DECISION THEORY

PROF. KAUSHIK PAUL

ASSOCIATE PROFESSOR
OPERATIONS AREA
IILM GRADUATE SCHOOL OF MANAGEMENT
GREATER NOIDA
 TOPICS OF DISCUSSION
 INTRODUCTION

 PAYOFF MATRIX

 REGRET TABLE

 DECISION MAKING UNDER UNCERTAINTY

 DIFFERENT METHODS OF DECISION MAKING UNDER UNCERTAINTY

 DECISION MAKING UNDER RISK

2
 TOPICS OF DISCUSSION
 DIFFERENT METHODS OF DECISION MAKING UNDER RISK
 MAXIMUM LIKELIHOOD PRINCIPLE

 MAXIMUM EXPECTATION PRINCIPLE

 CONCEPT OF DECISION TREE

 DECISION MAKING WITH PERFECT INFORMATION AND

ECONOMIC VALUE OF PERFECT INFORMATION (EVPI)

 DECISION MAKING WITH REVISED PROBABILITIES

( USING BAYE’S THEOREM)

 EXPECTED OPPORTUNITY LOSS/REGRET PRINCIPLE

3
 INTRODUCTION
 EXTERNAL ENVIRONMENT IMPOSES CERTAIN CONSTRAINTS ON US.
BASED ON OUR RESPONSE TO SUCH CONSTRAINTS, WE GET
DIFFERENT PAYOFFS.

 WE CAN NOT CHANGE THE PAYOFF MATRIX.

 AT BEST, WE CAN USE THE AVAILABLE INFORMATION JUDICIOUSLY

TO ARRIVE AT THE OPTIMAL DECISION AND MAXIMIZE OUR
PAYOFFS IN THE LONG RUN.

4
 EXAMPLE
 A WHOLE SALER OF FRUITS BUYS STRAWBERRIES AT $ 20 A CASE
AND SELLS THEM AT $ 50 A CASE. THE PRODUCT IS PERISHABLE BY
NATURE AND CAN NOT BE STORED OVERNIGHT. IT HAS BE SOLD
ON THE DAY OF THE PURCHASE ITSELF.

 FROM EXPERIENCE, THE WHOLE SALER KNOWS THAT THE DAILY

DEMAND WILL RANGE BETWEEN 10 TO 13 CASES.

 EVERY CASE OF STRAWBERRIES BOUGHT AND NOT SOLD WOULD

LEAD TO A MARGINAL LOSS OF $ 20, WHILE EVERY CASE THAT
COULD NOT BE SOLD BECAUSE OF STOCK OUT WOULD LEAD TO AN
OPPORTUNITY LOSS OF $ 30.

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 PAYOFF MATRIX IN US $
POSSIBLE POSSIBLE STOCK ACTION IN
DEMAND IN CASES
CASES 10 11 12 13

10 300 280 260 240

11 300 330 310 290

12 300 330 360 340

13 300 330 360 390

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 REGRET TABLE IN US $
POSSIBLE POSSIBLE STOCK ACTION IN
DEMAND IN CASES
CASES 10 11 12 13

10 0 20 40 60

11 30 0 20 40

12 60 30 0 20

13 90 60 30 0
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DECISION MAKING UNDER UNCERTAINTY
 HERE, WE HAVE NO INFORMATION ABOUT THE LIKELIHOOD(
PROBABILTY) OF ANY PARTICULAR STATE OF DEMAND.

 IN SUCH A CONDITION, WE ARE MAKING A DECISION UNDER

UNCERTAINTY.

 FOLLOWING PRINCIPLES ARE USED TO TAKE DECISIONS UNDER

UNCERTAINTY:

 LAPLACE PRINCIPLE
 MAXIMIN OR MINIMAX CRITERION
 MAXIMAX. OR MINIMIN. CRITERION
 HURWICZ CRITERION
 SALVAGE PRINCIPLE

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 LAPLACE PRINCIPLE
 ASSUMES ALL STOCK ACTION PAYOFF (US $)
EXTERNAL ( CASES)
CONSTRAINTS ( HERE
DEMAND OF 10 300
STRAWBERRIES IN
CASES TO BE
EQUIPROBABLE).
11 317.5
 MAXIMUM PAYOFF IS
ACHIEVED BY
PURSUING THE
12 322.5
STRATEGY OF
STOCKING 12 UNITS.

13 315

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 MAXIMIN. OR MINIMAX
PRINCIPLE
 HERE, MINIMUM PAYOFFS STOCK ACTION MIN. PAYOFF
FROM EACH STRATEGY
IS CONSIDERED. THE ( CASES) (US $)
STRATEGY WITH MAX. OF
THESE MINIMUM PROFITS 10 300
IS SELECTED. THIS IS
KNOWN AS MAXIMIN.
PRINCIPLE. FOR COSTS,
THE STRATEGY WITH 11 280
MIN. OF MAXIMUM COSTS
IS CHOSEN. THAT IS
KNOWN AS MINIMAX.
PRINCIPLE. THIS IS A 12 260
PESSIMISTIC DECISION
MAKING.
 MAXIMUM PAYOFF IS
ACHIEVED BY PURSUING 13 240
THE STRATEGY OF
STOCKING 10 UNITS.

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 MAXIMAX. OR MINIMIN.
PRINCIPLE
 HERE, MAXIMUM STOCK ACTION MAX. PAYOFF
PAYOFFS FROM EACH
STRATEGY IS ( CASES) (US $)
CONSIDERED. THE
STRATEGY WITH MAX. OF
THESE MAXIMUM 10 300
PROFITS IS SELECTED.
THIS IS KNOWN AS
MAXIMAX. PRINCIPLE.
FOR COSTS, THE
STRATEGY WITH MIN. OF 11 330
THE MINIMUM COSTS IS
CHOSEN. THAT IS KNOWN
AS MINIMIN. PRINCIPLE.
THIS IS A HIGHLY 12 360
OPTIMISTIC DECISION
MAKING.
 MAXIMUM PAYOFF IS
ACHIEVED BY PURSUING 13 390
THE STRATEGY OF
STOCKING 13 UNITS.

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 HURWICZ PRINCIPLE
 INDEX OF OPTIMISM= α

 CRITERION VALUE = α( MAX. PROFIT) + (1- α)(MIN. PROFIT)

 FOR COSTS,

CRITERION VALUE = α( MIN.COST) + (1- α)(MAX.COST)

 α = 0 STANDS FOR MAXIMIN. OR MINIMAX. PRINCIPLE

 α = 1 STANDS FOR MAXIMAX. OR MINIMIN. PRINCIPLE

 FOR OUR EXAMPLE, LET US ASSUME AN INDEX OF OPTIMISM OF

60% (α = 0.6)

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 HURWICZ PRINCIPLE CONTINUED
STOCK ACTION HURWICZ
( CASES) CRIETRION VALUE
 THE STRATEGY
WITH THE MAXIMUM (US $)
HURWICZ 10 300
CRITERION VALUE
IS CHOSEN.
 HERE, THE 11 310
MAXIMUM HURWICZ
CRITERION VALUE
12 320
IS ACHIEVED BY
PURSUING THE
STRATEGY OF 13 330
STOCKING 13 UNITS.

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 SALVAGE PRINCIPLE
STOCK ACTION MAX. REGRET
 HERE, WE SELECT THE ( CASES) VALUE
STRATEGY THAT (US $)
MINIMIZES THE MAXIMUM
REGRET. THIS IS ALSO A 10 90
PESSIMISTIC DECISION
MAKING. THIS IS CLOSE
TO THE MINIMAX.
PRINCIPLE BUT RESULTS
11 60
MAY VARY.
 HERE, THE MINIMUM OF
MAX. REGRET (SALVAGE) 12 40
VALUE IS ACHIEVED BY
PURSUING THE
STRATEGY OF STOCKING
13 60
12 UNITS.

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 DECISION MAKING UNDER RISK
 NOW, LET US ASSUME THAT BASED ON THE SALES OF PAST
100 DAYS, THE WHOLESALER HAS FOLLOWING
INFORMATION ABOUT THE MARKET DEMAND.

DAILY SALES NO. OF DAYS PROB. OF

( CASES) SOLD DEMAND
10 15 0.15
11 20 0.20
12 40 0.40
13 25 0.25
TOTAL 100 1.00
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 DECISION MAKING UNDER RISK
 HERE, WE HAVE ADDITIONAL INFORMATION ON THE PROBABILITY
OF EACH DEMAND STATE.

 WHEN WE HAVE PROBABILITIES ASSOCIATED WITH EACH DEMAND

STATE AVAILABLE TO US, THE DECISION MAKING TECHNIQUE IS
CALLED DECISION MAKING UNDER RISK.

 FOLLOWING PRINCIPLES ARE USED TO ARRIVE AT THE OPTIMAL

DECISION.

 MAXIMUM LIKELIHOOD PRINCIPLE

 MAXIMUM EXPECTATION PRINCIPLE
 MINIMUM EXPEXCTED OPPORTUNITY LOSS/REGRET
PRINCIPLE

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 MAXIMUM LIKELIHOOD PRINCIPLE
 HERE, WE CHOOSE TO STOCK ACCORDING TO THAT DEMAND
STATE WHICH HAS MAXIMUM PROBABILITY OF OCCURRENCE. IN
THIS CASE, THE WHOLE SALER SHOULD STOCK 12 CASES, IF HE
ADOPTS THIS PRINCIPLE.

DAILY SALES PROB. OF DEMAND

( CASES)
10 0.15
11 0.20
12 0.40
13 0.25
TOTAL 1.00 17
 MAXIMUM EXPECTATION PRINCIPLE
 HERE, WE CHOOSE THAT STRATEGY WHICH HAS MAXIMUM
EXPECTED PAYOFF. THIS IS THE MOST ACCEPTABLE PRINCIPLE
SINCE, THE EXPECTED PAYOFF WILL ALWAYS COME TRUE IN THE
LONG RUN.

 IN OUR EXAMPLE, THE WHOLE SALER SHOULD CHOOSE THAT

STRATEGY WHICH WILL MAXIMIZE HIS EXPECTED PROFIT.

 NOW, WE HAVE TO EXAMINE THE EXPECTED PROFIT FOR EACH

STRATEGY ( STOCK ACTION).

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EXPECTED PROFIT FROM PURSUING A
STRATEGY OF STOCKING 10 CASES

DEMAND IN CONDITIONAL PROB. OF EXPECTED

CASES PROFIT DEMAND PROFIT
(US $)
10 300 0.15 45.0

11 300 0.2 60.0

12 300 0.4 120.0

13 300 0.25 75.0

TOTAL 1.00 300.0

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EXPECTED PROFIT FROM PURSUING A
STRATEGY OF STOCKING 11 CASES

DEMAND IN CONDITIONAL PROB. OF EXPECTED

CASES PROFIT DEMAND PROFIT
(US $)
10 280 0.15 42.0

11 330 0.2 66.0

12 330 0.4 132.0

13 330 0.25 82.5

TOTAL 1.00 322.5

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EXPECTED PROFIT FROM PURSUING A
STRATEGY OF STOCKING 12 CASES

DEMAND IN CONDITIONAL PROB. OF EXPECTED

CASES PROFIT DEMAND PROFIT
(US $)
10 260 0.15 39.0

11 310 0.2 62.0

12 360 0.4 144.0

13 360 0.25 90.0

TOTAL 1.00 335.0

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EXPECTED PROFIT FROM PURSUING A
STRATEGY OF STOCKING 13 CASES

DEMAND IN CONDITIONAL PROB. OF EXPECTED

CASES PROFIT DEMAND PROFIT
(US $)
10 240 0.15 36.0

11 290 0.2 58.0

12 340 0.4 136.0

13 390 0.25 97.5

TOTAL 1.00 327.5

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 DECISION TREE
 SO, THE MAXIMUM PROFIT COMES FROM PURSUING A STRATEGY
OF STOCKING 12 CASES.

 NOW, HOW DO WE REPRESENT THIS LOGIC DIAGRAMATICALLY?

WELL, WE USE A DIAGRAM CALLED A DECISION TREE.

 IN A DECISION TREE, WE REPRESENT A DECISION ( STATEGY) WITH

A TECTANGLE WHILE AN OUTCOME ( DEMAND IN THIS CASE) IS
REPRESENTED BY A CIRCLE.

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DECISION TREE FOR THE
WHOLESALER PROBABILITIES 10,45.0,
0.15

$ 300.0 11,60,0.2

12,120.0,0.4

13,75,0.25
$ 322.5
$ 335.0

$ 335.0

$ 327.5
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 DECISION MAKING WITH PERFECT
INFORMATION (EVPI)
 IF WE GO BACK TO THE PAYOFF MATRIX, WE HAVE MARKED
OUR BEST DECISIONS FOR EACH DEMAND SCENARIO. IF WE
COULD HAVE PERFECT INFORMATION ABOUT THE MARKET
DEMAND, OUR EXPECTED PAYOFF TABLE WOULD HAVE
LOOKED LIKE THIS.

 PAYOFF MATRIX IN US $

MARKET CONDITIONAL PROB. OF EXPECTED

DEMAND PROFIT DEMAND PROFIT
( CASES) ( US $)
10 300 0.15 45.0
11 330 0.2 66.0
12 360 0.4 144.0
13 390 0.25 97.5
TOTAL 1.00 352.5 25
DECISION TREE FOR THE
WHOLESALER WITH PERFECT
INFORMATION 10, 300.0

$ 300.0 11, 280.0

12, 260.0

$ 330.0 13, 240.0

$ 352.5

$ 360.0

$ 390.0
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 ECONOMIC VALUE OF PERFECT
INFORMATION ( EVPI)

 INCREASE IN EXPECTED PROFIT WITH PERFECT INFORMATION

= ( 352.5- 335) $
= 17.5 $

 THIS IS KNOWN AS THE ECONOMIC VALUE OF PERFECT

INFORMATION ( EVPI).

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 DECISION MAKING WITH REVISED
PROBABILITIES
 LET, THERE BE A MARKET RESEARCH FIRM, THAT PROVIDES ADDITIONAL
INFORMATION ( FORECASTING) ABOUT THE POSSIBLE STATE OF DEMAND,
AND CHARGES A FEE FOR THE SAME.

 WHAT IS THE ADDITIONAL VALUE OF THIS FORECAST AND HOW MUCH CAN
THE WHOLESALER PAY FOR IT?

 THE AGENCY FORECASTS THE DEMAND BY RATING IT AS ABOVE NORMAL

(AN) OR BELOW NORMAL (BN).

 IT HAS BEEN OBSERVED IN THE PAST THAT IN 80% OF THE INSTANCES,

WHEN THE DEMAND WAS 10 CASES, THE AGENCY HAD FORECASTED
BELOW NORMAL (BN). IN 60% OF THE INSTANCES, WHEN THE DEMAND WAS
11 CASES, THE AGENCY HAD FORECASTED BELOW NORMAL (BN). IN 30% OF
THE INSTANCES, WHEN THE DEMAND WAS 12 CASES, THE AGENCY HAD
FORECASTED BELOW NORMAL (BN). IN 20% OF THE INSTANCES, WHEN THE
DEMAND WAS 13 CASES, THE AGENCY HAD FORECASTED BELOW NORMAL
(BN).

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 REVISED PROBABILITIES
(USING BAYE’S THEOREM)

FORECAST EVENT P( EVENT) P(FORECAST/ P(FORECAST REVISED

EVENT) & EVENT) PROB.
(EVENT/FORE
CAST)
ABOVE 10 0.15 0.2 0.03 0.05
NORMAL
(AN) 11 0.2 0.4 0.08 0.14

12 0.4 0.7 0.28 0.47

13 0.25 0.8 0.2 0.34

TOTAL 1.00 P(AN) = 0.59 1.00

BELOW 10 0.15 0.8 0.12 0.29

NORMAL
11 0.2 0.6 0.12 0.29
(BN)
12 0.4 0.3 0.12 0.29

13 0.25 0.2 0.05 0.13

TOTAL 1.00 P(BN) = 0.41 1.00 29

 DECISION TREE FOR THE
REVISED PROBABILITIES
DO NOT BUY FORECAST
A
$ 335.0 10
B
AN, 0.59

$ 348.14 C

$ 335.165 $335.165 13
D

A’ 11
BUY FORECAST

B’
$ 316.5
EVPI= $ 0.165
C’
BN, 0.41
D’ 30
12
 NODE ‘A’

STOCKING 10 CASES
10,300.0,0.05

$ 300.0

11,300,0.14

12,300.0, 0.47

13, 300.0, 0.34 31

 NODE ‘B’

STOCKING 11 CASES
10,280.0,0.05

$ 327.46

11,330,0.14

12,330.0, 0.47

13, 330.0, 0.34 32

 NODE ‘C’

STOCKING 11 CASES
10,260.0,0.05

$ 348.14

11, 310.0,0.14

12,360.0, 0.47

13, 360.0, 0.34 33

 NODE ‘D’

STOCKING 11 CASES
10,240.0,0.05

$ 345.08

11, 290.0,0.14

12,340.0, 0.47

13, 390.0, 0.34 34

 NODE ‘ A’ ’

STOCKING 10 CASES
10,300.0,0.29

$ 300.0

11,300,0.29

12,300.0, 0..29

13, 300.0, 0.13 35

 NODE ‘ B’ ’

STOCKING 11 CASES
10,280.0,0.29

$ 315.50

11,330,0.29

12,330.0, 0..29

13, 330.0, 0.13 36

 NODE ‘ C’ ’

STOCKING 12 CASES
10,260.0,0.29

$ 316.50

11,310,0.29

12,360.0, 0..29

13, 360.0, 0.13 37

 NODE ‘ D’ ’

STOCKING 13 CASES
10,240.0,0.29

$ 303.00

11,290,0.29

12,340.0, 0..29

13, 390.0, 0.13 38

 MINIMUM EXPECTED
REGRET/OPPORTUNITY LOSS PRINCIPLE
 THIS PRINCIPLE WOULD GIVE THE SAME ANSWER AS THE
PREVIOUS PRINCIPLE.

 THIS IS BECAUSE, ER(j)+ EP(j)= EPPI

( EXPECTED PAYOFF UNDER PERFECTINFORMATION)

 HENCE, THE STRATEGY THAT WOULD MINIMIZE ER(j) WOULD

AUTOMATICALLY MAXIMIZE EP(j).

 THE MIN. ER(j) IS ALSO THE EVPI IN THIS CASE.

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EXPECTED OPPORTUNITY LOSS/REGRET
FOR DIFFERENT STOCK ACTIONS

STOCK ACTION EXPECTED REGRET

( CASES) ( US $)
10 52.5

11 30.0

12 17.5

13 25.0

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 EVSI AND EFFICIENCY OF EVSI
 IN OUR EXAMPLE, ECONOMIC VALUE OF SAMPLE
INFORMATION ( EVSI) = (335.165- 335) $

= 0.165 $

 EFFICIENCY OF EVSI = 0.165/335 = 0.05 %

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QUESTIONS PLEASE

THANK YOU
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