DECISION THEORY

GMB 721-MANAGEMENT
SCIENCE
Prepared by: Alexa M. Vega, Shemineth Lomera,
Loriza Espiritu
What is Decision Theory?

Mathematical study of strategies for

optimal decision-making between options
involving different risks or expectations of
gain or loss depending on the outcome.
Decision Theory
Decision Theory Course Outline:
Mathematical Expectation (ME) or

Expected Value (EV)

Decision-making under Certainty

Decision-making under Uncertainty

Decision-making under Risk

Decision Tree

Expected Value of Perfect Information

Mathematical Expectation ME or Expected
Value (EV)

Mathematical Expectation or expected

value is the product of the probability
that an event will occur and the amount
to b received upon such an occurrence.
We predict outcome of future events
based on repeated experiments of
observations of the same events under
the same conditions.
Mathematical Expectation ME or Expected
Value (EV)

Probability of occurrence of the event

(success) and the probability of non-
occurrence (failure) is equal to 1 or
100%.
The probability of an event ranges from
0 to 1, the probability of success is 1 or
100%; if the event cannot occur, its
probability is 0.
Computation of ME or EV
Let P represent the probability value and X
represent the amount of money. ME is
computed as: EV=P(X)
If an event has several possible outcome with
probability P1,P2, P3 . Pn and if X denotes a
discrete variable which assumes the value X 1,
X2, X3, .. Xn then:
EV=P1(X1)+P2(X2)+P3(X3)...+Pn(Xn)
Expected Value is sometimes negative, that is
if the person will tend to lose instead of gain.
Sample Problem

A coin is tossed If the coin lands

heads, Mr. B will received P10, and
pay P8 if it lands tails. Find the EV.
Sample Problem
Solution:
There are only 2 possible outcomes, heads or tails the
probability of heads is and the probability of tails is so:
Let P1: heads
P2: tails
P1: X1: 10
P2: X2: 8
EV= (10) + (-8)
=54
=1
EV = P1, this means that the game will be a gain for Mr. B.
Sample Problem

Pasang Awa construction tends to accept

a bid for a project. If the project is
accepted the construction company may
gain P4 million and if it fails they will lose
P3 million. The probability that it will
succeed is 25%. Find the EV of the
company if it accepts the bid.
Sample Problem
Solution:
P1 = 25% X1 = 4
P2 = 75% X2 = 3
EV = .25(4) + .75(-3)
= 1-2.25
=-1.25
EV = -1.25, means that the company is
expected to lose.
Decision-making under certainty

Possible future conditions will actually

happen.
The decision maker is to pick the
alternative with the best pay-off.
The best alternative is the highest payoff
if the payoffs is expressed in profits; if
the payoffs are expressed in costs, the
best alternative is the lowest payoff.
Sample problem

States of Nature
Decisions Small Box Medium
Office Box Office
Sign with
Movie 200,000 1,000,000
Company
Sign with TV
900,000 900,000
Network
What is the best choice if the state of nature is small box office?
Answer: If the state of nature is small box office, the choice
would be sign with TV network since its payoff id P900,000 as
against the movie company with payoff of P200,000
Decision-making under uncertainty

Assumes that a manager can list

possible events but cannot estimate
their probabilities. The ff conditions will
be used in the decision rules: Maximin,
Maximax, Laplace, Minimax Regret.
Sample Problem
Jenny Lind is a writer of romance novels. A
movie company and a TV network both
want exclusive rights to one of her more
popular works. If she signs with the
network, she will receive a single lump
sum, but if she signs with the movie
company, the amount she will receive
depends on the market response to her
movie. What should she do?
Decision-making under uncertainty

Maximin Choose the alternative that I the best of

the best. This maximin approach is essentially a
pessimistic one because it takes into account only
the worst possible outcome for each aternative.

Decisions
Worst Payoff
Sign with Movie Company 200,000
Sign with TV Network 900,000

Since P900,000 is the worst payoff, the pessimist

will sign with the TV network
Decision-making under uncertainty

Maximax Choose the alternative that is the

best of the worst. The maximax approach is the
optimistic approach.
States of Nature
Decisions
Best Payoff
Sign with Movie Company 3,000,000
Sign with TV Network 900,000
Since P3 million is the best payoff, the optimist
would sign with the movie company.
Decision-making under uncertainty

Laplace Choose the alternative with

the best weighted payoff. The laplace
approach treats the states of nature as
equally
Assume that each event has 50%
probability: States of

Nature
Decisions
Small Box Medium Box
Office Office
Sign with Movie
200,000 1,000,000
Company
Sign with TV
900,000 900,000
Network
Sample Problem

Decisions
Weighted Payoff
Sign with Movie 0.5(200,000)+0.5(1,000,00
Company 0)= 600,000
0.5(900,000)+0.5(900,000)
Sign with TV Network
= 900,000

Since P900,000 is the best payoff, the realist

would sign with a TV network
 Decision-making under uncertainty

Minimax Regret Choose the alternative

with the best worst of regret. This
approach seek to minimize the
difference between the given payoff and
the best payoff for each
States of Nature state and
Decisions
nature. Small Box Office Large
Office
Box Maximum
Regret
Sign with Movie 1,000-
900-200 = 700
Company 1,000=0 700
Sign with TV 1,000-
900-900 = 0
Network 900=100 100
Decision-making under Risk
Assumes that manager has less
information than with decision-making
under certainty but more information
than with decision-making under
uncertainty. A widely used approach
under such circumstances is the
expected value(EV). The EV is the sum of
the payoffs for an alternative where each
payoff is weighted by the probability for
the relevant state of nature.
Sample Problem
Movie company Payouts
Small box office - $200,000
Medium box office - $1,000,000
Large box office - $3,000,000
TV Network Payout
Flat rate - $900,000
Probabilities
P(Small Box Office) = 0.3
P(Medium Box Office) = 0.6
P(Large Box Office) = 0.1
Sample Problem
Jenny Lind - Payoff Table

States of Nature
Small Box Medium Box Large Box
Decisions Office Office Office
Sign with Movie
200,000 1,000,000 3,000,000
Company
Sign with TV
900,000 900,000 900,000
Network
Prior
0.3 0.6 0.1
Probabilities
EVmovie=0.3(200,000)+0.6(1,000,000)+0.1(3,
000,000)
=P 960,000 = EVBest
EVtv
=0.3(900,000)+0.6(900,000)+0.1(900,00
0)
= P 900,000
Therefore, using this criteria, Jenny should
select the movie contract.
Decision Tree
A decision tree is a schematic model of
alternative available to the decision maker,
along with their possible consequences.
Can be used as visual aids to structure and
solve sequential decision problems
Especially beneficial when the complexity of
the problem grows
The decision tree is composed of number of
nodes that have branches emanating from
it.
Decision Tree
Three types of nodes
Decision nodes - represented by squares ()
Chance nodes - represented by circles ()
Terminal nodes - represented by triangles
(optional)
Solving the tree involves pruning all but
the best decisions at decision nodes, and
finding expected values of all possible
states of nature at chance nodes
Create the tree from left to right
Solve the tree from right to left
Example Decision Tree
Jenny Lind Decision Tree
Small Box Office
200,000

Sign with Movie Co. Medium Box Office

1,000,000

Large Box Office

3,000,000

Small Box Office

900,000

Sign with TV Network Medium Box Office

900,000

Large Box Office

900,000
 Example Decision Tree
Jenny Lind Decision Tree - Solved
Small Box Office
ER .3 $200,000
960,000
Sign with Movie Co. .6 Medium Box Office
$1,000,000
ER .1
960,000 Large Box Office
$3,000,000

Small Box Office

ER .3 $900,000
900,000
Sign with TV Network .6 Medium Box Office
$900,000
.1
Large Box Office
$900,000
Expected Value of Perfect Information
(EVPI)

Payoff increases and becomes certainty

and not probability.
EVPI the difference between the
expected payoff with perfect information
and the expected payoff under risk:
EVPI Calculation
EVwPI (or EVc)
=0.3(900,000)+0.6(1,000,000)+0.1(3,000,000) = P1,170,000

EVBest (calculated to be EVMovie from the previous page)

=0.3(200,000)+0.6(1,000,000)+0.1(3,000,000) = P960,000

EVPI = P1,170,000 - P960,000 = P210,000

Therefore, Jenny would be willing to spend up to

P210,000 to learn additional information before
making a decision