BUS 2: Operations Research

TOPIC:
Chapter 6

Decision
Theory
6.1 Introduction
*DECISION THEORY
also known as THEORY of CHOICE
is practically being used in most
areas of study
Economics
Psychology
Sociology
Philosophy
Mathematics
Computer Science
Statistics
• Apply the model and make a decision 6
• Opt for one of the mathematical decision 5
theory models
• List the payof or proft of each combination of 4
alternatives or outcomes.
• Recognize the possible outcome 3
• List the potential options or alternative 2
• Rationally defne the problem at hand 1
: 6.2 DECISION MAKING
6.3 Types of Decision
Making Environment
Decision making under certainty
Certainty
> Decision maker knows
with absolute confidence
the consequences of
every available option of
decision choice
Decision making under
uncertainty

?
？
Uncertainty
> The decision maker
does not discern the
probabilities of the
different outcomes.
Decision making under
risk
Risk
> There are several
possible outcomes for
each alternative.
>Decision maker has an
idea of the probabilities of
the various outcomes
6.4 Computation of Expected
Value
EV = P(X)

where: P = probability value

X= represents the amount of money

If an event has a number of possible

outcomes, then

EV= P1 (X1) + P2 (X2) + P3 (X3) + …+ Pn (Xn)

Note: Expected value may be negative; outcome

tends to be on the losing side instead of gain
Example problem:
A coin is tossed. If the
coin lands heads.carol will
collect Php50, and
willshell out Php20 if it
lands tails.Find the
expected value.
Solution:
Since a coin has two
sides. There are only two
possible outcomes in
tossing a coin. The
probability of heads is
50% and the probability
for tails is also 50%.
Let P1=0.5 X1=50
X2=-20
Let P2=0.5
EV=0.5(50)+0.5(-20)
EV=25-10
EV=Php15, Wich means
that carol Is expected to
gain.
6.5 Expected Monetary
Value (EMV)
•Is a ball park that shows how much
money one can reasonably expect in
mediation.
•Is the weighted sum of possible pay
offs for each alternative.
6.6 EMV: Parameters of Decision
How do you quantitatively prioritize a
risk ?

First, embark on QUALITATIVE RISK ANALYSIS.

Second, compromise a record or listing of risks

with a priority and urgency assigned. By means
of Expected Monetary Value, you can
quantify each risk to establish whether your
qualitative analysis is supported by numbers.
Steps to Calculate Expected
Monetary Value

Step 1. Assign a probability of

occurrence for the risk.

Step 2. Assign monetary value of

the impact of risk when it occurs.
The product of steps 1 and 2
equals expected monetary
value.

 This value is positive for

opportunities (optimistic risks)
and negative for threats
(pessimistic risks).
 To be sensible and realistic, it
is always best to consider and
reflect on both types of risks.
 Sample Case Problem:
Case 1: Suppose you are into production of cement.
Weather, cost of materials, and labor problems are key
production risks found in most assembly line operations
management.
Risk 1- Weather: There is a 10 percent chance of
excessive rain fall that will delay the production for one
and a half weeks which will, in turn, cost the production
P250,000.
 
Risk 2 – Cost of Production Materials: There is an 8
percent probability in the price of construction material
dropping, which will save the production P300,000.
 
Risk 3- Labor Disorder: There is a 6 percent
probability of production coming to a halt if the workers
go on strike. The impact would lead to a loss of
P420,000.
 We now quantity the
production risks by
calculating the
Expected Monetary
Value of each risk.
We now quantify the production risks
by calculating the Expected Monetary
Value of each Risk
Calculation of EMV:

Negative Risks Positive Risk

Weather Cost of production
materials
Labor Disorder
The Expanded Monetary Value for the
production risks are as follows:

EMV

Weather (10/100)(-250,000) -25,000

Cost of Production (8/100)(300,000) 24,000

Materials

Labor Disorder/Setback (6/100)(-420,000) -25,200

Suffice it to say that if the:
Weather negative- production
risk occurs, the operation loses
P25,000.
Cost of Production Materials
positive- production risk occurs,
the operation gains P24,000.
Labor Disorder/Setback negative-
production risk occurs, the
operation loses P25,200.
The operation’s Expected
Monetary Value based on these
production risk is:

(-25,000) + 24,000 + (-
25,200) =
(-26,200)

 
√ Therefore, if all risk
occurs in the production,
the operations would lose
P26,200. In this situation,
the production manager
can include P26,200 to
the funds or budget to
compensate for this.
6.8 Expected Value of Perfect
Information (EVPI)

>Perfect information may transpire from

precise historical data or probably a
result of thorough or technical analysis
of the market or of any production
practices.
The foremost question is how much is
the “price tag” of such information ?
In decision theory, the expected
value of perfect information (EVPI)
is the cost or price that one would
be willing to shell out in order to
acquire access to perfect
information .
6.9 Categories of Perfect
Information
Perfect Expected Expected
Information Value Value with
without Perfect
Perfect Information
Information
 The The expected The decision
maker recognizes
supposition value termed for sure that one or
that for a as the sum of several states of
chosen weighted pay nature will take
place, opt for the
(defined) off value decision alternative
phase of time parallel or for each of these
the decision corresponding states of nature,
and based on
maker can to the best identified and
establish with decision for proven subjectively
conviction, the state of selected
probabilities for the
6.10 Expected Opportunity
Loss

Expected Monetary Value (EMV)

deals with minimizing the
expected return from any decision
making scenario. An alternative to
this approach is to minimize the
Expected Opportunity Loss (EOL).
Expected Value of Perfect
Information places a higher
border on what an individual
would disburse for extra
supplementary information.
Technically, it is the expected
value with perfect information
minus the maximum EMV.
 
Expected Opportunity Loss
(EOL)
-is simply put as the cost of
not picking the best solution.
Opportunity loss, also known
as Regret, is the difference
between the payoff from the
chosen alternative given a
state of nature.
Expected Opportunity
Loss = Expected Regret
Rule:

Choose the alternative

with the minimum EOL.
Formula:

EVPI - EV with PI – maximum

EMV

Where:
Maximum EMV=
EV without PI
 
Sample Problem:
 
Below is a payoff table.
Calculate the EMV and
EVPI
 Econom
y
Alternatives Growin Stable Declining
g (in 000) (in 000)
(in 000)
Townhouse 55 60 20

Condominiums 85 45 -2

Apartment 68 60 -10

Probability 0.2 0.5 0.3

 Step 1. To compute EMV:
EMV is the weighted average of the
payoffs for a decision alternative.
Alternatives EMV

Townhouse 0.2(55000) + 0.5(60000) + 0.3(20000) 47,000

Condominiums 0.2(85000) + 0.5(45000) + 0.3(-2000) 38,900

Apartment 0.2(65000) + 0.5(60000) + 0.3(-10000) 40,600

Note:
Maximum EMV – EV
without PI

Therefore:
EV without PI = 47,000
Step 2. To compute for EVPI:
 
EVPI is the maximum payment for
additional information.
 
EV with PI = P85000(0.2) +
60000(0.5) + 20000(0.3)
 
= P17000 + 30000 + 6000 EV
with PI = P53,000
 
EVPI = EV with PI – maximum
EMV EVPI = P53000 – 47000
EVPI = P6,000

EVPI = EV with PI – maximum

EMV EVPI = P53000 – 47000
EVPI = P6,000
6.10 Expected
Opportunity Loss
 
Expected Monetary value
(EMV) deals with maximizing
the expected return from any
decision making scenario. An
alternative to this approach is
to minimize the Expected
Opportunity Loss (EOL).
 Expected Opportunity Loss
is simply put as the cost of
picking the best solution.
Opportunity Loss also known
as Regret, is the difference
between the payoff from the
chosen alternative given a
state of nature.
Expected Opportunity
Loss = Expected Regret
Rule: choose the
alternative with the
minimum EOL.
 Sample 1. Below is a Payoff table, calculate the EOL.

Economy
Alternatives Growing Stable (in Declining (in
(in 000) 000) 000)
Townhouse 55 60 20

Condominiums 85 45 -2

Apartment 68 60 -10

Probability 0.2 0.5 0.3

Regret = best payoff – payoff received

 
 
Step 1. Construct a Regret Table
 
Choose the highest value in the
“Growing” column. It is 85,000.
Subtract the highest value with
that of the other values in the
given column.
Repeat the process for the
remaining columns.
Hence For “Growing” state the nature
(in 000):
Townhouse 85-55 30

Condominiums 85-85 0

Apartment 85-68 17
For “Stable” state of
nature:
Townhouse 60-60 0

Condominiums 60-45 15

Apartment 60-60 0
For “Declining” state of nature:

Townhouse 20-20 0

Condominiums 20 –(-2) 22

Apartment 20 -(-10) 30
 Regret Table
Economy
Alternatives Growing Stable Declining
(in 000) (in (in 000)
000)
Townhouse 30 0 0

Condominiums 0 15 22

Apartment 17 0 30
  
Step 2. Compute for EOL

Economy

Alternatives Growing Stable Declining

(in 000) (in 000) (in 000)
Townhouse 30 0 0

Condominiums 0 15 22

Apartment 17 0 30

Probability 20% 50% 30%

 EOL 0.2(30) + 0.5(0) + 6
(Townhouse) 0.3(0)

EOL 0.2(0) + 0.5(15) + 14.1

(Condominiums) 0.3(22)

EOL (Apartment) 0.2(17) + 0.5(0) + 12.4

0.3(30)
 Expected Opportunity Loss

Economy
Altenatives Growing Stable Declining EOL
(in 000) (in 000) (in 000) (in
000)

Townhouse 30 0 0 6

Condominium 0 15 22 14.1
s
Apartment 17 0 30 12.4

Probability 0.2 0.5 0.3

Note: The Minimum EOL is
6

The decision,
therefore, is to

Invest in Townhouse.
Min EOL Decision = Max EMV Decision

Economy
Alternatives EMV (in EOL (in 000)
000)

Townhouse 47 6 53

Condominiums 38.9 14.1 53

Apartment 40.6 12.4 53

EVPI = min EOL
6000 = 6000

Min BOL Decision =

Max EMV Decision

Townhouse =
Townhouse
6.11 Decision Making Under Uncertainty

Equally
Likely
(Laplace Realism
Approach) (HURWICZ
Maximim )
Approach Approach

Decision
Making
Approache Minimax
Maximax s Regret
Approach Approach
6.11.1Maximax Approach
(Optimistic)
Best of the Best.

Maximizing the maximum

Maximizes the maximum

pay-off.
An optimistic decision
making principle that
prefers alternative with
the utmost feasible pay
off or return.
 Example 1: Using the payoff table.
Economy
Alternatives Growing Stable Declining
(in 000) (in 000) (in 000)
Townhouse 55 60 20

Condominium 85 45 -2

Apartment 68 60 -10

Probability 20% 50% 30%

Procedure:

Locate the maximum

payoff within each
alternative and then pick
the one with the highest
value
 Economy

Alternatives Growing Stable Declining

(in 000) (in 000) (in 000) Bes
t

Townhouse 55 60 20 60

Condominium 85 45 -2 85

Apartment 68 60 -10 68

Probability 0.2 0.5 0.3

Decision :

Invest in
Condominium
A pessimistic
decision
making
criterion. This
technique Maximizes the
maximizes the minimum Best of worst
minimum payoff.
payoff. It is
best of the
worst possible
payoffs.
6.11.2 Maximim Approach
 Example 2. Below is a payoff
table
Economy
Alternatives Growing Stable Declining
(in 000) (in 000) (in 000)
Bonds 45 45 5

Stocks 70 35 -12

Mutual Funds 57 55 -5

Probability 30% 40% 30%

Procedure:
Locate the minimum
payoff within each
alternative and then pick
the one with the
lowest value.
 Economy

Alternatives Growing Stable Declining

(in 000) (in 000) (in 000) WORST

Bonds 45 45 5 5

Stocks 70 35 -12 -12

Mutual Funds 57 55 -5 -5

Probability 30% 40% 30%

6.11.3 Equally Likely (Laplace)
Approach

Best of
Averages
Maximizes
the average
payoff
Example: Using the same payoff table

Economy

Alternatives Growing Stable Declining

(in 000) (in 000) (in 000)
Townhouse 55 60 20

Condominium 85 45 -2

Apartment 68 60 -10

Probability 20% 50% 30%

Procedure:
Average Payoff =
Townhouse
= (55 + 60 + 20 ) /3
= 45

Condominium
= (85 +45 -2) /3
= 42.67

Apartment
= (68 +60 – 10) /3
= 39.33
 Economy

Alternatives Growing Stable Declining

(in 000) (in 000) (in 000) Averag
e
Townhouse 55 60 20
45
Condominium 85 45 -2
42.6
7
Apartment 68 60 -10
39.3
3
Probability 20% 50% 30%
Decision:

Invest in Townhouse
6.11.4 Realism (HURWICZ)
Approach
Finds a Choose the
compromis best
e between weighted
the best average
and worst pay off
payoffs. based on α.
Coefficient
of realism α close to 1
α, optimism
0≤α≤1
 Example: Below is a payoff table
Economy
Alternatives Growing Stable Declining
(in 000) (in 000) (in 000)
Bonds 45 45 5

Stocks 70 35 -12

Mutual Funds 57 55 -5

Probability 30% 40% 30%

 α = 0.42 1- α = 0.58
Economy
Alternatives Growing Stable Declining Weighte
(in 000) (in 000) (in 000) d
Average
Townhouse 55 60 20
21.8
Condominium 85 45 -2
22.4
4
Apartment 68 60 -10
21.0
4
Probability 20% 50% 30%
α (best payoff) + (1- α)(worst
payoff)
Bonds
=0.42(45) + 0.58(5)
= 18.9 + 29 = 21.88

Stocks
= 0.42(70) + 0.58(-12)
= 29.4 – 6.96 = 22.44

Mutual Funds
= 0.42(57) + 0.38(-5)
= 23.94 – 2.9 = 21.04
Decision:

Invest in Stocks
6.11.5 Minimax Regret
Approach

*Minimizes the Maximum

Regret
*Regret= Best Payoff –
Payoff Received
Example 1: Using the same
payoff table
Economy

Alternatives Growing Stable Declini

(in 000) (in 000) ng
(in
000)

Townhouse 55 60 20
Condominium 85 45 -2
Apartment 68 60 -10
 Step 1 Choose the highest value in each
column and get the difference
Econom
y

Alternatives Growing Stable Declining

(in 000) (in 000) (in 000)
Townhouse 85-55= 60-60= 0 20-20= 0
30
Condominium 85-85= 0 60-45= 15 20- (-2)=
22
Apartment 85-68= 60-60= 0 20 – (-10)
17 =30
 Step 2: Construct the Regret
Table using the values
generated Step 1
Econom
y

Alternative Growing Stable Declining

s (in 000) (in 000) (in 000)
Townhouse 30 0 0

Condomini 0 15 22
um

Apartment 17 0 30
 Step 3. Choose the highest value in
each now.
Economy

Alternatives Growing Stable Declinin Maximu

m
(in 000) (in g
000) (in 000)
Townhouse 30 0 0 30

Condominiu 0 15 22 22
m

Apartment 17 0 30 30
 Step 4. Choose the one with the
lowest value
Econom
y

Alternative Growing Stable Declining Maximum

s (in 000) (in 000) (in 000)
Townhouse 30 0 0 30

Condomini
um
0 15 22 22
Apartment 17 0 30 30
Decision:

Invest in
Condominium
6.12 Decision Tree

* A decision is a decision support device

that employs a true-like diagram or
model of assessments and their
probable outcomes as well as chance
event results and resource costs.
 Decision
Tree

Branch
Decision Chance
(alternativ
Node Node
es)
Example:

Lets begin with a story. Lets say

your toying with the idea of
putting up a small business.
You have 2 business projects in
mind: either a burger joint or a
pizza parlor . The burger shop
can earn about 25,000 a week
while the pizza business can
earn up to 20,000 on the same
period. Which of the 2 potential
business projects would you
Example: burge
r
???

pizza
Answer:
Obviously, go for the
Burger Joint burge
r

since it will earn more

interesting. Assure that both
business venture has a
50-50 chance of success-failure
rate. However, there’s a catch , lets
say, if the burger joint succeed,
then it will earn
P 25, 000. But if it fails, then it will
lose P12,000. On the other hand,
with the 50% rate of success for
the pizza parlor pizza, it will
generate
P 20,000. In the event that it fails,
the said business would lose P
6,000. Will the additional
 Illustration:
burge
r

50% Success Php 25,000

??? 50%( 25,000) +50%(-
12,000) = P 6,500
50% Fail Php (12,000)

50% Success Php 20,000

50%( 20,000) +50%(-
6,000) = P 7,000
Pizza
50% Fail Php(6,000)
Which would you choose
now ?
Answer:

The Pizza Parlor

Business
pizza
End of the Report
Thank you !!!