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# Statistical Decision Theory

BBA Program.
Mahbub Parvez, Faculty of Business & Economics. DIU

Statistical Decision Theory: Statistical decision theory is concerned with the selection of an optimal course of action from among several alternatives where the outcome associated with an action is uncertain. Now, uncertainty can be classified into two ways/ types: 1. Subjective Probability: belief to occurrence of the event. 2. Subjective probability is the degree of

Objective Probability: Objective probability is the probability which can be derived either based on historical occurrences or based on experimentation. Alternatively can be derived from statistical formula.

Consistency requirement: If the probability of an event A is 0.65, then the probability of event B must be 0.35. i.e. P(A) + P(B) = 1 Mathematically, Then if A, B E

A, B E A B =

P(A) + P(B) = 1, which is called Consistency requirements. # Elements of Decision Problems: A decision problem is usually viewed as having four common elements 1. The alternative course of action: The alternative course of action involves two or more options or alternative course of action. One and only one of these alternatives must be selected. The states of nature: The state of nature are factors that affect the outcome of a decision but are beyond control of the decision maker, such as rain, inflation, political development etc. Payoff table: A payoff table is the combination for each possible combination of alternative course of action and state of nature. Uncertainty: The decision maker is uncertain about what state of nature will occur. However choose the criterion that results in the largest payoff.

2.

3. 4.

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## Statistical Decision Theory

BBA Program.
Mahbub Parvez, Faculty of Business & Economics. DIU

The types of decisions people make depend on how much knowledge or information they have about the situation. Three decision making environments are defined and explained as follows: Type 1: Decision Making Under Certainty: In the environment of decision making under certainty, decision makers know with certainty the consequence of every alternative that will maximize their- well being or will result in the best outcome. Lets say that you have \$ 1000 to invest for a one year period. One alternative is to open a savings account paying 6% interest and another is to invest in a government treasury bond paying 10% interest. Both investment are secure and guaranteed, but as treasury bond will pay a higher return, you may choose that one. Type 2: Decision Making Under Risk: In decision making under risk, the decision maker knows the probability of occurrence of each outcome. For example, that the probability of being dealt a club is 0.25. The probability of rolling a 5 on a die is 1/6. In decision making under risk, the decision maker attempts to maximize his or her expected well-being. Decision theory models for business problems in this environment typically employ two equivalent criteria: maximization of expected monetary value and minimization of expected loss. Type 3: Decision Making Under Uncertainty: In decision making under uncertainty the decision maker does not know the probabilities of the various outcomes. As an example, the probability that a BNP personnel will be president of Bangladesh 25 years from now is not known. Sometimes it is impossible to assess the probability of success of a new undertaking or product.

## Decision Making Under Risk

Decision making under risk is a probabilistic decision situation. Several possible states of nature may occur, each with a given probability. There are three types of methods or criteria available, which could be of help to the decision maker. 1. Expected Monetary Value: EMV is the weighted sum of possible payoffs for each alternative. i.e. EMV (alternative i ) = (Payoff of first state of nature) x ( Probability of first state of nature) +(Payoff of second state of nature)x(Probability of second state of nature) + . + (Payoff of last state of nature)x(Probability of last state of nature). Example: Mc Douglas a national chain fast food restaurant, has been offering a traditional selection of hamburgers, French fries, soft drinks etc. The company want to introduce breakfast items to the menu.

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## Statistical Decision Theory

BBA Program.
Mahbub Parvez, Faculty of Business & Economics. DIU

Breakfast items are relatively easy to prepare and would not require a large capital outlay for additional cooking equipment. Most important such items would be sold in the morning when the demand for the companys traditional products has been very week. However, because a. Many people are known to skip breakfast and b. The company does not know how competitors may react, the demand for the new products is uncertain. So, they consider three levels of customer demand- strong, average and weak. There are two alternative acts available to Mc Douglas A1 : Introduce breakfast items. A2 : Do not introduce breakfast items. And three possible states of nature S1 : S2 : S3 : Strong demand Average demand Weak demand

The management developed a set of payoffs for each act / state combination. The payoff considered such items as capital outlay, depreciation policies, training costs, additional advertising expenditures and so on. Act A2 , do not introduce breakfast items, has zero payoffs for all states since three would be no incremental revenue or cost associated with this decision. Solution: The payoff table according to the data is State (demand ) Strong, S1: Average, S2: Weak, S3: Act A1 (Introduc ed) 30 5 -15 A2 (Not Introduced) 0 0 0 Status Quo, means do not introduced anything. Now the management assigns the subjective probability distribution based on the beliefs.

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## Statistical Decision Theory

BBA Program.
Mahbub Parvez, Faculty of Business & Economics. DIU

State (demand ) Strong, S1: Average, S2: Weak, S3: Hence the payoff matrix S S1 : S2 : S3 :

## Probabili ty 0.2 0.4 0.4

Act A1 A2 30 5 -15 0 0 0

## = 30 (.2) + 5 (.4) 15 (.4) = 6 + 2 6 = \$2 = 0(.2) + 0 (.4) + 0(.4) = 0

A1 is the optimal act. So, introduced breakfast items. Example 14.4, (Page-628, Hira & Gupta.) A newspaper boy has the following probabilities of selling a magazine. No. of copies Probabili Sold ties 10 0.10 11 0.15 12 0.25 13 0.25 14 0.30 Cost of a copy is 30 paisa, sale price is 50 paisa. He cannot return unsold copies. How many copies should he order? Solution: Sales magnitude are 10,11,12,13,14 . There is no reason to buy less than 10 or more than 14. Now from any possible combination of supply and demand. The conditional profit table is 1. Stocking of 10 copies each day will always result in a profit of 200 paisa irrespective of demand. Even if the demand on some day is 13 copies, he can sell only 10 and hence his conditional profit is 200 paisa.

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## Statistical Decision Theory

BBA Program.
Mahbub Parvez, Faculty of Business & Economics. DIU

2.

When he stocks 11 copies his profit will be 220 paisa on days when buyers request 11, 12, 13 or 14 copies. But on days when he has 11 copies on stock and buyers buy only 10 copies, his profit decreases to (200 30) = 170 paisa. Thus the conditional profit in paisa is given by sold 30 x copies unsold. Conditional profit table Possible Demand (no. copies ) 10 11 12 13 14 Prob of 0.10 0.15 0.20 0.25 0.30 10 Copies 200 200 200 200 200 Possible Stock action 11 12 13 Copies Copies Copies 170 220 220 220 220 140 190 240 240 240 110 160 210 260 260 14 Copies 80 130 180 230 280 Payoff = 20 x copies

Expected Monetary Value: EMV (10) = .10 (200) + .15 (200) 30 + 40 + 50 + 60 = 200 EMV (11) = .10 (170) + .15 (220) 33 + 44 + 55 + 66 = 215 EMV (12) = .10 (140) + .15 (190) 28.5 + 48 + 60 + 72 = 222.5 EMV (13) = .10 (110) + .15 (160) 24 + 42 + 65 + 78 = 220 EMV (14) = .10 (80) + .15 (130) 19.5 + 36 + 57.5 + 84 = 205 + .20 (200) + .25 (200) + .30 (200) = 20 + + .20 (220) + .25 (220) + .30 (220) = 17 + + .20 (240) + .25 (240) + .30 (240) = 14 + + .20 (210) + .25 (260) + .30 (260) = 11 + + .20 (180) + .25 (230) + .30 (280) = 8 +

The news boy must, therefore order 12 copies to earn the highest possible average daily profit of 222.5 paisa. 2. Expected Opportunity Loss (EOL): It is an approach alternative to the EMV approach. Opportunity loss, sometimes called regret, refers to the difference between the optimal profit or payoff and the actual payoff received. In other words, EOL is the cost of not picking the best solution. The minimum expected opportunity loss is found by constructing and opportunity loss table and computing EOL for each alternative. The steps are: i. The first step is to create the opportunity loss table. This is done by determining the opportunity loss for not choosing the best alternative for each state of nature. Page5 of 12

## Statistical Decision Theory

BBA Program.
Mahbub Parvez, Faculty of Business & Economics. DIU

Define Lij = as the opportunity loss under state Si for act Aj and Li M ij M i*

Where Mi* =The best pay off under state Si. ii. The second step is to compute EOL by multiplying the probability of each state of nature times the appropriate opportunity loss value.

Example:

## Mc Douglas payoff matrix S S1 : S2 : S3 : Act A1 A2 30 5 -15 0 0 0 P (S) 0.2 0.4 0.4

* Now, Li j = M ij M i

i.e.

* L11 = M 11 M 1 = 30 30 = 0 ,

L12

M 12 M 1* = 0 30 = 30 ,
* * L21 = M 21 M 2 = 5 5 = 0 , L22 = M 22 M 2 = 0 5 = 5 ,

L31
* M 32 M 3 = 0 0 = 0 ,

* M 31 M 3 = 15 0 =15 ,

L32

Hence the opportunity loss table on the basis of the original matrix is S S1 : S2 : S3 : Act A1 A2 0 0 15 30 5 0 EOL (A1) P (S) 0.2 0.4 0.4 Hence A1 is the optimal act as it minimize EOL. Example 14.5, (Page-629, Hira & Gupta.) The Conditional Profit Table of the news paper boy is given Page6 of 12 EOL (A2) = 0 (.2) + 0(.4) + 15 (.4) = \$6 = 30(.2) + 5 (.4) + 0(.4) = 8

## Statistical Decision Theory

BBA Program.
Mahbub Parvez, Faculty of Business & Economics. DIU

## Possible Demand (no. copies ) 10 11 12 13 14

Prob of 0.10 0.15 0.20 0.25 0.30 10 Copies 200 200 200 200 200

Possible Stock action 11 12 13 Copies Copies Copies 170 220 220 220 220 140 190 240 240 240 110 160 210 260 260

## 14 Copies 80 130 180 230 280

The Opportunity Loss Table / Conditional Loss table (Paisa) Possible Demand (no. copies ) 10 11 12 13 14 Prob of 0.10 0.15 0.20 0.25 0.30 10 Copies 0 20 40 60 80 Possible Stock action 11 12 13 Copies Copies Copies 30 0 20 40 60 60 30 0 20 40 90 60 30 0 20 14 Copies 120 90 60 30 0

Hence EOL (10) = .10 (0) + .15 (20) + .20 (40) + .25 (60) + .30 (80) = 0 + 3 + 8 + 15 + 24 = 50 (Paisa) EOL (11) = .10 (30) + .15 (0) + .20 (20) + .25 (40) + .30 (60) = 3 + 0 + 4 + 10 + 18 = 35 EOL (12) = .10 (60) + .15 (30) + .20 (0) + .25 (20) + .30 (40) = 6 + 4.5 + 0 + 5 + 12 = 27.5 EOL (13) = .10 (90) + .15 (60) + .20 (30) + .25 (0) + .30 (20) = 9 + 9 + 6 + 0+ 6= 30 EOL (14) = .10 (120) + .15 (90) + .20 (60) + .25 (30) + .30 (0) = 12 + 13.5 + 12 + 7.5+ 0= 45 Hence stocking 12 copies each day will minimize expected opportunity loss, which is 27.5 paisa. 3. Expected Value of Perfect Information: (EVPI) Complete and accurate information about the future demand, referred to as perfect information would remove all uncertainty form the problem. With this perfect information, the decision maker would know in advance exactly about the future demand. EVPI represents the maximum amount he would pay to get the additional information on which may be based the decision alternative. EVPI = Expected profit with perfect information EMV EVPI = EPPI EMV (max) Example: Given Mc Douglas payoff matrix Page7 of 12 i.e

## Statistical Decision Theory

BBA Program.
Mahbub Parvez, Faculty of Business & Economics. DIU

S A1 S1 : S2 : S3 :

Act A2 0 0 0

30 5 -15

## P (S) 0.2 0.4 0.4

Let Mi* = Maximum payoff or best outcome for first state of nature. EPPI = S S1 : S2 : S3 :

8 i

Mi* 30 5 0

8 i

## . P ( Si ) = 8 Also Max EMV = 2 * EVPI is sometimes termed the cost of uncertainty.

EPPI = 8 EVPI = 8 2 = \$6

Example: 14.6, (Page-631, Hira & Gupta.) A dairy firm wants to determine the quantity of butter it should produce to meet the demand. Past records have shown the following demand patterns: Quantity required (Kg) 15 20 25 30 35 40 50 No. of days demand occurred 6 14 20 80 40 30 10

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## Statistical Decision Theory

BBA Program.
Mahbub Parvez, Faculty of Business & Economics. DIU

The stock levels are restricted to the range of 15 to 50 kg and the butter left unsold of the end of the day must be disposed of due to inadequate storing facilities. Butter cost Rs. 40 per kg and is sold at Rs. 50 per kg. i. ii. iii. Construct a conditional profit table. Determine the action alternative associated with the maximization of expected payoff. Determine EVPI.

Solution: The dairy firm would not produce butter less than 15 kg and more that 50 kg. From the given data The conditional profit table CP = 10S if D S 50D 40S if D < S

Also the quantity of butter required for 6 days out of a total of 200 days is 15 kg means that the demand of 15 kg has an associated probability of 6 / 200 = . 03 Conditional Profit Table Possi ble Dema nd 15 20 25 30 35 40 50 Probab ility 15 150 150 150 150 150 150 150 20 -50 200 200 200 200 200 200 Possible Stock action

## 50 -1250 -1000 -750 -500 -250 0 500

EMV (15) = 15(150) + .05(150) = EMV EMV EMV EMV EMV EMV (20) (25) (30) (35) (40) (50) = = = = = =

.03 (150) + .07(150) + .10(150) + .40(150) + .20(150) + . 4.5 + 10.5 + 15 + 60 + 30 + 22 + 7.5 = 150 192.50 217.50 (Max) 217.50 (Max) 117.50 -32.5 -407.50

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## Statistical Decision Theory

BBA Program.
Mahbub Parvez, Faculty of Business & Economics. DIU

Expected Profit Table With Perfect Information Possi ble Dema nd 15 20 25 30 35 40 50 Conditional Profit Under Certainty Mi* 150 200 250 300 350 400 500 Probability of Market size .03 .07 .10 .40 .20 .15 .05 Expected profit With Perfect Information

## 4.5 14 25 120 70 60 25 8 M i . P(Si ) = 318.5

EVPI = EPPI EMV (max) = 318.5 217.50 = 101(Rs) Example: Page 637, 14.7, 14.10, 14.12, 14.14, 14.15 (Hira & Gupta)

## Decision Making Under Uncertainty

When a manager cannot assess the outcome probability with confidence or when virtually no probability data are available, other decision criteria are required. This type of problem has been referred to as decision making under uncertainty. The criteria or method that we cover in this section include 1. 2. 3. 4. 5. Maximax (optimistic) Maximin (pessimistic) Minimax Hurwicz Criterion (Criterion of realism) Laplace Criterion or Equally likely criterion or Criterion of Rationality.

1. Maximax (Optimistic) Criterion: Under this the decision maker finds the maximum possible payoff for each alternative and then chooses the alternative with maximum payoff within this group.

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## Statistical Decision Theory

BBA Program.
Mahbub Parvez, Faculty of Business & Economics. DIU

2. Maximin (Pessimistic) Criterion: To use this criterion the decision maker finds the minimum possible payoff for each alternative and then chooses the alternative with maximum payoff within this group. 3. Minimax Criterion : The decision maker tries to minimize the regret before actually selecting a particular alternative. For this he determines the maximum regret amount for each alternative and then choose the alternative with the minimum of the above maximum regrets. 4. Hurwicz Criterion: Also called the weighted average criterion. It is a compromise between the maximax and maximin decision criteria. It takes both of them into account by assigning them weights in accordance with the degree of optimism or pessimism. Select = Index of optimism, If = 0 pessimistic, then = 1 optimistic.

Hence is specified (0,1) range. Also = 0.5 implies neither optimistic nor pessimistic. 5. Laplace Criterion: It is based on what is known as the principle of insufficient reason. Because of the probability distribution of the states of nature is not known, the criterion assigns equal probabilities toa ll the events of each alternative and select the alternative associated with the maximum expected payoff. Example: 14.1, Page 623 (Hira & Gupta) The following matrix gives the payoff of different strategies (alternatives) S1,S2, S3 against conditions (events) N1, N2, N3 & N4 . N1 Rs. 4000 20000 20000 N2 Rs. 100 5000 15000 N3 Rs. 6000 400 -2000 N4 Rs. 18000 0 1000

S1 S2 S3

Indicate the decision taken under the following approach: i. ii. iii. iv. v. Solution: Pessimi stic Optimis tic Page11 of 12 Equal Probability Value Pessimistic Optimistic Equal Probability Regret Hurwicq Criterion, his degree of optimism being 0.7

## Statistical Decision Theory

BBA Program.
Mahbub Parvez, Faculty of Business & Economics. DIU

-100 0 -2000

## 18000 20000 20000

Rs. ( 4000 100 + 6000 + 18000) = 6975 Rs. ( 20000 + 5000 + 400 + 0) = 6350 Rs. ( 20000 + 15000 -2000 + 1000) = 8500

S2 is the optimal decision. S2 or S3 is the optimal decision. S3 is the alternative to be selected. Under regret criterion i th regret = (maximum payoff i th payoff) for the jth event. N1 S1 S2 S3 1600 0 0 0 N2 15100 10000 0 N3 0 5600 8000 N4 0 18000 17000 Maxim um regret 16000 18000 17000

The decision alternative S1 would be chosen since it corresponds to the minimal of the maximum possible regrets. v. For the given payoff matrix the minimum and the maximum payoff for each alternative are given below. Minimu m payoff -100 0 -2000 Maximu m payoff 18000 20000 20000 Payoff = . Maximum + (1- ) minimum Where = 0.7 .7 x 18000 + .3 x (-100) = 12570 .7 x 20000 + .3 (0) = 14000 .7 x 20000 + .3 (-2000) = 13400

S1 S2 S3

Thus under Hurwicz rule, alternative S2 should be chosen as it is associated with the highest payoff of Rs. 14000. Example: 14.2- Page 625, 14.11-Page 639 (Hira & Gupta) Exercise: Page- 715, No. 1,2,3,4,5,6,7,8 (Hira & Gupta)

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