Lecture 2: Decision Analysis

Definition of Decision Theory

An analytic and systematic approach to the study of decision making

What consists of a Good Decision?

One that is based on logic, considers all available data and possible alternatives, and applies a quantitative approach

Definition of Decision Alternatives

Different posisble strategies the decision maker can employ

Definition of States of Nature

Refer to future events, not under the control of the decision maker, which may occur.

How should States of Nature be defined?

Either mutually exclusive and collectively exhaustive

Definition of Payoff

Consequence resulting from a specific combination of a decision alternative and a state of nature

What are the Types of Decision-Making Environments?

• Decision making under certainty

• Decision making under uncertainty

• Decision making under risk

Definition of Decision Making Under Certainty

The decision maker knows with certainty the consequences of every alternative or decision choice

Definition of Decision Making Under Uncertainty

The decision maker does not know the probabilities of the various outcomes

Definition of Decision Making Under Risk

The decision maker knows the probabilities of the various outcomes

What is the criteria for making Decisions Under Uncertainty?

• Maximax

• Maximin

• Minimax regret

What is Maximax Criterion (Optimistic) used for?

To find the alternative that maximizes the maximum payoff

How does the Maximax Criterion (Optimistic) function?

• Locate the maximum payoff for each alternative

• Select the alternative with the maximum number

In Maximax Criterion (Optimistic) what do you focus on?

The highest outcome

What is Maximin Criterion (Pessimistic) used for?

To find the alternative that maximizes the minimum payoff

How does the Maximin Criterion (Pessimistic) function?

• Locate the minimum payoff for each alternative

• Select the alternative with the maximum number

In Maximin Criterion (Pessimistic) what do you focus on?

The payoff that doesn’t cost you anything or the minimum possible outcome.

What is Minimax Regret based on?

Opportunity loss or regret.

In Minimax Regret what do you focus on?

The difference between the optimal profit and actual payoff for a decision

How does the Minimax Regret function?

1. Create an opportunity loss table by determining the opportunity loss from not choosing the best alternative

2. Calculate opportunity loss by subtracting each payoff in the column from the best payoff in the column (i.e., under each state of nature)

3. Find the maximum opportunity loss for each alternative and pick the alternative with the minimum number

How does the Decision Making Under Risk function?

Choose the alternative with the highest expected monetary value (EMV)

How is the EMV calculated?