PRESENTATION ON DECISION THEORY

Group members: 1. Amul Shrestha 2. Bikash Gyanwali 3. Dinesh Basnet 4. Manish Maharjan 5. Niraj Gautam 6. Shiva Kumar Yadav

Decision Theory
Making of a decision requires an enumeration of feasible and viable alternatives, the projection of consequences associated with different alternatives and a measure of effectiveness to identify best alternatives. Decision Theory is a set of concepts, principles, tools and techniques that aid the decision maker in dealing with complex decision problems under certainty

Elements in Decision Analysis Problem

Course of action:- Finite number of alternatives available to the decision maker in any given situation. They are under the control of decision maker. State of nature:- List of possible of future events. They are not under the control of decision maker. Pay Off:- Effectiveness associated with specified combination of a course of action and state of nature. Also known as profit.

Decision Table
States of Nature

Course of action

c c c

1 2 3

s P P P

1,1 2 ,1 3,1

s P P P P

1, 2 2, 2 3, 2

s P P P P

1, 3 2,3 3, 3

s P P P P

1, n 2,n 3, n

m,2

m ,3

m,n

m ,1

where: sj = state of nature cj = course of action Pi,j = payoff for decision i under state j

Types of Decision Making Environment

1. Decision making under certainty 2. Decision making under uncertainty 3. Decision making under risk

Decision making under certainty

Decision maker has the complete knowledge of consequences of every decision choice with certainty.

Select that alternative which yields largest return for the known future.

Decision Variable Units to build Parameter Estimates Cost to build (/unit) Revenue (/unit) Demand (units) Consequence Variables Total Revenue Total Cost Performance Measure Net Revenue

150

$ $

6,000 14,000 250

$ 2,100,000 $ 900,000

$ 1,200,000

Decision making under uncertainty

Decision maker is unable to specify the probability with which various nature will occur. Decision maker has to act with imperfect information in such a situation. There are different criteria available for selection to deal with such situation.

1. Optimism (Maximax or Minimin) Criterion

Locate the maximum (or minimum) payoff values corresponding to each alternative ( or course of action), then Select an alternative with best anticipated payoff value ( maximum for profit and minimum for cost)

2. Pessimism (Maximin or Minimax) Criterion

Locate the minimum ( or maximum in case of profit) payoff value in case of loss (or cost) data corresponding to each alternative, then Select an alternative with the best anticipated pay off value (maximum for profit and minimum for loss or cost)

3. Equal probabilities (Laplace) Criterion

Assign equal probability value to each state of nature by using formula: 1/(number of states of nature) Compute the expected payoff for each alternative by adding all the payoffs and dividing by the number of possible states of nature or by applying the formula: (Probability of state of nature j) * (Payoff value for the combination, I and state of nature j) Select the best expected payoff value (maximum for profit and minimum for cost)

4. Coefficient of Optimum (Hurwicz) Criterion

This approach suggests that the decision maker must select an alternative that maximizes H(Criterion of realism) = (Maximum in column) + (1 ) (Minimum in column) The working method is summarized as follows: Decide the coefficient of optimism and then coefficient of pessimism (1) For each alternative select the largest and lowest payoff value and multiply these and (1- ) values, respectively. Then calculate the weighted average, H by using above formula.

Select an alternative with best anticipated weighted average payoff value

5. Regret (Savage) Criterion

From the given payoff matrix, develop an opportunity-loss (or regret) matrix as follows: Find the best payoff corresponding to each state of nature, and Subtract all other entries (payoff values) in that row from this value For each course of action (strategy or alternative) identify the worst or maximum regret value. Record this number in a new row Select the course of action (alternative) with the smallest anticipated opportunity-loss value

The following matrix gives the payoff (in Rs) of different strategies (alternatives) S1, S2 and S3 against conditions (events) N1, N2, N3 and N4.
State of nature
Strategy N1 N2 N3 N4

S1
S2 S3

4000
20000 20000

-100
5000 15000

6000
400 -2000

18000
0 1000

Indicate the decision taken under the following approaches: i) Pessimistic (Maximin) ii) Optimistic (Maximax) iii) Equal Probability iv) Regret v) Hurwicz criterion, the degree of optimistic being 0.7

i) Pessimistic (Maximin) Strategies

State of nature N1 N2 N3 N4 S1 4000 -100 6000 18000 S2 20000 5000 400 0 S3 20000 15000 -2000 1000

Column (Minimum)

-100

-2000

Maximum

Decision: S2

ii) Optimistic (Maximax) Strategies

State of nature N1 N2 N3 N4 S1 4000 -100 6000 18000 S2 20000 5000 400 0 S3 20000 15000 -2000 1000

Column (Maximum)

18000

20000

20000

Maximum

Maximum

Decision: S2, S3

iii) Equal probability

Expected Return in Rs
Strategies S1
S2 S3

(4000 100 + 6000 +18000) / 4

(20000 + 5000 + 400 + 0) / 4 (20000 + 15000 2000 + 1000) / 4

= 6975
= 6350 = 8500

Since the largest expected return is from strategy S3, hence S3 must be selected.

iv) Regret (Minimax)

Strategies
State of nature S1 N1 20000 4000 = 16000 S2 S3 20000 20000 = 0 20000 20000 = 0

N2
N3 N4 Column (Maximum)

15000 -(-100) = 15100 15000 5000 = 10000

6000 6000 = 0 18000 18000 = 0 16000

15000 15000 = 0

6000 400 = 5400 6000 - (-2000) = 8000 180000 0 = 18000 18000 18000 1000 = 17000 17000

Minimax (Regret) Decision: S1

5. Hurwicz Criterion, the degree of optimum being 0.7

Given the coefficient of optimism equal to 0.7, the coefficient of pessimism will be 1 0.7 = 0.3. Then according to Hurwicz, select course of action that optimizes the payoff value. H = (Best payoff) + (1 ) (Worst payoff) = (Maximum in column) + (1 ) (Minimum in column)
Strategy S1 S2 S3 Best payoff 18000 20000 20000 Worst payoff -100 0 -20000 H 12570 14000 13400

Since strategy S2 has the maximum profit = 20000 * 0.7 + 0 * 0.3 = Rs 140000 Hence, S2 must be selected

 Decision making under risk:

Decision making under risk is a probabilistic decision situation, in which more than one state of nature exits and the decision maker has sufficient information to assign probability values to the likely occurrence of each of these sates. Decision making under risk can be calculated on 3 basis. They are

A)Expected Monetary Value (EMV)

The excepted monetary value for a given course of action is the weight sum of possible payoff for each alternative. It is obtained by summing the payoff for each course of action multiplied by the probabilities associated with each state of nature.

m Mathematically, EMV= PijPi i=1 Where: m= number of possible states of nature Pij= payoff associated with state of nature, Ni and course of action, Sj. Pi= probability of occurrence of state of nature, Ni Example: Condition Cost Probability of missing flight Airport bus Rs 25 0.08 Stay in hotel Rs 270 0.04 Taxi Rs 350 0.01 If he catches flight, he concluded a business transactions which will produce profit of Rs 10,000.

Expected Monetary Value (EMV) State of Nature Bus Cost Catches the flight 9,975 Prob. 0.92 EV 9177 Course of Action Stay in hotel Cost 9,730 Prob. 0.96 EV 9,340.80 Taxi Cost 9,650 Prob. EV 0.99 9,533.5

Miss the 25 Flight

EMV

0.08

2.0
9,175

2.70

0.04

10.80
9,330

350

0.01

3.5
9,550

B) Expected Opportunity Loss (EOL):

EOL is also called expected value of regret. The EOL is defined as the difference between the highest profit(or payoff) for state of nature and the actual profit obtained for the particular course of action taken. In other words, EOL is the amount of payoff that is last by not selecting the course of action that has the greatest payoff for the state of nature that actually occur. The course of action due to which EOL is minimum is recommended. Mathematically, m EOL (state of nature, Ni )= lijPi i=1 Where, lij= opportunity loss due to state of nature, Ni and course of action, Ni Pi= probability of occurrence of state of nature, Ni

Example: Fixed cost= Rs 60,000 Selling price= Rs 6,000 for each unit Cost price= Rs 2,000 for each unit No of customer= 100 Proportion of customer: 0.04 0.08 0.12 0.16 0.20 Probabilities: 0.10 0.10 0.20 0.40 0.20 There is two condition i.e. Develop or Do not develop Solution: Conditional profit= (6,000-2,000)*100p-60,000 = Rs(4,00,000-60,000)

Opportunity Loss Values State of Nature (prop. of Cus.) 0.04 0.08 0.12 0.16 0.20 Probability Conditional Profit (Rs) S1 (Develop) 0.1 0.1 0.2 0.4 0.2 -44,000 -28,000 -12,000 4,000 20,000 S2 (Do not develop) 0 0 0 0 0 Opportunity Loss (Rs) S1 (Develop) 44,000 28,000 12,000 0 0 S2 (Do not develop) 0 0 0 4,000 20,000

EOL(S1)= (44,000*0.1)+(28,000*0.1)+(12,000*0.2)= Rs 9,600 EOL(S2)= (4,000*0.4)+(20,000*0.2)= Rs 5,600

C)Expected Value of Perfect Information (EVIP):

In decision making under risk state of nature is associated with the probability of its occurrence. However, if the decision maker can acquire perfect (complete and accurate ) information about the occurrence of various state of nature, then he will be able to select a course of action that yields the desired payoff for what state for what state of nature that actually occurs. Mathematically, EVIP= (Expected profit with perfect information)- (Expected profit without perfect information) m =pi max(pij) EMV* i=1 Where, pij= best payoff when action, Sj is taken inn the presence of state of nature, Nj pi= probability of state of nature, nj EMV*= maximum expected monetary value

Example: A project of manufacturing a dancing doll with three different movements designs. Designs Fixed cost Variable cost Gears and levels Rs 1,00,000 Rs 5 per unit Spring action Rs 1,60,000 Rs 4 per unit Weights and pulleys Rs 3,00,000 Rs 3 per unit One of the following demand events can occurs for the doll with the probabilities Demands Units Probabilities Light demand 25,000 0.10 Moderate demand 1,00,000 0.07 Heavy demand 1,50,000 0.20

Solution: Payoff=(demand*selling price)- fixed cost-(demand*variable cost) =Revenue-total cost-fixed cost EMV and Payoff values
State of nature Prob Conditional payoff (Rs) due . to course of action Gears Light 0.10 25,000 4,00,000 6,50,000 Spring -10,000 4,00,000 7,40,000 Weight -1,25,000 4,00,000 7,50,000 Expected payoff(Rs) due to course of action Gears 2,500 2,80,000 1,30,000 4,12,500 Spring -1,000 Weight -12,500

Modera 0.70 te Heavy EMV 0.20

3,08,000 2,80,000 1,48,000 1,50,000

4,55,000 4,17,500

Expected payoff with perfect information State of nature Prob. Course of action Gears Light Moderate Heavy 0.10 0.70 0.20 25,000 4,00,000 7,40,000 Spring -10,000 4,40,000 7,40,000 Weight -1,25,000 25,000 4,00,000 4,40,000 7,50,000 7,50,000 Maximum payoff Maximum payoff* prob.

2,5oo 3,08,000 1,50,000

4,60,000

EVIP= (Expected payoff with perfect information)- (Expected payoff without information, EMV) = Rs(4,60,000- 4,55,000 ) =Rs 5,500

Decision tree
A decision tree analysis involves the construction of a diagram that shows at glance, when decisions are expected to be made in what sequence, their possible consequences, and what are the resultant payoffs.

A decision tree consist of 2 types of nodes Decision nodes commonly represented by squares Chance nodes represented by circles.

Chance branch

A3
Chance node

R
A4 S R S A3 A4 R S R S R S

Decision branch

P (state of nature)

Q (state of nature)

Decision node
A1 (COURSE OF ACTION)

A3
A2 (COURSE OF ACTION)

A4

S
Q A3 A4

R
S R S

Fig: Decision Tree

Example
A businessman has two independent investment portfolios A and B available to him, but he lacks the capital to undertake both of them simultaneously. He can choose A first and then stop , or if A is not successful, then take, B or vice versa. The probability of success of A is 0.6, while for B it is 0.4. Both investment schemes require an initial capital outlay of Rs. 10,000 and both return nothing if the venture is unsuccessful. Successful completion of A will return Rs. 20000(over cost) and successful completion of B will return Rs.24000 (over cost). Draw Decision Tree and determine the best strategy. Solution : The decision tree corresponding to the given information is given below: Evaluation of Decision and chance nodes

Decision point D3 i. Accept

Outcome Success Failure

probabilit y 0.6 o.4

Conditiona Expected l values value 20000 -10000 12000 -4000 8000 0

ii. Stop

D2

i. Accept B

Success Failure

0.4 0.6

24000 -10000

9000 -6000 3600 0 14160 -4000 10160

ii. Stop D1 i. Accept A

-------Success Failure

-------0.6 0.4

-------20000+3600 -10000

ii. Accept B

Success Failure

0.4 0.6

20000+8000 12800 -1000 -6000 6800 --0

iii. Do nothing

---

---

Stop Rs.0 Rs.3600 D2 Success(0.6) EMV=10160 Accept A Rs.20000 Failure (0.4) -Rs 10000 EMV=3600 Accept B Success: (0.4) Rs.24000

0.4 *24000 = 9600 0.6*-10000 =-6000 Rs.0

-Rs 10000 Failure (0.6) 0.4*-10000=-4000

D1

Do nothing Failure (0.6) -Rs.10000 Rs 24000 Success (0.4) D3 EMV= 8000 0.6*-10000 =-6000 Success (0.6) Rs.20000 Failure (0.4) -Rs. 10000 0.6*20000 =12000

Accept B EMV=6800

0.4*-10000= 4000

Re. 0
Stop

Rs . 0