Decision Theory

Why Decision Theory?

As the name implies, Decision theory is the logical (or intelligent) approach to problems, which do not have sufficient information about the uncertainties of the future.

Steps in Decision theory Approach

To achieve a Decision theoretic solution (an optimized decision), a decision maker needs to do some sequential processes which are given below:

First and foremost, a decision maker has to make a list of all decision alternatives which are available to him.

The next step for a decision maker is to categorize all the future events that possibly will occur.  It is not too difficult to identify these future events; but the true difficulty arises when we try to pick one of these events which probably going to occur. 

These future events (not under the control of decision maker) are termed as states of nature in decision theory.

The most important challenge before the decision maker is nothing but building a payoff table (table representing profit, gain, etc.), for each and every combination of alternatives and states of nature.

At last, the decision maker has to opt out one suitable criterion that will result a better payoff.  The criterion may be economical, accountable or subjective.

Example:

If a manufacturing company wants to increase its production to meet the increasing market demand.  There may be only the following three options:

  1. Expanding the present unit
  2. Constructing a new unit
  3. Giving subcontract to others, which are known as Alternatives.

Uncertainty of the company lies in product demand.  The future events related to the demand may be

  • High demand
  • Moderate demand
  • Low demand
  • No demand, which are known as States of nature.

The possible payoffs for the company’s expansion decision is given by the Payoff table:

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