7.

1 Decision Theory

Objective of Decision Making

Before a decision maker embarks on the process of decision making he/she must set clear
objectives as to what is expected to be achieved at the end of the process. In Business
decision analysis; there are two broad objectives that decision makers can possible set to
achieve. These are:
 maximisation of profit
 minimisation of loss.

Most decisions in business fall under these two broad categories of objectives. The decision
criterion to adopt will depend on the objective one is trying to achieve. In order to achieve
profit maximisation, the Expected Monetary Value (EMV) approach is most appropriate. As
will be seen later, the Expected Value of the decision alternative is the sum of highlighted
pay offs for the decision alternative, with the weight representing the probability of
occurrence of the states of nature. This approach is possible when there are probabilities
attached to each state of nature or event. The EMV approach to decision making is assumed
to be used by the optimistic decision maker who expects to maximise profit from his
investment. The technique most suitable for minimisation of loss is the Expected opportunity
loss (EOL) approach. It is used in the situation where the decision maker expects to make a
loss from an investment and tries to keep the loss as minimum as possible. This type of
problem is known as minimisation problem and the decision maker here is known to be
pessimistic. The problem under the EMV approach is known as a maximisation
problem as the decision maker seeks to make the most profit from the investment.
These two approaches will be illustrated in details in the next section.
Types of decisions
There are many types of decision making

1. Decision making under uncertainty

These refer to situations where more than one outcome can result from any single decision

2. Decision making under certainty

Whenever there exists only one outcome for a decision we are dealing with this category e.g. linear
programming, transportation assignment and sequencing e.t.c.

3. Decision making using prior data

It occurs whenever it is possible to use past experience (prior data) to develop probabilities for the
occurrence of each data

4. Decision making without prior data

No past experience exists that can be used to derive outcome probabilities in this case the decision
maker uses his/her subjective estimates of probabilities for various outcomes

Decision making under uncertainty

Several methods are used to make decision in circumstances where only the pay offs are known and
the likelihood of each state of nature are known:

Decision Making Criteria

 Maximax Criterion (Criterion of Optimism)
  Maximin Criterion (Criterion of Pessimism)
 Minimax Regret Criterion (Savage Criterion)
 Equally Likely of Laplace Criterion (Bayes’ or Criterion of Rationality
 Hurwicz Criterion (Criterion of Realism)

a) Maximin Method
This criteria is based on the “conservative approach’ to assume that the worst possible is going to
happen. The decision maker considers each strategy and locates the minimum pay off for each and
then selects that alternative which maximizes the minimum payoff

Illustration
Rank the products A B and C applying the Maximin rule using the following payoff table showing
potential profits and loses which are expected to arise from launching these three product in three
market conditions
(see table 1 below)
 Pay off table in £ 000’s
Boom condition Steady state Recession Mini profits row
minima
Product A +8 1 -10 -10
Product B -2 +6 +12 -2
Product C +16 0 -26 -26

Table 1
Ranking the MAXIMIN rule = BAC

b) MAXIMAX method
This method is based on ‘extreme optimism’ the decision maker selects that particular strategy
which corresponds to the maximum of the maximum pay off for each strategy

Illustration
Using the above example
Max. profits rw maxima
Product A +8
Product B +12
Product C +16

Ranking using the MAXIMAX method = CBA

c) MINIMAX regret method

This method assumes that the decision maker will experience ‘regret’ after he has made the decision
and the events have occurred. The decision maker selects the alternative which minimizes the
maximum possible regret.

Illustration
Regret table in £ 000’s
Boom condition Steady state Recession Mini regret row
maxima
Product A 8 5 22 22
Product B 18 0 0 18
Product C 0 6 38 38

A regret table (table 2) is constructed based on the pay off table. The regret is the ‘opportunity loss’
from taking one decision given that a certain contingency occurs in our example whether there is
boom steady state or recession
The ranking using MINIMAX regret method = BAC

d) The expected monetary value method

The expected pay off (profit) associated with a given combination of act and event is obtained by
multiplying the pay off for that act event combination by the probability of occurrence of the given
event. The expected monetary value (EMV) of an act is the sum of all expected conditional profits
associated with that act

Example
A manager has a choice between
i. A risky contract promising shs 7 million with probability 0.6 and shs 4 million with
probability 0.4 and
ii. A diversified portfolio consisting of two contracts with independent out comes each
promising Shs 3.5 million with probability 0.6 and shs 2 million with probability 0.4
Can you arrive at the decision using EMV method?
 Solution
The conditional payoff table for the problem may be constructed as below.
(Shillings in millions)
Event Ei Probability Conditional pay offs decision Expected pay off decision
(Ei)
(i) Contract (ii) Portfolio(iii Contract (i) Portfolio (i) x
) x (ii) (iii)
Ei 0.6 7 3.5 4.2 2.1
E2 0.4 4 2 1.6 0.8
- -
EMV 5.8 2.9

Using the EMV method the manager must go in for the risky contract which will yield him a higher
expected monetary value of shs 5.8 million

e) Expected opportunity loss (EOL) method

This method is aimed at minimizing the expected opportunity loss (OEL). The decision maker
chooses the strategy with the minimum expected opportunity loss

f) The Hurwiz method

This method was the concept of coefficient of optimism (or pessimism) introduced by L. Hurwicz.
The decision maker takes into account both the maximum and minimum pay off for each alternative
and assigns them weights according to his degree of optimism (or pessimism). The alternative
which maximizes the sum of these weighted payoffs is then selected

g) The Laplace method

This method uses all the information by assigning equal probabilities to the possible payoffs for
each action and then selecting that alternative which corresponds to the maximum expected pay off

Example
A company is considering investing in one of three investment opportunities A, B and C under
certain economic conditions. The payoff matrix for this situation is economic condition

Investment 1£ 2£ 3£
opportunities
A 5000 7000 3000
B -2000 10000 6000
C 4000 4000 4000

Determine the best investment opportunity using the following criteria

i. Maximin
ii. Maximax
iii. Minimax
iv. Hurwicz (Alpha = 0.3

Solution
Economic condition
Investment 1£ 2£ 3£ Minimum Maximum £
opportunities £
A 5000 7000 3000 3000 7000
B -2000 10000 6000 -2000 10000
C 4000 4000 4000 4000 4000
i. Using the Maximin rule Highest minimum = £ 4000
 Choose investment C
ii. Using the Maximax rule Highest maximum = £ 10000
Choose investment B
iii. Minimax Regret rule

1 2 3 Maximu
m regret
A 0 3000 3000 3000
B 7000 0 0 7000
C 1000 6000 2000 6000

Choose the minimum of the maximum regret i.e. £3000

Choose investment A
iv. Hurwicz rule: expected values
For A (7000 x 0.3) + (3000 x 0.7) = 2100 + 2100 = £4200
For B (10000 x 0.3) + (-2000 x 0.7) = 3000 + 1400 = £ 1600
For C (4000 x 0.3) + (4000 x 0.7) = 1200 + 2800 = £ 4000
Best outcome is £ 4200 choose investment A

Value of perfect information

It relates to the amount that we would pay for an item of information that would enable us to forecast
the exact conditions of the market and act accordingly.
The expected value of perfect information EVPI is the expected outcome with perfect information
minus the expected outcome without perfect information namely the maximum EMV

Example
From table 1 above and given that the probabilities are Boom 0.6, steady state 0.3 and recession 0.1
then
When conditions of the market are; boom launch product C: profit = 16
When conditions of the market are; steady state launch product B: profit = 6
When conditions of the market are; recession launch product B: profit = 12
The expected profit with perfect information will be
(16 x 0.6) + (6 x 0.3) + (12 x 0.1) = 12.6
our expected profit choosing product C is 7
the maximum price that we would pay for perfect information is 12.6 – 7 = 5.6