Decision Theory

Joannah Mae Diano

Rachel Anne Donaasco
Hazel May Doronio
Brya Rose Salazar
Decision Trees
Decision Tree for Real Estate Developer
The Payoff Table
 Payoff Table for Real Estate Developer

State of Nature
No Center Medium Center Large Center

Residential $400,000 $1,600,000 $1,200,000

Alternative
Commercial #1 $600,000 $500,000 $1,400,000
Commercial #2
-$100,000 $400,000 $1,500,000
Decision Under Complete Certainty

• The simplest of all circumstances occurs when decision

making takes place in an environment of complete
certainty. For example, in the case of the real state
problem, an unexpected early announcement concerning
the building of the shopping center could reduce the
problem to a situation of certainty.
 Payoff Table for Real Estate Developer

State of Nature
No Center Medium Center Large Center

Residential $400,000 $1,600,000 $1,200,000

Alternative
Commercial #1 $600,000 $500,000 $1,400,000
Commercial #2
-$100,000 $400,000 $1,500,000
Decision Making Under Complete Uncertainty

• The decision maker either is unable to estimate the

probabilities for the occurrence of the different states of
nature, or else he or she lacks confidence in available
estimates of probabilities, and for that reason,
probabilities are not included in the analysis.
Five Approaches

1. Maximin
2. Maximax
3. Minimax Regret
4. Hurwicz (Realism) Criterion
5. Equal Likelihood Criterion
 MAXIMIN
The maximin strategy is a conservative approach; it consists if
identifying the worst (minimum) payoff for each alternative and then
selecting the alternative that has the best (maximum) of the worst
payoffs.
 Maximin Solution for Real Estate Problem
State of Nature
No Center Medium Center Large Center Worst
Payoff

Residential $400,000 $1,600,000 $1,200,000 $400,000

Alternative Maximum
Commercial #1 $600,000 $500,000 $1,400,000 $500,000 of the
Worst
payoffs
Commercial #2
-$100,000 $400,000 $1,500,000 -$100,000
 MAXIMAX
The maximax approach is the opposite of the maximin. The best
payoff for each alternative is identified, and the alternative with the
maximum of these is the designated decision.
 Maximax Solution for Real Estate Problem
State of Nature
No Center Medium Center Large Center Best
Payoff

Residential $400,000 $1,600,000 $1,200,000 $1,600,000 Maximum

Alternative
Commercial #1 $600,000 $500,000 $1,400,000 $1,400,000

Commercial #2
-$100,000 $400,000 $1,500,000 $1,500,000
 MINIMAX REGRET
An approach that does take all payoffs into account is minimax regret. In order to
use this approach, it is necessary to develop an opportunity loss table. The
opportunity loss reflected the difference between each payoff and the best possible
payoff in a column. Hence, opportunity loss amounts are found by identifying the
best payoff in a column and then subtracting each of the other values in the column
from that payoff.
 Original Payoff Table for Real Estate Problem

State of Nature
No Center Medium Center Large Center

Residential $400,000 $1,600,000 $1,200,000

Alternative
Commercial #1 $600,000 $500,000 $1,400,000

Commercial #2
-$100,000 $400,000 $1,500,000

Best Payoff in Column $600,000 $1,600,000 $1,500,000

 Opportunity Loss Table for Real Estate Problem

State of Nature
No Center Medium Center Large Center

Residential $200,000 0 $300,000

Alternative
Commercial #1 0 $1,100,000 $100,000
Commercial #2
$700,000 $1,200,000 0
 MINIMAX REGRET
The value in an opportunity loss table can be viewed as potential regrets
that might be suffered as the result of choosing various alternatives. A
decision maker could select an alternative in such a way as to minimize the
maximum possible regret. This requires identifying the maximum
opportunity loss in each row and then choosing the alternative that would
yield the best (minimum) of those regrets.
 Identifying the Minimax Regret Alternative
State of Nature
No Center Medium Center Large Center Maximum
Loss

Residential $200,000 0 $300,000 $300,000 Minimum

Alternative
Commercial #1 0 $1,100,000 $100,000 $1,100,000

Commercial #2
$700,000 $1,200,000 0 $1,200,000
 The Hurwicz (Realism)
Criterion
This approach requires the decision maker to specify a degree of optimism,
in the form of a coefficient of optimism,α. Possible values of α from 0 to
1.00.
Formula: α (best payoff) + (1- α) (worst payoff)
 Maximax Solution for Real Estate Problem
State of Nature
No Center Medium Center Large Center Best Worst
Payoff Payoff

Residential $400,000 $1,600,000 $1,200,000 $1,600,000 $400,000

Alternative
Commercial #1 $600,000 $500,000 $1,400,000 $1,400,000 $500,000

Commercial #2
-$100,000 $400,000 $1,500,000 $1,500,000 $100,000
 Hurwicz (Realism) Criterion for Real Estate
Problem

Best Payoff Worst Payoff

Residential .30($1,600,000) + .70($400,000) =$760,000

Alternative
Commercial #1 .30($1,400,000) + .70($500,000) =$770,000 (best)

Commercial #2
.30($1,500,000) + .70($100,000) =$380,000
Equal Likelihood Criterion
The equal likelihood criterion offers a method that
incorporates more of the information. It treats the states of
nature as if each were equally likely, and it focuses on the
average payoff for each row, selecting the alternative that
has the highest row average.
 Payoff Table for Real Estate Developer

State of Nature
No Center Medium Center Large Center

Residential $400,000 $1,600,000 $1,200,000

Alternative
Commercial #1 $600,000 $500,000 $1,400,000
Commercial #2
-$100,000 $400,000 $1,500,000
Decision Making Under Risk

• The essential difference between decision making under

complete uncertainty and decision making under partial
uncertainty is the presence of probabilities for the
occurrence of the various states of nature under partial
uncertainty. The term risk is often used in conjunction
with partial uncertainty.
Expected Monetary Value (EMV)

• The expected monetary value (EMV) approach provides the

decision maker with a value that represents an average payoff
for each alternative. The best alternative is, the, the one that
has the highest expected monetary value.

• Formula: where
EMVi= the expected monetary value for the ith alternative
EMVi= Pj= the probability of the jth state of nature
Vij= the estimated payoff for alternative i under state of
nature j
 Payoff Table for Real Estate Developer

State of Nature
No Center Medium Center Large Center

Residential $400,000 $1,600,000 $1,200,000

Alternative
Commercial #1 $600,000 $500,000 $1,400,000
Commercial #2
-$100,000 $400,000 $1,500,000
Probabilities .2 .5 .3
 Expected Monetary Value

Expected
Alternative Payoff

Residential
.2($400,000)+.5($1,600,000)+.3($1,200,000)
Maximum
$1,240,000
Alternative
.2($600,000)+.5($500,000)+.3($1,400,000)
Commercial #1 $790,000
Commercial #2
.2(-$100,000)+.5($400,000)+.3($1,500,000)
$630,000
Expected Opportunity Loss

• An alternate method for incorporating probabilities into the

decision- making process is to use expected opportunity loss
(EOL). The approach is nearly identical to the EMV approach,
except that a table of opportunity losses is used rather than a
table of payoffs. Hence, the opportunity losses for each
alternative are weighted by the probabilities of their respective
states of nature to compute a long-run average opportunity
loss, and the alternative with smallest expected loss is selected
as the best choice
 Opportunity Loss Table for Real Estate Problem

State of Nature
No Center Medium Center Large Center

Residential $200,000 0 $300,000

Alternative
Commercial #1
0 $1,100,000 $100,000
Commercial #2
$700,000 $1,200,000 0
Probabilities .2 .5 .3
 Expected Opportunity Loss

Expected
Alternative Payoff

Residential
.2($200,000)+.5(0)+.3($300,000)
Minimum
$130,000
Alternative
.2(0)+.5($1,000,000)+.3($100,000)
Commercial #1 $580,000
Commercial #2
.2($700,000)+.5($1,200,000)+.3(0)
$740,000
Expected Value of Perfect Information

• It is a measure of the difference between the certain payoff that could be

realized under a condition of certainty and the expected payoff under a
condition involving risk.

Formula:
EVPI = EPC-EMV

Where
EVPI = the expected value of perfect information
EMV = the expected monetary value
EPC = the expected payoff under certainty
 Payoff Table for Real Estate Developer

State of Nature
No Center Medium Center Large Center

Residential $400,000 $1,600,000 $1,200,000

Alternative
Commercial #1 $600,000 $500,000 $1,400,000
Commercial #2
-$100,000 $400,000 $1,500,000
Expected Value of Perfect Information

EPC= .2($600,000)+.5($1,600,000)+.3($1,500,000)
EPC= $1,370,000

EPC= $1,370,000 EMV= $1,240,000

EVPI = $1,370,000 - $1,240,000

EVPI = $130,000