1. What is decision theory?

A decision theory problem is characterized by decision alternatives, states of nature, and resulting payoffs. The decision alternatives are the different possible strategies the decision maker can employ. a. States of nature: The states of nature could be defined as low demand and high demand. b. Alternatives: CAL could decide to build a small, medium, or large condominium complex. c. Payoffs: The profit for each alternative under each potential state of nature is going to be determined. d. A Decision Criterion: Evaluate Criteria for Selecting the Best Course of Action e. An assessment of the degree of certainty of possible future events. List Uncertain Events: Possible events or outcomes 2. Outline a process map of the decision-making process using decision theory. 3. Describe the following approaches to decision-making: a. b. Decision Making under Certainty Decision-Making under Uncertainty

If the decision maker does not know with certainty which state of nature will occur, then he/she is said to be making decision under uncertainty. The five commonly used criteria for decision making under uncertainty are: a. The optimistic approach (Maximax) would be used by an optimistic decision maker. The decision with the largest possible payoff is chosen. If the payoff table was in terms of costs, the decision with the lowest cost would be chosen. b. The conservative approach (Maximin) would be used by a conservative decision maker. For each decision the minimum payoff is listed and then the decision corresponding to the maximum of these minimum payoffs is selected. (Hence, the minimum possible payoff is maximized.)If the payoff was in terms of costs, the maximum costs would be determined for each

decision and then the decision corresponding to the minimum of these maximum costs is selected. (Hence, the maximum possible cost is minimized.) c. The minimax regret approach (Minimax regret) requires the construction of a regret table or an opportunity loss table. This is done by calculating for each state of nature the difference between each payoff and the best payoff for that state of nature. Then, using this regret table, the maximum regret for each possible decision is listed. The decision chosen is the one corresponding to the minimum of the maximum regrets.Equally likely (Laplace criterion)

d. Hurwicz often called weighted average, the criterion of realism (or Hurwicz) decision criterion is a compromise between optimistic and a pessimistic decision.First, select coefficient of realism, a, with a value between 0 and 1. When a is close to 1, decision maker is optimistic about future, and when a is close to 0, decision maker is pessimistic about future. Payoff = a x (maximum payoff) + (1-a) x (minimum payoff) C. Decision-Making under Risk a. Expected Monetary Value If probabilistic information regarding the states of nature is available, one may use the expected Monetary value (EMV) approach (also known as Expected Value or EV). Here the expected return for each decision is calculated by summing the products of the payoff under each state of nature and the probability of the respective state of nature occurring. The decision yielding the best expected N EMV ( j ) = xij Pi return is chosen.

i =1

Where EMV(j) = expected monetary value of action j xij = payoff for action j when event i occurs Pi = probability of event i b. Expected Opportunity Loss is the weighted average loss, given specified probabilities for each event.

EOL( j ) = Lij Pi
Where EOL(j) = expected monetary value of action j
i =1

Lij = opp. loss for action j when event i occurs Pi = probability of event i c. Expected Value of Perfect Information frequently information is available which can improve the probability estimates for the states of nature. The expected value of perfect information (EVPI) is the increase in the expected profit that would result if one knew with certainty which state of nature would occur. The EVPI provides an upper bound on the expected value of any sample or survey information.

4. Show how decision trees can be used to obtain a visual portrayal of decision alternatives and their possible consequences. A decision tree is a chronological representation of the decision problem. Each decision tree has two types of nodes; round nodes correspond to the states of nature while square nodes correspond to the decision alternatives. The branches leaving each round node represent the different states of nature while the branches leaving each square node represent the different decision alternatives. At the end of each limb of a tree are the payoffs attained from the series of branches making up that limb.