An Introduction to Decision

Theory (web only)

Chapter 20

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Learning Objectives
 LO20-1 Identify and apply the three components of a
decision.
 LO20-2 Analyze a decision using expected monetary value.
 LO20-3 Analyze a decision using opportunity loss.
 LO20-4 Apply maximin, maximax, and minimax regret
strategies to make a decision.
 LO20-5 Compute and explain the expected value of perfect
information.
 LO20-6 Apply sensitivity analysis to evaluate a decision
subject to uncertainty.
 LO20-7 Use a decision tree to illustrate and analyze decision
making under uncertainty.

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 LO20-1 Identify and apply the
three components of a decision.

Elements of a Decision
There are three components to any decision-
making situation:

1. The available choices (alternatives or acts).

2. The states of nature, which are not under the
control of the decision maker - uncontrollable
future events.
3. The payoffs - needed for each combination of
decision alternative and state of nature.

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 LO20-1

Statistical Decision Theory

 Classical statistics focuses on estimating a
population parameter, such as the population
mean, and constructing confidence intervals, or
testing hypotheses to make inferences about the
population.

 Statistical Decision Theory evaluates a set of

alternatives and selects the best decision
alternative based on a selected criterion or
basis.

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 LO20-1

Decision Making

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 LO20-2 Analyze a decision
using expected monetary value.

Payoff Table and Expected Payoff

 A Payoff Table is a listing of all possible
combinations of decision alternatives and
states of nature, and the payoffs for each
combination.

 The Expected Payoff or the Expected

Monetary Value (EMV) is the expected value for
each decision.

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 LO20-2

Calculating the EMV

EMV(Ai ) = å[P(Sj )×V(Ai , Sj )]
 Let Ai be the ith decision alternative.
 Let P(Sj) be the probability of the jth state of nature.
 Let V(Ai, Sj) be the value of the payoff for the
combination of decision alternative Ai and state of
nature Sj.
 Let EMV (Ai) be the expected monetary value for
the decision alternative Ai.

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 LO20-2

Decision Making Under Conditions of

Uncertainty - Example
Bob Hill, a small investor, has $1,100 to invest. His choices are Kayser Chemicals,
Rim Homes, and Texas Electronics. He estimated that, if his $1,100 were invested in
Kayser Chemicals and a strong bull market developed by the end of the year (that is,
stock prices increased drastically), the value of his Kayser stock would more than
double, to $2,400. However, if there were a bear market (i.e., stock prices declined),
the value of his Kayser stock could conceivably drop to $1,000 by the end of the year.
His predictions regarding the value of his $1,100 investment for the three stocks for a
bull market and for a bear market are shown below. A study of historical records
revealed that during the past 10 years stock market prices increased six times and
declined only four times. According to this information, the probability of a market rise
is .60 and the probability of a market decline is .40.

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 LO20-2

Expected Monetary Value (EMV)-

Example

(A1)=(.6)($2,400)+(.4)($1,000) =$1,840

(A2)=(.6)($2,400)+(.4)($1,000) =$1,760

(A3)=(.6)($2,400)+(.4)($1,000) =$1,600

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 LO20-3 Analyze a decision
using opportunity loss.

Opportunity Loss
Opportunity Loss or Regret is another
criterion for evaluating and selecting a
decision alternative. It is based on the
concept of opportunity costs or buyers regret.

 Opportunity loss is computed by taking the

difference between the payoff of the best
decision for each state of nature and payoff
for each of the other decision alternatives.

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 LO20-3

Expected Opportunity Loss

EOL(Ai ) = å[P(Sj ) ´ R(Ai , Sj )]

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 LO20-3

Opportunity Loss - Example

Opportunity Loss when
Market Rises
Kayser:
$2,400 - $2,400= $0

Rim Homes:
$2,400 - $2,200 = $200

Texas Electronics:
$2,400 - $1,900 = $500

Opportunity Loss when

Market Declines
Kayser:
$1,150 - $1,000= $150

Rim Homes:
$1,150 - $1,100 = $50

Texas Electronics:
$1,150 - $1,150 = $0
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 LO20-3

Opportunity Loss - Example

(A1)=(.6)($0)+(.4)($150) =$60

(A2)=(.6)($200)+(.4)($50) =$140

(A3)=(.6)($500)+(.4)($0) =$300

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 LO20-4 Apply maximin, maximax, and
minimax regret strategies to make a decision.

Maximin, Maximax, and Minimax

Regret Strategies to Evaluate Decision
Alternatives
Maximin strategy selects the alternative that
maximizes the minimum gain. It is a pessimistic or
conservative strategy.

Maximax strategy selects the alternative that

maximizes the maximum gain. It is an optimistic
strategy.

Minimax regret strategy selects the alternative that

minimizes the maximum regret (opportunity loss).

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 LO20-4

Maximin, Maximax, and Minimax

Regret Strategies
Payoff Table

Maximin Maximax
1,000 2,400
1,100 2,200
1,150 1,900

Opportunity Loss Table

Minimax
Regret
150
200
500
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 LO20-5 Compute and explain the
expected value of perfect information.

Value of Perfect Information

What is the worth of additional information when making
a decision based on Expected Monetary Value?

Expected Value of Perfect Information (EVPI) is the

difference between the expected payoff if the state of
nature were known and the best decision under the
conditions of uncertainty.

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 LO20-5

EVPI Example

Step 1: Computing Expected value under conditions of certainty.

Expected Value Under Certainty

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 LO20-5

EVPI Example
Step 2: Compute the Expected Value Under Uncertainty

Step 3: Subtract the Expected Value Under Uncertainty from

the Expected Value Under Certainty

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 LO20-6 Apply sensitivity analysis to
evaluate a decision subject to uncertainty.

Sensitivity Analysis
 Sensitivity Analysis examines the effects of various
probabilities for the states of nature on the expected
values for the decision alternatives.

 Decision Trees are useful for structuring the various

alternatives. They present a picture of the various
courses of action and the possible states of nature.

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 LO20-6

Sensitivity Analysis

Conclusion: Based on EMV, the decision is

to purchase Kayser Chemicals regardless of
the three sets of probabilities.

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 LO20-7 Use a decision tree to illustrate and
analyze decision making under uncertainty.

Decision Tree
A decision tree is a picture of all the possible
courses of action and the consequent possible
outcomes.

A box is used to indicate the point at which a

decision must be made.

The branches going out from the box indicate

the alternatives under consideration

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 LO20-7

Decision Tree Example

$2,400

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