5.

Decision Making Theory

The environment within which decisions are made is often classified into four states:
Certainty , Risk, Uncertainty , and Conflict. Decision theory is primarily concerned with
decision making under conditions of Risk and Uncertainty. The theory of games is concerned
with decision making under Conflict. Both decision theory and game theory assist the decision
maker in analyzing problems with numerous alternative courses of action and consequences.
A basic objective of decision and game theories is to provide a structure where is information
concerning the relative likelihood of different occurrences maybe evaluated to enable the
decision maker to identify the best course of action.

- A State of Certainty:

Exists when all the information required to make a decision known and available - perfect
information.

-A State of Risk:

Exists when perfect information is not available, but the probabilities that certain outcomes
will occur can be estimated.

- A State of Uncertainty:

Refers to a condition in which the probabilities of occurrences in a decision situation are not
Known.

- A State of Conflict:

Exists when the interests of two or more decision makers are in competition. The steps in
making a good decision are basically the same. These steps are:
1. Clearly define the problem at hand.
2. List the possible alternatives.
3. Identify the possible outcomes ( State of nature ).
4. List the payoff or profit of each combination of alternatives and outcomes.
5. Select one of the mathematical decision theory models.
6. Apply the model and make your decision.

Note: The mean ( expected value ) of the probability as follows:

E = a1p1 + a2p2 + + anpn

Where pi is the probability of action, and ai is a constant

n
( i = 1, 2, , n ): pi 1
i 1
; 0 pi 1

1.1: Decision Making Under Uncertainty

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When no probability data are available, other decision criteria are required.

Laplace Criteria.
Minimax Criteria.
Maximin Criteria.
Savage ( Minimax ) Regret Criteria.
Hurwicz Criteria

1.1.1: Laplace Criteria:

This criteria is based on what is known as the principle of insufficient reason.

State of nature
1 2 3 n
a1 V(a1, 1) V(a1, 2) V(a1, 3). V(a1, n)
Alterna- a2
tive . V(a2, 1) V(a2, 2) V(a2, 3). V(a2, n)
. .
am .
V(am, 1) V(am, 2) V(am, 3) V(am, n)

a- V(ai, j) Profit:
1 n
The best alternative is Max
ai
{ v(ai, j )}
n j 1
1
Where is the probability that j ( j = 1, 2, , n ) occurs.
n
Example ( 1 ): Profit matrix

State of nature
1 2 3 4
a1 5 10 18 25
Alterna- a2 8 7 8 23
tive a3 21 18 12 21
a4 30 22 19 15

Solution:
E(a1) = ( 5 + 10 + 18 + 25 ) = 14.5
E(a2) = ( 8 + 7 + 8 + 23 ) = 11.5
E(a3) = ( 21 + 18 + 12 + 21 ) = 18.0
E(a2) = ( 30 + 22 + 19 + 15 ) = 21.5
The best alternative is a4 with maximum expected value.

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b- V(ai, j) Loss:
1 n
The best alternative is Min
ai
{ v(ai, j )}
n j 1
1
Where is the probability that j ( j = 1, 2, , n ) occurs.
n
Example ( 2 ): Cost matrix

State of nature
1 2 3 4
a1 5 10 18 25
Alterna- a2 8 7 8 23
tive a3 21 18 12 21
a4 30 22 19 15

Solution:

E(a1) = ( 5 + 10 + 18 + 25 ) = 14.5
E(a2) = ( 8 + 7 + 8 + 23 ) = 11.5
E(a3) = ( 21 + 18 + 12 + 21 ) = 18.0
E(a2) = ( 30 + 22 + 19 + 15 ) = 21.5

The best alternative is a2 with minimum expected value.

1.1.2: Minimax ( Maximin ) Criteria:

This is the most conservative criteria since it is based on making the best out of the worst
possible conditions. That is, if the outcome V(ai , j ) represents Loss for the decision maker,
then for ai , the worst loss regardless of what j maybe is max j [V(ai , j ) ]. The minimax
criteria then selects, the action ai associated with Minai {V(ai , j ) }. In similar manner ; if V(a i ,
j ) represents Gain , the criteria selects the action ai associated with maxai minj [V(ai , j ) ],
this call the maximin criteria.

Example 3: As previous example 1.

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a- If V ( ai , 1 ) is profit:

State of nature minj [V(ai , j ) ]

1 2 3 4
a1 5 10 18 25 5
a2 8 7 8 23 7
a3 21 18 12 21 12
a4 30 22 19 15 15 maximin

The best alternative is a4 with maximin gain.

Example 4: As previous example 3.

b- If V ( ai , 1 ) is Cost:

State of nature Maxj [V(ai , j ) ]

1 2 3 4
a1 5 10 18 25 25
a2 8 7 8 23 23
a3 21 18 12 21 21 minimax
a4 30 22 19 15 30

The best alternative is a3 with minimax loss.

1.1.3: Savage ( Minimax ) Regret Criteria:

This criteria is constructing a new loss matrix in which V(a i , j ), is replaced by r(ai , j )
which is defined by:

a. If V(ai , j ) is profit
r(ai , j ) = max
ak
{ V(ak , j ) } - V(ai , j )

b. If V(ai , j ) is cost
r(ai , j ) = V(ai , j ) - min
ak
{ V(ak , j ) }

This means that r(a i , j ) is the difference between the best choice in column j and the
values of v (ai , j ) in the same column. In essence, r (ai , j ) is a representation of the regret
of the decision maker as a result of missing the best choice corresponding to a given future state
j . The function r (ai , j ) is referred to as the regret matrix.

Example 5: As previous example 1

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a- If V ( ai , 1 ) is Cost:

State of nature
1 2 3 4
a1 5 10 18 25
a2 8 7 8 23
a3 21 18 12 21
a4 30 22 19 15

Solution:

r(ai , j ) = V(ai , j ) - min

ak
{ V(ak , j ) }

State of nature
1 2 3 4
a1 5 10 18 25
a2 8 7 8 23
a3 21 18 12 21
a4 30 22 19 15

State of nature Max

1 2 3 4
a1 0 3 10 10 10
a2 3 0 0 8 8 Minimax
a3 16 11 4 6 16
a4 25 15 11 0 25

The best alternative is a2 with minimax loss.

b- If V ( ai , 1 ) is Profit:

State of nature
1 2 3 4
a1 5 10 18 25
a2 8 7 8 23
a3 21 18 12 21
a4 30 22 19 15

Solution:

73
 r(ai , j ) = max
ak
{ V(ak , j ) } - V(ai , j )

State of nature
1 2 3 4
a1 5 10 18 25
a2 8 7 8 23
a3 21 18 12 21
a4 30 22 19 15

State of nature Max

1 2 3 4
a1 25 12 1 0 25
a2 22 15 11 2 22
a3 9 4 7 4 9 Minimax
a4 0 0 0 10 10
The best alternative is a3 with minimax loss.

1.1.4: Hurwicz Criteria:

This criteria represents a range of attitudes from the most optimistic to the most pessimistic.
The Hurwicz criterion stricks a balance between extreme pessimistic and extreme optimistic by
weighting the above conditions by the respective weight and ( 1 ), where 0 1.

a- If V ( ai , 1 ) is Profit:

max{ max v(ai, j ) (1 ) min v(ai, j )}

ai j j

b- If V ( ai , 1 ) is Cost:

min{ min v(ai, j ) (1 ) max v(ai, j )}

ai j j

Example 6: As previous example 1 with = 2/5

a- If V ( ai , 1 ) is Cost:
State of nature
1 2 3 4
a1 5 10 18 25
74
a2 8 7 8 23
a3 21 18 12 21
a4 30 22 19 15
Solution:

min{ min v(ai, j ) (1 ) max v(ai, j )}

ai j j

ai min v ( ai, j ) max v( ai, j ) min v ( ai, j ) + ( 1- )

j j j

max v( ai, j )
j

1 5 25 2/5(5) + 3/5 (25) = 17

2 7 23 2/5(7) + 3/5(23) = 15.2
3 12 21 2/5(12) + 3/5(21)= 15 min
4 15 30 2/5(15) + 3/5(30)= 21

The best alternative is a3 with minimum expected value

1.2: 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. One of the most popular methods of making
decisions under risk, namely, selecting that alternative with highest expected monetary value,
also look at the concepts of perfect information and opportunity loss value.

1.2.1: Expected Monetary Value ( EMV ):

n

EMV ( Alternative I ) = aipi

i 1
Example 7:
A company is going to introduce name X, Y, and Z. The market conditions ( Favorable, Stable,
and Poor ) will determine the profit or loss the company realize in the first year the product is
introduced as shown in the following table.

Product Favorable Stable Poor

X 1,200,000 700,000 -300,000
Y 600,000 400,000 200,000
Z 350,000 300,000 100,000

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Probability 0.25 0.45 0.30

Determine the best investment under conditions of risk using Expected Value.

Solution:

EMV( X ) = 0.25 ( 1,200,000 ) + 0.45 ( 700,000 ) + 0.30 (-300,000 ) = 525,000 L.D

EMV( Y ) = 0.25 ( 600,000 ) + 0.45 ( 400,000 ) + 0.30 (200,000 ) = 390,000 L.D

EMV( Z ) = 0.25 ( 350,000 ) + 0.45 ( 300,000 ) + 0.30 (100,000 ) = 252,500 L.D.

The best product is X with maximum expected value.

1.2.2: Expected Value of Perfect Information ( EVPI ):

Determining the value of such perfect information can be very useful. If places an upper bound
on what you would be willing to spend on information such as that being sold by scientific
marketing.

EVPI = ( Expected value with perfect information ) ( Expected

monetary value )

The expected value with perfect information is average return in the long run, if we have
perfect information before a decision has to be made.

Example 8:
As previous example 7, determine the best investment using Expected value of perfect
information.
EVPI = [ 0.25 * 1,200,000 + 0.45 * 700,000 + 0.30 * 200,000 ] - 525,000 = 150,000 L.D.
The best product is X with select maximum expected value.

1.2.3: Expected Opportunity Loss ( EOL ):

An alternative approach to maximizing expected monetary value ( EMV ) it to minimize

expected opportunity loss. EOL, some times called regret, refers to a different between the
optimal profit ( payoff ) and the actual payoff received.

Example 9:
As previous example 7, determine the best investment using Expected Opportunity Loss.

Solution:

Product Favorable Stable Poor

X 0 0 500,000

76
 Y 600,000 300,000 0
Z 850,000 400,000 100,000
Probability 0.25 0.45 0.30

EOL(X) = 0.25 ( 0 ) + 0.45 ( 0 ) + 0.3 ( 500,000 ) = 150,000 L.D.

EOL(Y) = 0.25 ( 600,000 ) + 0.45 (300,000 ) + 0.3 ( 0 ) = 285,000 L.D.
EOL(Z) = 0.25 (850,000 ) + 0.45 ( 400,000 ) + 0.3( 100,000) = 414,000 L.D.

The best product is X with select minimum EOL.

Note: EVPI = Minimum EOL = 150,000

1.3: Game Theory

The criteria for the decisions under uncertainty are developed under the assumption that
nature is opponent. This means involving two or more intelligent opponent in which opponent
aspires to optimize his own decision at the expense of the opponents.
An opponent is referred to as a player. Each player has a number of choices, finite or infinite,
called strategies. The outcomes or payoffs of a game with two player are summarized as
functions of the different strategies for each player. A game with two players, where a gain of one
player equal a loss to the other, is known as a Two Player Zero Sum game.

a- Pure Strategy:

The pure strategy where the equality holds, that is minimax = maximin value, the
corresponding pure strategies are called optimal strategies and the same is said to have a
saddle point.
The value of the game, given by the common entry of the optimal pure strategies is equal to the
Minimax and the Maximin values.

Example 10 :

Find the optimal pure strategies of each player. If the player A is gain. The outcomes of the
two players are shown in the following table.

Player B
1 2 3 4
1 8 2 9 5
Player A 2 6 5 7 18
3 7 3 -4 10

Solution:

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 Player B Row minimum
1 2 3 4
1 8 2 9 5 2
Player A 2 6 5 7 18 5 Maximin
3 7 3 -4 10
-4
8 5 9 18
Coloumn
Maximin Minimax

Then Maxinin = Minimax = 5, This means that the Saddle point is equal to 5, which is the
game value. Player A select strategy 2 and player B select strategy 2.

b- Mixed Strategy:

Some games do not have saddle points, however. For example, consider the following zero
sum game.

Player B Row minimum

1 2 3 4
1 5 -10 9 0 -10
Player A 2 6 7 8 1 1
3 8 7 15 2
2 Maximin
4 3 4 -1 4
-1
8 7 15 4
Coloumn
Maximum Minimax

Minimax Maximin, is means no saddle point, which is no game value.

There are several methods for solving Two Person zero sum games for the optimal values
of Xi and Yj . We consider only Linear Programming method and Graphical method for ( 2 * n )
and ( m * 2 ) games.

1.4: Linear Programming Method

a- In case of gain ( player A ):

78
 Max: Y0 = Y1 + Y2 + Y3 + + YN

S.T: a11Y1 + a12Y2 + + a1nYn 1

a21Y1 + a22Y2 + + a2nYn 1
.
.
Am1Y1 + am2Y2 + + amnYn 1
Y1, Y2, , Yn 0
1
Value game = v = k and
w
Yj
probability yj* = ; j = 1, 2, , n
w
Example 11:

Player B Row minimum

1 2 3
1 3 -1 -3 - 3 Maximin
Player A 2 -3 3 -1 - 3 Maximin
3 -4 -3 3 -4
Coloumn 3 3 1
Maximin
Minimax

No saddle point; Where k = 5

Player B Row minimum

1 2 3
1 8 4 2 2 maximin
Player A 2 2 8 4 2 maximin
3 1 2 8 1
Column Maximum 8 8 8
Minimax

Max: Y0 = Y1 + Y2 + Y3
S.T: 8Y1 + 4Y2 + 2Y3 1
2Y1 + 8Y2 + 4Y3 1
Y1 + 2Y2 + 8Y3 1
Y1, Y2,Y3 0
Solution:

Max: Y0 = Y1 + Y2 + Y3 + 0S1 + 0S2 + 0S3

S.T: 8Y1 + 4Y2 + 2Y3 + S1 =1

5Y1 + 8Y2 + 4Y3 + S2 =1

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 Y1 + 2Y2 + 8Y3 + S3 = 1
Y1, Y2,Y3 , S1, S2, S3 0

Y1 Y2 Y3 S1 S2 S3
-1 -1 -1 0 0 0 0
S1 8 4 2 1 0 0 1
S2 2 8 4 0 1 0 1
S3 1 2 8 0 0 1 1

Final Iteration:

Y1 Y2 Y3 S1 S2 S3 45/196
0 0 05/49 11/196 1/14
Y1 1 0 0 1/7 -1/14 0 1/14
Y2 0 1 0 -3/98 31/196 -1/14 11/196
Y3 0 0 1 -1/98 -3/98 1/7 5/49

The expected value of the game is:

1 196 29
V* = k = 5
w 45 45
Probabilities for player B as follows:
Yj
yj* = ; j = 1, 2, 3
w

Y1 1 / 14 14
y1* =
w 45 / 196 45

Y 2 11 / 196 11
y2* =
w 45 / 196 45

Y3 5 / 49 20
y3* =
w 45 / 196 45

Then player B select strategy 3 with most probability.

Probabilities for player A as follows:

X1 = 5/49 ; X2 = 11/196 ; X3 = 1/14

X1 5 / 49 20
x1* =
w 45 / 196 45

X 2 11 / 196 11
x2* =
w 45 / 196 45

80
 X3 1 / 14 14
x3* =
w 45 / 196 45

Then player A selected strategy 1 with the most probability.

b- In case of loss ( player B ):

Min: X0 = X1 + X2 + X3 + + XN

S.T: a11X1 + a21X2 + + am1Xm 1

a12X1 + a22X2 + + am2Xm 1
.
.
an1X1 + an2X2 + + amnXm 1
X1, X2, , Xm 0
1
Value game = v* = k and
w
Xi
probability xi* = ; i = 1, 2, , m
w
1.5: Graphical Solution of (2*n) & (m*2) Games

Graphical solutions are only applicable to games in which at least one of the players has two
strategies only.
Consider the following ( 2 * n ) games.

Player B
y1 y2 y3 yn
Player A X1 a11 a12 a13 a1n
X2 = 1 X1 a21 a22 a23 a2n

It is assume that the game does not have a saddle point.

Bs Pure Strategy As expected Payoff

1 ( a11 a21 ) x1 + a21
2 ( a12 a22 ) x1 + a22
3 ( a13 a23 ) x1 + a23
. .
. .
n ( a1n a2n ) x1 + a2n

This shows that As average varies linearly with x1.

Example : Consider the following ( 2 * 4) game

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 Player B
1 2 3 4
Player A 1 2 2 3 -1
2 4 3 2 6

Solution:

Player B
1 2 3 4 Min:
Player 1 2 2 3 -1 -1
A 2 4 3 2 6 2 Maximin
Max: 4 3 3 6

Minimax

No saddle point; minimax maximin

Bs Pure Strategy As expected Payoff

1 ( 2 4 ) x1 + 4
2 ( 2 3 ) x1 + 3
3 ( 3 2 ) x1 + 2
4 ( -1 6 ) x1 + 6

These four strategies ( Straight Lines ) are then plotted as functions of x 1 as shown in the
following figure.

82
 7 7
6 6
1
5 5
4 4
3
2 3 3
V= 5/2
2 2
1 1
X1=0 X1=1
-1 0.1 0.2 0.3 -1
X1=0.5
-2 -2
-3 -3 4
-4 -4

The maximin occurs at x1* = 0.5. This is the point of intersection of any two of the lines 2, 3, &
4. Consequently, As optimal strategy is x1* = 0.5 or x2* = 0.5 and the value of the game is v* =
5/2.
To determine B's optimal strategies, it should be noticed that three lines pass through the
maximin point. This is an indication that B can mix all three strategies. Any two lines having
opposite signs for their slopes define an alternative optimum solution. Thus, of the three
combinations ( 2, 3 ), ( 2, 4 ), & ( 3, 4 ), the combination ( 2, 4 ) must be excluded as non
optimal.
The first combination ( 2, 3 ) implies that y1* = y4* = 0. Consequently y3* = 1 y2* and B's
average payoffs corresponding to A's pure strategies are given as follows:

A's Pure Strategy B's expected Value

1 ( 2 3 ) y2* + 3
2 ( 3 2 ) y2* + 2

- y2* + 3 = y2* + 2 ; Then y2* = 1/2 ; and y3* = 1/2;

Also the expected value ( Minimax ) = v* = 5/2

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Example :

Consider the following game

Player B
1 2
1 2 4
Player A 2 2 3
3 3 2
4 -2 6

Solution:
Player B
1 2
Min:
1 2 4 2
Player A 2 2 3 2 Maximin
3 3 2 2
4 -2 6 -2
Max: 3 6
Minimax
No saddle point Maximin Minimax

A's Pure Strategy B's expected Value

1 ( 2 4 ) y1 + 4
2 ( 2 3 ) y1 + 3
3 ( 3 2 ) y1 + 2
4 ( -2 6 ) y1 + 6

84
 7 7
6 6
5 5
4 4
3
3 3
v = 8/3
2 2 2
1 1 2
y1=0 y1=1
-1 0.1 0.2 0.3 0.6 0.7 -1
-2 y1 = 2/3 -2
-3 -3
-4 -4 4

y1* = 2/3 and y2* = 1/3 with ( Minimax ) = v* = 8/3

Player B should select strategy 1 with maximum probability.

The intersection point of lines 1 and 3 yields an optimum with y1* and with v* = 8/3

A's Pure Strategy B's expected Value

1 ( 2 3 ) x1* + 3
2 ( 4 2 ) x1* + 2

-x1* + 3 = 2 x1* + 2 ; then x1* = 1/3 and x3* = 2/3; & x2*= x4* = 0
Then the maximin point of A is strategy 3 with maximum
probably = 2/3 and expected value = v* = 8/3

85
 Assignment # 5

Q.1:

You are given the following payoff matrix:

Action State of Nature

W1 W2 W3 W4 W5
A -100 160 40 200 0
B 60 80 140 40 100
C 20 60 -60 20 80
D -20 -100 -140 -40 400
Probability 0.09 0.10 0.50 0.13 0.20

Find the best action by using:

a ) Decision under Risk
Opportunity Loss Criteria
EVPI Criteria
b)
Laplace Criteria.
Savage Criteria.
Hurwicz Criteria = 0.55.

Q.3:

The Army is planning a mock battle between two opposing forces, the blue and the red. The
blue force will be the attacking force, and the red force will be on the defensive. Each force has
three available strategies. The outcomes of the battles resulting from these strategies are shown
in the following payoff matrix in terms of simulated casualties ( in thousands of troops ).

Red forces Strategies

X Y Z

1 3 6 4
Blue Forces
Strategies 2 7 -2 5

3 -4 8 -1

Determine the strategy for each force and the casualties inflicted on one of the forces.

86
Q.3:

Find the optimal strategies for the two players:

Player B
1 2
2 4
5 3
Player A 2 0
-1 4
2 -2

87