DECISION THEORY

I.

INTRODUCTION theory is theory about decisions. It might be

Decision

considered to be a branch of mathematics. It provides a more precise and systematic study of the formal or abstract

properties of decision-making scenarios. Game theory concerns situations where the decisions of more than two parties are involved. Decision theory considers only the decisions of a

single individual. Here we discuss only some very basic aspects of decision theory. The decision situations we consider are cases where a decision maker has to choose between lists of mutually exclusive

decisions. In other words, from among the alternatives, one and only one choice can be made. Each of these choices might have one or more possible consequences that are beyond the control of the decision maker, which again are mutually exclusive. II. NORMATIVE AND DESCRIPTIVE DECISION THEORY.

Most of decision theory is normative or prescriptive, i.e., it is concerned with identifying the best decision to take,

assuming an ideal decision maker who is fully informed, able to compute with perfect accuracy, and fully rational. The practical

application to make

of

this is

prescriptive

approach

(how

people ought and aimed at

decisions)

called decision

analysis,

finding tools, methodologies and software to help people make better decisions. The most systematic and comprehensive software tools developed in this way are called decision support systems. The distinction between normative and descriptive decision

theories is, in principle, very simple. A normative decision theory is a theory about how decisions should be made, and a descriptive theory is a theory about how decisions are actually made. The "should" in the foregoing sentence can be interpreted in many ways. There is, however, virtually complete agreement among decision scientists that it refers to the prerequisites of rational decision-making. In other words, a normative decision theory is a theory about how decisions should be made in order to be rational.

III.

DECISION PROCESS

Most decisions are not momentary. They take time, and it is therefore natural to divide them into phases or stages. Five steps in Decision Process: 1. Identification of the problem 2. Obtaining necessary information 3. Production of possible solutions 4. Evaluation of such solutions Brim et al. (1962, p. 9).

5. Selection of a strategy for performance (They also included a sixth stage, implementation of the

decision.) The proposals by Dewey, Simon, and Brim et al are all sequential in the sense that they divide decision processes into parts that always come in the same order or sequence. Several authors,

notably Witte (1972) have criticized the idea that the decision process can, in a general fashion, be divided into consecutive stages. His empirical material indicates that the "stages" are performed in parallel rather than in sequence. Although the possible returns of the investment are beyond the control of the decision maker, the decision maker might or might not be able or willing to assign probabilities to them. If no probabilities are assigned to the possible consequences, then the decision situation is called "decision under uncertainty". If probabilities are assigned then the situation is called

"decision under risk". This is a basic distinction in decision theory, and different analyses are in order.

IV.

DECISION MAKING UNDER UNCERTAINTY.

Example: A bicycle shop Zed and Adrian and run a small bicycle shop called "Z to A Bicycles". They must order bicycles for the coming season.

Orders for the bicycles must be placed in quantities of twenty (20). The cost per bicycle is $70 if they order 20, $67 if they order 40, $65 if they order 60, and $64 if they order 80. The bicycles will be sold for $100 each. Any bicycles left over at the end of the season can be sold (for certain) at $45 each. If Zed and Adrian run out of bicycles during the season, then they will suffer a loss of "goodwill" among their customers. They estimate this goodwill loss to be $5 per customer who was unable to buy a bicycle. Zed and Adrian estimate that the demand for bicycles this season will be 10, 30, 50, or 70 bicycles with probabilities of 0.2, 0.4, 0.3, and 0.1 respectively. Actions There are four actions available to Zed and Adrian. They have to decide which of the actions in each criterion the best. 1. Buy 20 bicycles 2. Buy 40 bicycles 3. Buy 60 bicycles 4. Buy 80 bicycles Zed and Adrian have control over which action they choose. That is the whole point of decision theory - deciding which action to take.

States of Nature There are four possible states of nature. A state of nature is an outcome. 1. The demand is 10 bicycles 2. The demand is 30 bicycles 3. The demand is 50 bicycles 4. The demand is 70 bicycles Zed and Adrian have no control over which state of nature will occur. They can only plan and make the best decision based on the appropriate decision criteria. Payoff Table After deciding on each action and state of nature, create a payoff table. The numbers in parentheses for each state of

Action State of Nature Demand (0.2) Demand (0.4) Demand (0.3) Demand (0.1) 10 30 50 70 Buy 20 50 550 450 350 Buy 40 -330 770 1270 1170 Buy 60 -650 450 1550 2050 Buy 80 -970 130 1230 2330

nature represent the probability of that state occurring.

Ok, the question on your mind is probably "How the [expletive deleted] did you come up with those numbers?". Let's take a look at a couple of examples. Demand is 50, buy 60: They bought 60 at $65 each for $3900. That is -$3900 since that is money they spent. Now, they sell 50 bicycles at $100 each for $5000. They had 10 bicycles left over at the end of the season, and they sold those at $45 each of $450. That makes $5000 + 450 - 3900 = $1550. Demand is 70, buy 40: They bought 40 at $67 each for $2680. That is a negative $2680 since that is money they spent. Now, they sell 40 bicycles (that's all they had) at $100 each for $4000. The other 30 customers that wanted a bicycle, but couldn't get one, left mad and Zed and Adrian lost $5 in goodwill for each of them. That's 30 customers at -$5 each or -$150. That makes $4000 - 2680 - 150 = $1170. Opportunistic Loss Table The opportunistic loss (regret) table is calculated from the payoff table. It is only needed for the Minimax criteria, but let's go ahead and calculate it now while we're thinking about it.

The

maximum

payoffs

under

each

state

of

nature

are

shown

in bold in the payoff table above. For example, the best that Zed and Adrian could do if the demand was 30 bicycles is to make $770. Each element in the opportunistic loss table is found taking each state of nature, one at a time, and subtracting each payoff from the largest payoff for that state of nature. In the way we have the table written above, we would subtract each number in the row from the largest number in the row.

Action State of Nature Demand 10 Demand 30 Demand 50 Demand 70 Buy 20 0 220 1100 1980 Buy 40 380 0 280 1160 Buy 60 700 320 0 280 Buy 80 1020 640 320 0

Remember that the numbers in this table are losses and so the smaller the number, the better. i. Expected Value Criterion

Compute the expected value under each action and then pick the action with the largest expected value. This is the only method of the four that incorporates the probabilities of the states of

nature. The expected value criterion is also called the Bayesian principle. For each action, do the following: Multiply the payoff by the probability of that payoff occurring. Then add those values

together. Matrix multiplication works really well for this as it multiplied pairs of numbers together and adds them. If you place the probabilities into a 1x4 matrix and use the 4x4 matrix shown above, then you can multiply the matrices to get a 1x4 matrix with the expected value for each action. Here is an example of the "Buy 60" action if you wish to do it by hand. 0.2(-650) + 0.4(450) + 0.3(1550) + 0.1(2050) = 720 The expected values for buying 20, 40, 60, and 80 bicycles are $400, 740, 720, and 460 respectively. Since the best that you could expect to do is $740, you would buy 40 bicycles. ii. The Maximax Criterion Maximax looks at the best that could happen under each

action and then chooses the action with the largest value. They assume that they will get the most possible and then they take the action with the best case scenario.

The maximum of the maximums or the "best of the best". This is the lotto player; they see large payoffs and ignore the

probabilities. The Maximax criterion is much easier to do than the expected value. You simply look at the best you could do under each action (the largest number in each column). You then take the best (largest) of these. The largest payoff if you buy 20, 40, 60, and 80 bicycles is $550, 1270, 2050, and 2330 respectively. Since the largest of those is $2330, you would buy 80 bicycles. iii. Maximin Criterion

The Maximin looks at the worst that could happen under each action and then choose the action with the largest payoff. They assume that the worst that can happen will, and then they take the action with the best worst case scenario.

The maximum of the minimums or the "best of the worst". This is the person who puts their money into a savings account because they could lose money at the stock market. The Maximin criterion is as easy to do as the Maximax. Except instead of taking the largest number under each action, you take

the smallest payoff under each action (smallest number in each column). You then take the best (largest of these). The smallest payoff if you buy 20, 40, 60, and 80 bicycles is $50, -330, -650, and -970 respectively. Since the largest of those is $50, you would buy 20 bicycles. iv. Minimax Criterion

Minimax decision making is based on opportunistic loss. They are the kind that looks back after the state of nature has occurred and say "Now that I know what happened, if I had only picked this other action instead of the one I actually did, I could have done better". So, to make their decision (before the event occurs), they create an regret table. The minimum of the maximum or the best of the worst losses. It sounds backwards, but remember, were talking about regret.

Regret is sometimes also called "opportunity loss". Be sure to use the opportunistic loss (regret) table for the minimax criterion. You take the largest loss under each action (largest number in each column). You then take the smallest of these (it is loss, afterall). The largest losses if you buy 20, 40, 60, and 80 bicycles are $1980, 1160, 700, and 1020 respectively. Since the smallest of those is $700, you would buy 60 bicycles.

Putting it all together Here is a table that summarizes each criteria and the best

Action Criterion Expected Value Maximax Maximin Minimax Buy 20 400 550 Buy 40 Buy 60 720 2050 -650 Buy 80 460 Best Action Buy 40 Buy 80 Buy 20 Buy 60

740
1270 -330 1160

2330
-970 1020

50
1980

700

V.

DECISION MAKING UNDER RISK.

Risk implies a degree of uncertainty and an inability to fully control the outcomes or consequences of such an action.

Effective handling of a risk requires its assessment and its subsequent impact on the decision process. The decision process allows the decision-maker to evaluate alternative strategies

prior to making any decision. The process is as follows: 1. The problem is defined and all feasible alternatives are considered. The possible outcomes for each alternative are evaluated. 2. Outcomes are discussed based on their monetary payoffs or net gain in reference to assets or time.

3. Various

uncertainties

are

quantified

in

terms

of

probabilities. 4. The quality of the optimal strategy depends upon the

quality of the judgments. The decision-maker should and examine the sensitivity of the optimal strategy with

respect to the crucial factors. Whenever states the decision-maker he/she has may some be knowledge to regarding the

of

nature,

able

assign

subjective

probability estimates for the occurrence of each state. In such cases, the problem is classified as decision making under risk. The decision making under risk process is as follows: a. Use the information you have to assign your beliefs

(called subjective probabilities) regarding each state of the nature, p(s), b. Each action has a payoff associated with each of the states of nature X(a,s), c. We compute the expected payoff, also called the return (R), for each action R(a) = Sums of [X(a,s),p(s)], d. We accept the principle that we should minimize (or

maximize) the expected payoff, e. Execute the action which minimizes (or maximize) R(a).

Expected Monetary Value (EMV) Determine the expected payoff of each alternative/action and

choose the alternative/action that has the best expected payoff. Expected Payoff: The actual outcome will not equal the expected value. a) For each action, multiply the probability and payoff then b) Add up the results by row, c) Choose largest number and take that action. G (0.4) B S D 0.4(12) 0.4(15) 0.4(7) MG (0.3) + 0.3(8) + 0.3(9) + 0.3(7) NC (0.2) + 0.2(7) + 0.2(5) + 0.2(7) L(0.1) + 0.1(3) + 0.1(2) + 0.1(7) Exp.Value = 8.9 = 9.5* = 7

The Most Probable States of Nature a) Take the state of nature with the highest probability b) In that column, choose action with greatest payoff. In our numerical example, there is a 40% chance of growth so we must buy stocks.

Expected Opportunity Loss (EOL): a. Setup a loss payoff matrix by taking largest number in each state of nature column (say L), and subtract all numbers in that column from it. L Xij. b. For each action, multiply the probability and loss then add up for each action. c. Choose the action with smallest EOL.

Loss Payoff Matrix G (0.4) B .4(15-12) + S .4(15-15) + D .4(15-7) + MG (0.3) 0.3(9-8) 0.3(9-9) 0.3(9-7) NC (0.2) + 0.2(7-7) + 0.2(7-5) + 0.2(7-7) L(0.1) + 0.1(7-3) + 0.1(7+2) + 0.1(7-7) EOL = 1.9 = 1.3* = 3.8

Computation of the Expected Value of Perfect Information (EVPI) EVPI helps to determine the worth of an insider who possesses perfect information. EVPI= Expected payoff under certainty less expected payoff under risk a) Take the maximum payoff for each state for nature,

b) Multiply

each

case

by

the

probability

for

that

state

of

nature and then add them up, c) Subtract the expected payoff from the best payoff computed under risk *the highest payoff in under risk is 9.5 G MG NC L Total EVPI = 10.8 9.5 EVPI = 1.3 15(0.4) 9(0.3) 7(0.2) 7(0.1) = = = = 6.0 2.7 1.4 0.7 10.8