The Six steps in decision theory
Types of decision making environments
Decision Making under risk
Decision making under uncertainty
The game theory
To a extent , the success or failure that a person experiences in life
depends upon the decision he or she makes.There are several examples
we know where good decisions made individual's destiny.
A good decision is one that is based on logic, considers all available data
and possible alternatives, and applies quantitative approach. Its rare
possibility, that a good decision brings unexpected or unfavorable
Sometimes it happened when you make a bad decision but are lucky to
get favorable outcome, it is said that you still make a bad decision.
So, the decision theory is an analytic and systematic way to tackle
Language of games
The Minimax Criterion
Pure strategy games
Mixed strategy games
History-According the modern history, the game theory dates back to 1944
when John von Neuman and Oscar Morgestern published their book ‘Theory
of games and economic behaviour’. Since then the game theory has been
used by army generals to plan war strategies , union negotiators and
managers in collective bargaining and business of all types to determine the
best strategies given a competitive business environment.
Game theory is one way to consider the impact of strategiesof others on
our strategies and outcomes.A game is a contest involving two or more
decision makers,each of whom wants to win .It is the study of how
optimal strategies are formulated in conflict .
There are two stores in the market having different advertising strategies
for the two products , the radio spots and the newspaper ads.
Store X’s Payoff Matrix
Language of the Game(Payoff Matrix)
Game Game Player
Player X’s Y1(use radio) Y2(Use
Strategies X1(Use Radio) 3 5
Store X’s Strategy StoreY’s Strategy Outcome(%Change in
X1(Use radio) Y1(Use radio) X wins 3 andY loses 3
X1(Use radio) Y2(use news paper) X wins 5 andY loses 5
X2(Use newspaper) Y1(use radio) X wins 1 andY loses 1
X2(Use newspaper) Y2(use newspaper) X loses 2 andY wins 2
A player using the minimax criterion will select the strategy that
minimizes the maximum possible loss.
The upper value of the game is equal to the minimum of the maximum
values in the columns.
The lower value of the game is equal to the maximum values in the rows.
An equilibrium or saddle point condition exists if the upper value of the
game is equal to the lower value of the game. This is called as value of
The Minimax Criterion
When saddle point is present, the strategy each player should follow will
always be the same regardless of other players strategy.This called as the
pure strategy . The saddle point is situation in which both players are
facing pure strategies.
Pure strategy Games
In a mixed strategy game, each player should optimize the expected gain.
When there is no saddle point, players will play each strategy for certain
percentage of time.
The most common way to solve a mixed strategy game is to use the
expected gain or loss approach.
Mixed Strategy Games
The principle of dominance can be used to reduce the size of the games by
eliminating strategies that would never be played . A strategy for a player is
said to be dominated if the player can always do as well or better playing
another strategy Any dominated strategy can eliminated from the game
depending on the outcomes.
Clearly define the problem at hand.
List the possible alternatives.
Identify the possible outcomes or states of nature.
List the payoff or profit of each combination of alternatives and
Select one of the mathematical decision theory models.
Apply the model and make your decision.
The Six steps in decision theory
Here we use the Thompson Lumber Company case as an example to
illustrate these decision theory steps. John Thompson is the founder and
president of Thompson Lumber Company, a profitable firm located in
Portland , Oregon.
The problem that John Thompson identifies is whether to expand his
product line by manufacturing and marketing a new product, backyard
The second step is to list the alternative.
Thompson’s second step is to generate alternatives that are available to
him .In decision theory the alternative is a course of action or strategy
that the decision maker can choose .According to him his alternatives are
to construct –
1-a large new plant to manufacture the storage sheds
2-a small plant, or
3-no plant at all
So, the decision makers should try to make all possible alternatives ,on
some occasion even the least important alternative might turn out to be
the best choice.
Third step is to identify possible outcomes.
The criteria for action are established at this time .According to
Thompson there are two possible outcomes :the market for the storage
sheds could be favourable means there is a high demand of the product
or it could be unfavourable means that there is low demand of the
Optimistic decision makers tend to ignore bad outcomes, where as
pessimistic managers may discount a favourable outcome. If you don’t
consider all possibilities, it will be difficult to make a logical decision, and
the result may be undesirable.
There may be some outcomes over which the decision maker has little or
no control are known as states of nature.
Fourth step is to list payoffs.
This step is to list payoff resulting from each possible combination of
alternatives and outcomes. Because in this case he wants to maximize his
profits, he use profits to evaluate each consequences .Not every
decision,of course, can be based on money alone –any appropriate
means of measuring benefit is acceptable.In decision theory we call such
payoff or profits conditional values.
The last two steps are to select and apply the decision theory model.
Apply it to the data to help make the decision. Selecting the model
depends on the environment in which you are operating and the amount
of risk and uncertainty invovled.
DecisionTable with condition values for Thompson-
STATE OF NATURE
Construct a large
Construct a small
No Plants 0 0
The types of decisions people make depends on how much knowledge or
information they have about the situation.There are three kind of
decision making environments:
Decision making under certainty.
Decision making under risk.
Decision making under uncertainty.
TYPES OF DECISION MAKING
Here the decision makers know about the certainty of consequences
every alternative or decision choice has.
Naturally they will choose the alternative that will result in the best
Example: Lets say that you have $10000 to invest for a period of one year.
And you have two alternatives either to open a savings account paying
6% interest and another is invest in Govt. Treasury Bond paying 10%
interest. If both the investments are secure and guaranteed, the best
alternative is to choose the second investment option to gain maximum
Decision Making under Certainty
Here the decision Maker knows about the several possible outcomes for
each alternative and the probability of occurance of each outcome.
Example : The probability of being dealt a club is .25.The probability of
rolling a 5 on die is 1/6.
In the decision making under risk, the decision maker usually attempts to
maximize his or her expected well being . Decision theory models for
business problems in this in this environment typically employ two
equivalent criteria: maximization of expected monetary value and
minimization of expected loss.
Expected monetary value is the weighted value of possible payoffs for
Decision Making Under Risk
Here there are several outcomes for each alternative, and the decision
maker does not know the probabilities occurrences of various outcomes.
ExampleThe probability that a Democrat/Republican will be the
President of a country 25Years from now is not known.
The criteria that is covered in this section as follows:
1- Maximax-This criterion find the alternative that maximizes the maximum
payoffs or consequence for every alternative.here we first locate the
maximum payoff with every alternative and then pick that alternative with
the maximum number.This is also known as optimistic decision criterion.
Maximin-This criterion finds the alternative that maximizes the minimum
payoff or consequence for every alternative. Here we first locate the
minimum outcome within every alternative and then pick that alternative
with maximum number.This is called as pessimistic decision criterion.
Decision Making under Uncertainty
Criterion of Realism:Also called as weighted average, is a compromise
between an optimistic and a pessimistic decision.Let the coefficient of
realism is ‘a’ selected.The coefficient is between 0 and 1. when ‘a’ is close
to 1, the decision maker is optimistic about the future.When ‘a’ is close ‘0’
the decision maker is pessimistic.It helps the decision maker to build
feelings about relative optimism and pessimism.
Weighted average =a(maximum in row)+(1-a)(minimum in row).
Equally likely(Laplace)-one criterion that uses all the payoffs for each
alternative is the equally likely also called Laplace decision criterion.This
is to find alternative with highest payoff.
Minimax Regret-The final decision criterion that we discuss is based on
opportunity loss or regret.