
S2 20000 5000 400 0 20000 0 14000
S3 20000 15000 - 2000 1000 20000 - 2000 13400
HERE = 0.7
WORKING NOTES:

H1 = 0.7 *18000 + 0.3 * (- 100) = 12570

H2 = 0.7 * 20000+ 0.3 * 0 = 14000
H3 = 0.7 * 20000 + 0.3 * (- 2000) = 13400

THE MAXIMUM VALUE OF H = Rs. 14000 WHICH CORRESPONDS TO STRATEGY

“S2”.
(V) EQUAL PROBABILITY CRITERION:

CONDITION
STRATEGY
N1 N2 N3 N4
(Rs) (Rs) (Rs) (Rs)
S1 4000 -100 6000 18000 6975
S2 20000 5000 400 0 6350
S3 20000 15000 - 2000 1000 8500

WORKING NOTES:
(E.P.)1 = ¼(4000 - 100 + 6000 + 18000) = 6975.
(E.P.)2 = ¼(20000 + 5000 + 400 + 0 ) = 6350.
(E.P.)3 = ¼(20000 + 15000 – 2000 + 1000 ) = 8500.

THE MAXIMUM PAYOFF IS Rs. 8500 WHICH CORRESPONDS

TO THE STRATEGY – “S3”.
 DECISION MAKING UNDER RISK:
Here more than one state of nature exists 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 simply the subjective judgment of the
decision maker.
Under conditions of risk, knowing the probability
distribution of the state of nature, the best
decision is to select the course of action which
has the largest expected pay off value.
 DECISION MAKING UNDER RISK:

Expected Value Expected Opportunity Expected Value

Criterion Loss Criterion
or or for Perfect
Expected Monetary Expected Value of Information
Value Criterion Regret

Conditional Profit Table

Conditional Profit Conditional Profit
with P.I.
Table Table
Expected Profit Table
Expected Profit Table Conditional Loss table
with P.I.
Expected Loss Table
 ILLUSTRATION
A newspaper boy has the following probabilities of selling a
magazine:
No. of copies sold Probability
10 0.10
11 0.15
12 0.20
13 0.25
14 0.30
Cost of the copy is 30 paisa and sale price is 50 paisa. He
cannot return the unsold copies. How many should he
order?
 EXPECTED VALUE CRITERION:
 The expected monetary value for a given course of action
is the weighted sum of possible payoffs for each
alternative. It is obtained by summing the payoffs for each
course of action multiplied by the probabilities associated
with state of nature. It consists of following steps:
Construct a payoff table listing the alternative decisions and
the various state of nature. Enter the conditional profit for
each decision event combination along with the associated
probabilities. (Construct Conditional profit table).
Calculate the EMV for each decision alternative by multiplying
the conditional profits by assigned probabilities and adding
the resulting conditional values. (Construct expected profit
table).
Select the alternative that yields the highest EMV.
 SOLUTION
Cost Price = 30 paisa.
Selling Price = 50 paisa.
Profit = Selling price – Cost price = 20 paisa.
STEP I : CONSTRUCT CONDITIONAL PROFIT TABLE
Conditional Profit * D = 20 D. ;When D ≥ S
Profit
=
profit*D – C.P.*U= 20D – 30U; When D < S
Possible Possible Stock Action
Demand Probability 10 11 12 13 14
(No. of Copies Copies Copies Copies Copies
Copies)
10 0.10 200 170 140 110 80
11 0.15 200 220 190 160 130
12 0.20 200 220 240 210 180
13 0.25 200 220 240 260 230
14 0.30 200 220 240 260 280
STEP II: CONSTRUCT EXPECTED PROFIT TABLE:
Possible Possible Stock Action
Demand Probability 10 11 12 13
(No. of 14
Copies Copies Copies Copies Copies
Copies)
10 0.10 20 17 14 11 8
11 0.15 30 33 28.5 24 19.5
12 0.20 40 44 48 42 36
13 0.25 50 55 60 65 57.5
14 0.30 60 66 72 78 84
TOTAL EXPECTED
200 215 222.5 220 205
PROFIT

THE NEWS BOY MUST, THEREFORE, ORDER 12 COPIES TO

EARN THE HIGHEST POSSIBLE AVERAGE DAILY PROFIT
OF 222.5 PAISE
 EXPECTED OPPORTUNITY LOSS CRITERION:
EOL represents the amount by which maximum possible profit
will be reduced under various possible stock actions. The course
of action that minimizes these losses or reductions is the
optimal decision alternative. The procedure to calculate
expected opportunity losses is as follows:
Prepare the conditional profit table for each decision-event
combination and write associated probabilities. (Construct
Conditional profit table).
For each event, determine the conditional opportunity loss (COL)
by subtracting the payoff from the maximum payoff for that
event. (Construct Conditional loss table).
Calculate the expected opportunity loss for each decision
alternative by multiplying the COL’s by the associated
probabilities and then adding the values. (Construct Expected
loss table).
Select the alternative that yields the lowest EOL.
 SOLUTION
Cost Price = 30 paisa.
Selling Price = 50 paisa.
Profit = Selling price – Cost price = 20 paisa.
STEP I : CONSTRUCT CONDITIONAL PROFIT TABLE
Conditional Profit * D = 20 D ;When D ≥ S
Profit = Profit * D – C.P. *U = 20D – 30U; When D < S

Possible Possible Stock Action

Demand Probability 10 11 12 13 14
(No. of Copies Copies Copies Copies Copies
Copies)
10 0.10 200 170 140 110 80
11 0.15 200 220 190 160 130
12 0.20 200 220 240 210 180
13 0.25 200 220 240 260 230
14 0.30 200 220 240 260 280
STEP III: CONSTRUCT EXPECTED LOSS TABLE:
Possible Possible Stock Action
Demand 10 11 12 13 14
Probability
(No. of Copies Copies Copies Copies Copies
Copies)
10 0.10 0 3 6 9 12
11 0.15 3 0 4.5 9 13.5
12 0.20 8 4 0 6 12
13 0.25 15 10 5 0 7.5
14 0.30 24 18 12 6 0

E.O.L. 50 35 27.5 30 45

THE OPTIMUM STOCK ACTION IS THE ONE WHICH WILL

MINIMIZE EXPECTED OPPORTUNITY LOSS; THIS ACTION
CALLS FOR THE STOCKING OF 12 COPIES EACH DAY AT
WHICH POINT THERE IS MINIMUM EXPECTED LOSS OF
27.5 PAISE.
 EXPECTED VALUE FOR PERFECT INFORMATION:
Perfect Information means complete and accurate
information about the future demand and that remove all
the uncertainty for future.
EVPI represents the maximum amount of money the
decision maker has to pay to get this additional information
about the occurrence of various state of nature before a
decision has to be made. The procedure to calculate
expected value of perfect information is as follows:
Construct conditional profit table with perfect information.
Construct expected profit table with perfect information.
Determine EVPI from relation;

EVPI = EPPI – max EMV

 SOLUTION
Cost Price = 30 paisa.
Selling Price = 50 paisa.
Profit = Selling price – Cost price = 20 paisa. STEP I :
CONSTRUCT CONDITIONAL PROFIT TABLE

Possible Possible Stock Action

Demand Probability 10 11 12 13 14
(No. of Copies Copies Copies Copies Copies
Copies)
10 0.10 200
11 0.15 220
12 0.20 240
13 0.25 260
14 0.30 280
STEP II: CONSTRUCT EXPECTED PROFIT TABLE
WITH PERFECT INFORMATION:
DEMAND Probability Conditional Profit Expected Profit With
(No. Of Copies) Under Certainty Perfect Information

10 0.10 200 20
11 0.15 220 33
12 0.20 240 48
13 0.25 260 65
14 0.30 280 84
EPPI = 250

= min E.O.L.
 ILLUSTRATION
Under an employment promotion program, it is proposed to allow
sale of newspapers on the buses during off peak hours. The
vendor can purchase the newspaper at a special concessional
rate of 25 paise per copy against the selling price of 40 paise.
Any unsold copies are, however a dead loss. A vendor has
estimated the following probability distribution for the no. of
copies demanded:
No. of copies 15 16 17 18 19 20
Probability 0.04 0.19 0.33 0.26 0.11 0.07
a) How many copies should he ordered so that his expected
profit will be maximum?
b) Compute EPPI
c) The vendor is thinking of spending on a small market survey to
obtain additional information regarding the demand levels.
How much should he be willing to spend on such a survey?
 SOLUTION
(a) CALCULATION OF EXPECTED PROFIT:
Cost Price = 25 paisa.
Selling Price = 40 paisa.
Profit = Selling price – Cost price = 40 – 25 = 15 paisa.
STEP I : CONSTRUCT CONDITIONAL PROFIT TABLE:
Demand Possible Stock Action
(No. of 15 16 17 18 19 20
Copies) Prob
Copies Copies Copies Copies Copies Copies

15 0.04 225 200 175 150 125 100

16 0.19 225 240 215 190 165 140
17 0.33 225 240 255 230 205 180
18 0.26 225 240 255 270 245 220
19 0.11 225 240 255 270 285 260
20 0.07 225 240 255 270 285 300