Manuel S.

Enverga University Foundation

Lucena City, Philippines
Granted Autonomous Status
CHED CEB Res. 076-2009

H083
MME 321 / QUANTITATIVE TOOLS IN
ENGINEERING MANAGEMENT

Fundamentals of Decision Theory Models

- Steps in Decision Making
- Types of Decision-Making Environment
- Decision Making under Risk
- Decision Making under Uncertainty
- Marginal Analysis with a large number of Alternatives and State of Nature
Decision Trees and Utility Theory
- Decision Theory
- Utility Theory
- Sensitivity Analysis

JOHN YVES G. NAÑEZ

MM-EM

DR. GUILLERMO M. RAGO JR.

September 7, 2019
 Manuel S. Enverga University Foundation
Lucena City, Philippines
Granted Autonomous Status
CHED CEB Res. 076-2009

1. Illustrate the steps in making a good decision.

1. Clearly define the problem at hand.

2. List the possible alternatives.

3. Identify the possible outcomes or states of nature.

4. List the payoff or profit of each combination of alternatives and outcomes.

5. Select one of the mathematical decision theory models.

6. Apply the model and make your decision.

2. Give examples on how the different types of decision-making environment are made.
a. DECISION MAKING UNDER UNCERTAINTY
i. Optimistic
In using the optimistic criterion, the best (maximum) payoff for each
alternative is considered and the alternative with the best (maximum) of these is
selected. Hence the optimistic criterion is sometimes called the maximax criterion.
ii. Pessimistic
In using the pessimistic criterion, the worst (minimum) payoff for each
alternative is considered and the alternative with the best (maximum) of these is
selected. Hence, the pessimistic criterion is sometimes called the maximin criterion.
This criterion guarantees the payoff will be at least the maximin value (the best of
the worst values). Choosing any other alternative may allow a worse (lower) payoff
to occur.

NAÑEZ, JY. G. 2
 Manuel S. Enverga University Foundation
Lucena City, Philippines
Granted Autonomous Status
CHED CEB Res. 076-2009

iii.Criterion of Realism (Hurwicz Criterion)

Often called the weighted average, the criterion of realism (the Hurwicz
criterion) is a compromise between an optimistic and a pessimistic decision. To
begin with, a coefficient of realism, is selected; this measures the degree of
optimism of the decision maker. This coefficient is between 0 and 1. When is 1, the
decision maker is 100% optimistic about the future. When is 0, the decision maker
is 100% pessimistic about the future. The advantage of this approach is that it
allows the decision maker to build in personal feelings about relative optimism and
pessimism.
iv. Equally Likely (Laplace)
One criterion that uses all the payoffs for each alternative is the equally
likely, also called Laplace, decision criterion. This involves finding the average
payoff for each alternative, and selecting the alternative with the best or highest
average. The equally likely approach assumes that all probabilities of occurrence
for the states of nature are equal, and thus each state of nature is equally likely.
v. Minimax Regret
The next decision criterion that we discuss is based on opportunity loss or
regret. Opportunity loss refers to the difference between the optimal profit or payoff
for a given state of nature and the actual payoff received for a particular decision.
In other words, it’s the amount lost by not picking the best alternative in a given
state of nature.
b. DECISION MAKING UNDER RISK
i. Expected Monetary Value
Given a decision table with conditional values (payoffs) that are monetary
values, and probability assessments for all states of nature, it is possible to
determine the expected monetary value (EMV) for each alternative. The expected
value, or the mean value, is the long-run average value of that decision. The EMV
for an alternative is just the sum of possible payoffs of the alternative, each
weighted by the probability of that payoff occurring.
ii. Expected Value of Perfect Information
The average or expected value of information if it were completely accurate.
The increase in EMV that results from having perfect information.
iii. Expected Opportunity Loss
An alternative approach to maximizing EMV is to minimize expected
opportunity loss (EOL). First, an opportunity loss table is constructed. Then the
EOL is computed for each alternative by multiplying the opportunity loss by the
probability and adding these together.
iv. Sensitivity Analysis
Sensitivity analysis investigates how our decision might change given a
change in the problem data.

NAÑEZ, JY. G. 3
 Manuel S. Enverga University Foundation
Lucena City, Philippines
Granted Autonomous Status
CHED CEB Res. 076-2009

3. Describe:
a. Certainty
The quality or state of being certain especially on the basis of evidence.
b. Decision Alternatives
One of the two or more ways of achieving the same desired end or goal especially
business decisions.
c. Expected Marginal Loss
The expected loss that would be incurred by stocking and not selling an additional
unit.
d. Expected Marginal Profit
The expected additional profit that would be realized by stocking and selling one
or more unit.
e. Opportunity Loss
The amount you would lose by not picking the best alternative. For any state of
nature, this is the difference between the consequences of any alternative and the best
possible alternative.
f. Payoff
Payoff is also considered as the consequence resulting from a specific combination
of a decision alternative and a state of nature. Payoffs can be expressed in terms of profit,
cost, time, distance, or any other measure appropriate for the decision problem being
analyzed.
g. Risk
Risk is the potential for uncontrolled loss of something of value. Values (such as
physical health, social status, emotional well-being, or financial wealth) can be gained or
lost when taking risk resulting from a given action or inaction, foreseen or unforeseen
(planned or not planned). Risk can also be defined as the intentional interaction with
uncertainty. Uncertainty is a potential, unpredictable, and uncontrollable outcome; risk is
an aspect of action taken in spite of uncertainty.
h. Salvage Value
Salvage value is the estimated book value of an asset after depreciation is
complete, based on what a company expects to receive in exchange for the asset at the
end of its useful life.

4. Discuss the differences among:

a. Decision-making under Certainty
In the environment of decision making under certainty, decision makers
know with certainty the consequence of every alternative or decision choice.
Naturally, they will choose the alternative that will maximize their well-being or
will result in the best outcome.

NAÑEZ, JY. G. 4
 Manuel S. Enverga University Foundation
Lucena City, Philippines
Granted Autonomous Status
CHED CEB Res. 076-2009

b. Decision-making under Risk

In decision making under risk, there are several possible outcomes for each
alternative, and the decision maker knows the probability of occurrence of each
outcome.
c. Decision-making under Uncertainty
In decision making under uncertainty, there are several possible outcomes
for each alternative, and the decision maker does not know the probabilities of the
various outcomes.

5. Why is a marginal analysis approach sometimes used instead of developing a payoff table?
Explain the basic rationale for the approach.
a. Marginal analysis is a decision-making approach that can help select the optimal
inventory level. It involves two new terms: marginal profit and marginal loss. Marginal
analysis can be used to obtain the best decision with a large number of alternatives.
There are two techniques use under marginal analysis approach which is marginal
analysis with discrete distribution and marginal analysis with normal distribution. First
is used if there are manageable number of alternatives and states of nature and we know
the probabilities for each state of nature and the latter is used when there are very large
number of possible alternatives and states of nature and the probability distribution of
the state of nature can be described with a normal distribution.

6. Philip Gamboa is the principal owner of Total Oil, Inc. After quitting his university teaching
job, Philip has been able to increase his annual salary by the factor of over 100. At the
present time, Philip is forced to consider purchasing some more equipment for Total Oil
because of competition. His alternatives are shown in the following table:
Equipment Favorable Market (Php) Unfavorable Market (Php)
Sub 100 3,000,000 -2,000,000
Japan 2,500,000 -1,000,000
American 750,000 -180,000
If Philip purchases a Sub 100 and if there is a favorable market, he will realize a profit of Php
3,000,000. On the other hand, if the market is unfavorable, Philip will suffer a loss of Php
2,000,000. But Philip has always been a very optimistic decision maker.
a. What type of decision is Philip facing?
Philip is facing a decision making under uncertainty. Because there are several
possible outcomes for each alternative, and the decision maker does not know the
probabilities of the various outcomes.
b. What decision criterion should he use?
Philip has always been a very optimistic decision maker so he can use the
maximax criterion of decision making.

NAÑEZ, JY. G. 5
 Manuel S. Enverga University Foundation
Lucena City, Philippines
Granted Autonomous Status
CHED CEB Res. 076-2009

c. What alternative is best?

Buying the Sub 100 is the best as per the Maximax Criterion of decision making.

7. Fujitsu Electronics specializes in manufacturing modern electronic components. It also builds

the equipment that produces the components. Mr. Arturo Lomibao, who is responsible for
advising the president of Fujitsu on electronic manufacturing equipment, has developed the
following table concerning a proposed a facility:
Profit (Php)
Strong Market Fair Market Poor Market
Large Facility 550,000 110,000 310,000
Medium-Sized Facility 300,000 129,000 100,000
Small Facility 200,000 100,000 32,000
No facility 0 0 0

a. Develop an opportunity loss table.

b. What is the minimax regret decision?
State of Nature
Profit (Php)
Strong Market Fair Market Poor Market
Large Facility 550,000 - 550,000 129,000 - 110,000 310,000 - 310,000
Medium-
550,000 - 300,000 129,000 - 129,000 310,000 - 100,000
Sized Facility
Small Facility 550,000 - 200,000 129,000 - 100,000 310,000 - 32,000
No facility 550,000 - 0 129,000 - 0 310,000 - 0

a. Opportunity Loss Table for Fujitsu Electronics

Profit (Php)
Strong Market Fair Market Poor Market
Large Facility 0 19,000 0
Medium-Sized Facility 250,000 0 210,000
Small Facility 350,000 29,000 278,000
No facility 550,000 129,000 310,000

Profit (Php)
Facility Maximum (Php)
Strong Market Fair Market Poor Market
Large 0 19,000 0 19,000
Medium 250,000 0 210,000 250,000
Small 350,000 29,000 278,000 350,000
No facility 550,000 129,000 310,000 550,000

NAÑEZ, JY. G. 6
 Manuel S. Enverga University Foundation
Lucena City, Philippines
Granted Autonomous Status
CHED CEB Res. 076-2009
b. The decision would be to build a large facility since the maximum regret for this is 19,000,
while the maximum regret for each of the other three alternatives is higher as shown in the
opportunity loss table.

NAÑEZ, JY. G. 7