Decision Theory is a methodology for making management decisions which constitutes a particular

branch of operations research/decision science.

Steps in Decision Making

1. Clearly define the problem.

2. List all the possible alternative events that may occur.
3. Determine all possible outcomes.
4. Identify the profit/loss of each combination of alternative events and outcomes.
5. Choose one mathematical decision theory model.
6. Apply the model and make the decision.

Decision Environments

1. Decision-Making Under the Condition of Certainty.

The decision maker knows which state of nature will occur.
2. Decision-Making Under the Condition of Uncertainty.
The decision maker has no information or estimates of the probability of the events, his
choice of strategy reveals his attitude based on experience and the influence or
persuasion of the people in his environment.
a) Maximax Strategy (optimistic approach)-choose the alternative with the maximum among
the maximum payoffs.
b) Maximin Strategy (conservative approach)-selecting the alternative with the largest
minimum payoff .
c) Minimax Regret Strategy-choose the alternative that would minimize the maximum regret.
3. Decision-making Under the Condition of Risk
Decisions are made in an environment where the probability of each state of nature is
known or can be estimated.

Example 1.

A farmer in Region 2 must decide which crop to plant next year on his land: corn, peanuts, or soybeans.
The return from each crop will be determined by whether a new trade bill with Hongkong passes the
Senate. The profit the farmer will realize from each crop given the two possible results on the trade bill
is shown in the following payoff table.

Trade Bill
Crop Pass Fail
Corn 2,000,000 700,000
Peanuts 1,100,000 500,000
Soybeans 1,400,000 1,200,000
Determine the best crop to plant using the following decision criteria.

a. Maximax
b. Maximin
c. Minimax Regret

Example 2.

An investor is considering investing in stocks, bonds or Real Estate under uncertain economic
conditions. The payoff table of returns for the investor’s decision situation is shown below.
Economic Conditions
Decision Good Stable Poor
Stocks 250,000 350,000 150,000
Bonds 200,000 200,000 200,000
Real Estate -100,000 500,000 300,000
Determine the best investment using the following decision criteria.

a. Maximax
b. Maximin
c. Minimax Regret

Mathematical Expectation (ME)/ Expected Value (EV)- computed by getting the product of the
probability of an event and the amount to be received upon the occurrence of that event.

Example3

If a man purchases a raffle ticket, he will win a first prize of ₱500,000 or a second prize of ₱200,000 with
probabilities 0.0001 and 0.0005. What should be a fair price to pay for the ticket?

Example 4.

A gambler tosses a die. If 1, 3, or 5 appears, the gambler will be paid ₱9; if a 2, or a 4 turns up, he will
lose₱9; and if 6 is showing, he will win ₱12. Determine the expectation of the gambler.
Example 5.

The Omega Corp., a corporate raider, has acquired a shoe company and is contemplating the future of
one of its major plants located in Marikina. Three alternative decisions are being considered: (1) expand
the plant and produce lightweight, durable shoes for possible sales to the department store, a market
with little foreign competition; (2) maintain the status quo of the plant, continuing production of shoes
that are subject to heavy foreign competition; or (3) sell the plant now. If one of the first two
alternatives is chosen, the plant will still be sold at the end of the year. The amount of profit that could
be earned by selling the plant in a year depends on foreign market conditions, including the status of a
trade embargo bill in Congress. The following payoff table describes this decision situation.

States of Nature
Decision Good Foreign Bad Foreign Competitive
Competitive Condition Condition
Expand 30,000,000 20,000,000
Maintain status 50,000,000 -7,500,000
quo
Sell now 15,000,000 15,000,000

a. Assume that it is now possible to estimate a probability of 0.75 that good foreign competitive
conditions will exist and a probability of 0.25 that bad conditions will exist. Determine the best
decision using expected value and expected opportunity loss.
b. Compute the expected value of perfect information.
Example 6.

ABC Company is planning to manufacture its own new PC-based system, which intends to be marketed
by next year under its own brand. One particular concern of the company has something to do with the
keyboard that will be used in the system, which will be having a special feature on function keys.

The following are the different decision alternatives identified by the management:

a. The company can manufacture its own unique keyboard.

b. The company can buy the keyboards from a local manufacturer.
c. The company can buy the keyboards from Japan.

The payoff table is given below. The profit contribution is in thousand pesos.

Economic Conditions
Alternatives Future Low (25%) Sales Moderate (60%) Level High (15%)
Manufacture -30 20 110
Buy from local 20 60 50
Buy from Japan 10 45 80
Determine the best alternative using the following decision criteria.

a. Maximax
b. Maximin
c. Minimax Regret

Determine the best decision using expected value and expected opportunity loss.

Compute the expected value of perfect information.

A local real estate investor in Cebu is considering three alternative investments: a theater, a restaurant,
or a motel. Profits from the theater will be relatively stable under any conditions; profits from the
restaurant or motel will be affected by the availability of gasoline and the number of tourists. The
following payoff table shows the profit or loss that could result from each investment.

Economic Conditions
Investment Shortage (15%) Stable (60%) Surplus (25%)
Theater 300,000 300,000 250,000
Restaurant 100,000 400,000 300,000
Motel -400,000 750,000 1,000,000
Determine the best investment using the following decision criteria.

a. Maximax
b. Maximin
c. Minimax Regret

Determine the best decision using expected value and expected opportunity loss.

Compute the expected value of perfect information.