CHAPTER TWO

Decision Analysis and Game Theory

Chapter Topics under decision analysis
■ Components of Decision Making
■ Decision Making without Probabilities
■ Decision Making with Probabilities
■ Decision Analysis with Additional Information
 2.1.Introduction to Decision Analysis
The field of decision analysis provides a framework for making important
decisions.

Decision analysis allows us to select a decision from a set of possible

decision alternatives when uncertainties regarding the future exist.

The goal is to optimize the resulting payoff in terms of a decision criterion.

 2.2. Decision Making Criteria
 Classifying decision-making criteria
A. Decision making under certainty.
 The future state-of-nature is assumed known.
B. Decision making under risk.
 There is some knowledge of the probability of the states of nature
occurring.

C. Decision making under uncertainty.

 There is no knowledge about the probability of the states of nature
2.3. Payoff Table Analysis
Payoff Tables

Payoff table analysis can be applied when:

There is a finite set of discrete decision alternatives.

The outcome of a decision is a function of a single future event.

In a Payoff table -

The rows correspond to the possible decision alternatives.

The columns correspond to the possible future events.

Events (states of nature) are mutually exclusive and collectively

exhaustive.
The table entries are the payoffs.
2.4. Components of Decision Making

■A state of nature is an actual event that may occur in the future.

■A payoff table is a means of organizing a decision situation, presenting the payoffs

from different decisions given the various states of nature.
 2.5. Decision Making Without Probabilities
An investor is to purchase one of three types of real estate, as illustrated in
Figure below. The investor must decide among an apartment building, an
office building, and a warehouse.
 Con’t…
The future states of nature that will determine how much profit the investor will
make are good economic conditions and poor economic conditions. The profits
that will result from each decision in the event of each state of nature are shown
in the given Table.
 2.6. Decision-Making Criteria

Once the decision situation has been organized into a payoff table, several
criteria are available for making the actual decision. These decision criteria,
which will be presented in this section, include:-
 maximax,
 maximin,
 minimax regret,
 Decision Making without Probabilities
1. Maximax Criterion
In the maximax criterion the decision maker selects the decision that will result in the
maximum of maximum payoffs; an optimistic criterion.

Table 12.3 Payoff Table Illustrating a Maximax Decision

Decision Making without Probabilities
2. Maximin Criterion

In the maximin criterion the decision maker selects the decision that will reflect
the maximum of the minimum payoffs; a pessimistic criterion.

Table 6.4 Payoff Table Illustrating a Maximin Decision

Decision Making without Probabilities
3. Minimax Regret Criterion

Regret is the difference between the payoff from the best decision and all
other decision payoffs.
The decision maker attempts to avoid regret by selecting the decision
alternative that minimizes the maximum regret. [select max. then min.]

Table 6.6 Regret Table Illustrating the Minimax Regret Decision

 Decision Making with Probabilities
Expected Value

Expected value is computed by multiplying each decision outcome under each

state of nature by the probability of its occurrence.

EV(Apartment) = $50,000(.6) + 30,000(.4) = 42,000

EV(Office) = $100,000(.6) + 40,000(.4) = 44,000
EV(Warehouse) = $30,000(.6) + 10,000(.4) = 22,000
Decision Making with Probabilities
Expected Opportunity Loss

The expected opportunity loss is the expected value of the regret for each decision.
The expected value and expected opportunity loss criterion result in the same decision.

EOL(Apartment) = $50,000(.6) + 0(.4) = 30,000

EOL(Office) = $0(.6) + 70,000(.4) = 28,000 selected
EOL(Warehouse) = $70,000(.6) + 20,000(.4) = 50,000
Decision Making with Probabilities
Decision Trees (1 of 4)
A decision tree is a diagram consisting of decision nodes
(represented as squares), probability nodes (circles), and
decision alternatives (branches).

Table 12.10 Payoff Table for Real Estate Investment Example

Decision Making with Probabilities
Decision Trees (2 of 4)

Figure 6.2 Decision Tree for Real Estate Investment Example

Decision Making with Probabilities
Decision Trees (3 of 4)

The expected value is computed at each probability node:

EV(node 2) = .60($50,000) + .40(30,000) = $42,000
EV(node 3) = .60($100,000) + .40(-40,000) = $44,000
EV(node 4) = .60($30,000) + .40(10,000) = $22,000

Branches with the greatest expected value are selected.

Decision Making with Probabilities
Decision Trees (4 of 4)

Figure 12.3 Decision Tree with Expected Value at Probability Nodes

 2. 2. Game theory

Game theory was developed for the purpose of analyzing competitive situations
involving conflicting interests. In other words, game theory is used for decision
making under conflicting situations where there are one or more opponents
(i.e., players). For example, chess, poker, etc., are the games which have the
characteristics of a competition and are played according to definite rules.

Game theory provides solutions to such games, assuming that each of the players
wants to maximize his profits and minimize his losses.
 Con’t…

The game theory models can be classified into several categories. Some important
categories are listed below.

1. Two-person & N-person games: If the number of players is two, it is known as

two-person game. On the other hand, if the number of players is N, it
is known as N,…person game.

2. Zero sum & Non-zero sum game: In a zero sum game, the sum of the points won
equals the sum of the points lost, i.e., one player wins at the expense of the other.

To the contrary, if the sum of gains or losses is not equal to zero, it is either positive or
negative, then it is known as non-zero sum game
 Con’t…
An example of non-zero sum game is the case of two competing firms each with a choice
regarding its advertising campaign. In such a situation, both the firms may gain or loose, though
their gain or loss may not be equal.

If the sum of the players' gains and losses equals zero, the game is referred to as a zero-sum
game.

e.g. In a two-person game, one player's gains represent another's losses. For example, if one
player wins $100, then the other player loses $100; the two values sum to zero (i.e., +$100 and
-$100). Alternatively, if the sum of the players' gains and losses does not equal zero, the game
is known as a non-zero-sum game
Con’t…
BASIC TERMINOLOGIES:-

1.Player :- Each participant (interested party) is called a player.

2. Strategy:-The strategy of a player is the predetermined rule by which a player

decides his course of action from the list of courses of action during the game. A

strategy may be of two types:

A. Pure strategy:- It is a decision, in advance of all plays, always to choose

a particular course of action. In other words, if the best strategy for each player is

to play one particular strategy throughout the game, it is called pure strategy.
 Con’t…

B. Mixed strategy:- It is a decision, in advance of all plays, to choose a course

of action for each play in accordance with some particular probability
distribution. In other words, if the optimal plan for each player is to employ
different strategies at different times, we call it mixed strategy.
3. Optimal strategy
The course of action which maximizes the profit of a player or minimizes his
loss is called an optimal strategy.
Con’t…

4. Saddle point

A saddle point is an element of the matrix that is both the smallest element in its row
and the largest element in its column. Furthermore, saddle point is also regarded as an
equilibrium point in the theory of games.

Pay-off:-The outcome of playing the game is called pay-off.

Pay-off Matrix:- It is a table showing the outcomes or payoffs of different strategies of

the game.

5. Value of the Game:-It refers to the expected outcome per play, when players follow
their optimal strategy. It is generally denoted by V.
Con’t…
Example for Pure Strategy:-

The simplest type of game is one where the best strategies for both players are pure strategies.
This is the case if and only if, the pay-off matrix contains a saddle point. To illustrate, consider
the following pay-off matrix concerning zero sum two person game.
    Player    
B
I II III IV V
I -2 0 0 5 3
Player A II 4 2 1 3 2
III -4 -3 0 -2 6
IV 5 3 -4 2 -6

1. What is the optimal plan for both the players?

Solution.
We use the maximin (minimax) principle to analyze the game.
Since values in the table would be pay off
Player B
I II III IV V Minimum

I -2 0 0 5 3 -2
Player A II 4 2 1 3 2 1
III -4 -3 0 -2 6 -4
IV 5 3 -4 2 -6 -6
Maximum 5 3 1 5 6
Select minimum from the maximum of columns.
Minimax = 1
Player A will choose II strategy, which yields the maximum payoff of 1.
Con’t…
Select maximum from the minimum of rows.
Maximin = 1
Similarly, player B will choose III strategy.
Since the value of maximin coincides/matches with the value of the
minimax, therefore, saddle point (equilibrium point) = 1.

The optimal strategies for both players are: Player A must select II
strategy and player B must select III strategy. The value of game is 1,
which indicates that player A will gain 1 unit and player B will sacrifice
1 unit.
2. Mixed Strategy
In situations where a saddle point does not exist, the maximin (minimax)
principle for solving a game problem breaks down. The concept is illustrated
with the help of following example.
Example for mixed strategy.
Two companies A and B are competing for the same product. Their different
strategies are given in the following pay-off matrix:
  Company B
I II III
I -2 14 -2
Compan
y II -5 -6 -4
A
III -6 20 -8
1. Determine the optimal strategies for both the companies.
Solution.

First, we apply the maximin (minimax) principle to analyze the game.

  Company B
I II III Minimum
Company I -2 14 -2 -2
A II -5 -6 -4 -6 Maximin = -2
III -6 20 -8 -8
Maximum -2 20 -2

Minimax = -2
There are two elements whose value is –2. Hence, the solution to such a game
is not unique. In the above problem, there is no saddle point. In such cases, the
maximin and minimax principle of solving a game problem can't be
applied. Under this situation, both the companies may resort to what is known
as mixed strategy.
Con’t…
A mixed strategy game can be solved by following methods:
Algebraic Method
Calculus Method
Linear Programming Method
1. ALGEBRAIC METHOD :- Consider the zero sum two person game
given below: Player B
I II
Player A I a b
II c d
Con’t…
Formulas:
The solution of the game is:
A play’s (p, 1 - p)
where:
d-c
p = --------------------
(a + d) - (b + c)

B play’s (q, 1 - q) where: where:

d-b
q = -------------------
(a + d) - (b + c)
Con’t…
ad - bc
Value of the game, V = --------------------
(a + d) - (b + c)
Example 1 Consider the game of matching coins. Two players, A & B,
put down a coin. If coins match (i.e., both are heads or both are tails) A
gets rewarded, otherwise B. However, matching on heads gives a
double premium. Obtain the best strategies for both players and the
value of the game. Player B
I II
Player I 2 -1
A II -1 1
Solution. This game has no saddle point.
1 - (-1)
p= -----------------------
(2 + 1) - (-1 - 1)
=2/5
Therefore, 1 – p = 3/5
1 - (-1)
P= ----------------------
(2 + 1) - (-1 - 1)
=2/5
Therefore, 1 – q = 3/5
2 X 1 - (-1) X (-1)
V= -------------------------- , V =1/5
(2 + 1) - (-1 - 1)
 DOMINANCE
The principle of dominance states that if one strategy of a player dominates
over the other strategy in all conditions then the later strategy can be
ignored. A strategy dominates over the other only if it is preferable over
other in all conditions.

The concept of dominance is especially useful for the evaluation of two-

person zero-sum games where a saddle point does not exist.
 Con’t…
Rules
 If all the elements of a column (say ith column) are greater than or equal to
the corresponding elements of any other column (say jth column), then the ith
column is dominated by the jth column and can be deleted from the matrix.

 If all the elements of a row (say ith row) are less than or equal to the
corresponding elements of any other row (say jth row), then the ith row is
dominated by the jth row and can be deleted from the matrix.
 Dominance property
In some games, it is possible to reduce the size of the payoff matrix by
eliminating rows (or columns) which are dominated by other rows or columns
respectively.
 Dominance property for rows :- X ≤ Y
which shows to delate the least rows

Dominance property for columns :- X ≥ Y

here, all point in the pay off matrix value/column of X is greater than column
Y, then column X is dominated by Y columns. So, delete /eliminate the
maximum value of the columns.
Example1.
The following tables represents the pay off matrix with respect to
player A. solve it is optimality using the dominance property.
player B Row minimum/minimax
Player A 4 6 54 10 6
7 8 5 5 9 10
8 9 8 11 10 9
6 4 10 6 4
4
Maximin 8 9 11 10 10
Here, Maximin = Minimax
So, the value of the game is =8
b/c saddle point =8, which means , Maximin = Minimax
Player A [0,0,1,0] and player B [1,0,0,0,0]
 Example 2
Let we can do by dominance property again.
Player B
Player A Sum values across the rows
31
39
47
30 first minimum value and dominated
by row 3
 Con’t…

Player B

31 dominated by row 3 again

Player A 39 no dominance here,
47
Know column dominance should be applied;- if it is greater than the
other columns. The maximum columns should be eliminated from the
payoff the matrix.
Column 5 would be dominated by column 1 and 2
Column 4 would be dominated by column 1 and 2 again
Con’t….

Player B
B1 B3
Minimax
Player A A2 712 minimum
5 value and dominated by row 3
A3 8 11
19
Lastly , after row 2 eliminated, we have one rows so we have to go
column reduction.
Therefore, the selected column greater or equal to other column. So, we
have delete and we have 1 strategy, which is =8
Player A [0,0,1,0,0]
Player B [1,0,0,0,0] and value of the game is =8
Example 3

Solve the following game theory using Dominance principles.

Player B
B1 B2 B3 B4
hence, they don’t have saddles point. So
A1 8 10 9 we used dominance rule.
14

Player A A2 10 11 8 so, 12 column B4 is dominated by column

B1 and
A3 13B2. so
12 eliminate
14 13 B4.
Again row A1 is dominated by Row A3.
Player B
B1 B2 B3
know we can used average of B2 and B3=
A2 10 11 8
11+8/2=9.5
A3 13 12 14
Player A 12+14/2=13
Con’t…

Player B
B1Know
B2&B3
column B1 is dominated by B2&B3
A2 10 9.5
Player A
A3 13 13

Player B
B2Minimax
B3
A2 118 8 saddle point =12, at A3 and B2
Player A Value of the Game is =12 as it represent
the best
A3 pay
12 off
14 for both the players.
12
Maximin 12 14