Decision TheoryDecision TheoryDecision TheoryDecision Theory

• Decision theory problems are characterized by the following:1. A list of alternatives.

2. A list of possible future states of nature.

3. Payoffs associated with each alternative/state of nature combination.

4. An assessment of the degree of certainty of possible future events.

5. A decision criterion.

Table Table General Format of a Decision TableGeneral Format of a Decision TableTable Table General Format of a Decision TableGeneral Format of a Decision Table

Decision Making under Decision Making under Complete UncertaintyComplete Uncertainty

Decision Making under Decision Making under Complete UncertaintyComplete Uncertainty

• Approaches to decision making under complete uncertainty:1. Maximin

2. Maximax.

3. Minimax regret.

4. Hurwicz

5. Equal likelihood

Table 11–11Table 11–11 Summary of Methods for Decision Making under Complete Summary of Methods for Decision Making under Complete UncertaintyUncertainty

Table 11–11Table 11–11 Summary of Methods for Decision Making under Complete Summary of Methods for Decision Making under Complete UncertaintyUncertainty

The Hurwicz (Realism) Criterion (Weighted The Hurwicz (Realism) Criterion (Weighted Average or Realism Criterion)Average or Realism Criterion)

The Hurwicz (Realism) Criterion (Weighted The Hurwicz (Realism) Criterion (Weighted Average or Realism Criterion)Average or Realism Criterion)

• The approach offers the decision maker a compromise between the maximax and the maximin criteria.

– Requires the decision maker to specify a degree of optimism, in the form of a coefficient of optimism α, with possible values of α ranging from 0 to 1.00.

– The closer the selected value of α is to 1.00, the more optimistic the decision maker is, and the closer the value of α is to 0, the more pessimistic the decision maker is.

Decision Making under RiskDecision Making under RiskDecision Making under RiskDecision Making under Risk

• Decision making under partial uncertainty–Distinguished by the present of probabilities for the

occurrence of the various states of nature under partial uncertainty.

–The term risk is often used in conjunction with partial uncertainty.

• Sources of probabilities–Subjective estimates–Expert opinions–Historical frequencies

Approaches to Incorporating Probabilities in Approaches to Incorporating Probabilities in the Decision Making Processthe Decision Making Process

Approaches to Incorporating Probabilities in Approaches to Incorporating Probabilities in the Decision Making Processthe Decision Making Process

• Expected Monetary Value (EMV) approach– Provides the decision maker with a value that represents an

average payoff for each alternative.

• Expected Opportunity Loss (EOL)– The opportunity losses for each alternative are weighted by the

probabilities of their respective states of nature to compute a long-run average opportunity loss, and the alternative with the smallest expected loss is selected as the best choice.

• Expected Value of Perfect Information (EVPI)– A measure of the difference between the certain payoff that could

be realized under a condition of certainty and the expected payoff under a condition involving risk.

Figure Decision Tree FormatFigure Decision Tree FormatFigure Decision Tree FormatFigure Decision Tree Format

Decision trees are used by decision makers to obtain a visual portrayal of decision alternatives and their possible consequences.