Quantitative Methods

Decision Making Under Uncertainty/

Risk
Marginal Analysis, Utility Theory,
Decision Trees, Game Theory
 DECISION ANALYSIS
Objectives:
1. Examine the decision-making process and the
environments in which decisions are made.
2. Examine uncertainty and risk as decision
environments and review methods to solve
problems under them.
3. Introduce expected value as a decision criterion under
conditions of risk.
4. Introduce marginal analysis and utility as decision
criteria.
5. Illustrate how decisions can be structured
using decision trees.
6. Introduce the concept and applications of
game theory.
 Steps in Decision Making:

1. Define the problem

2. List all viable alternatives

3. List future events affecting demand states of

nature

4. Construct payoff table

5. Select and apply model

6. Make decision
 Environments in which decisions are
made:
1. DM under certainty

2. DM under uncertainty – more than one state of

nature no knowledge about varying states

3. DM under risk – more than one state of nature

can assign probabilities for state of nature
Decision Making Under Uncertainty/ Risk,
Marginal Analysis

Aling Mary owns a jeepney which she uses to transport lanzones

from Laguna which she buys on wholesale basis at Php 4.50 per
kilo. She buys and sells the fruits to sidewalk vendors in Quiapo at
Php 12.00 per kilo. The maximum number of kilos she can sell in
one day is 120 kilos while the minimum is 100 kilos. The following
observations were made during the past 100 days:

100 kilos demanded on 20 days, 105 kilos on 30 days, 110 kilos on

20 days, 115 kilos on 10 days and 120 kilos on 20 days.

Her son who was taking up quantitative methods advises her to use
decision analysis to determine the right number of kilos to
purchase daily.
Decision Making Under Uncertainty/
Risk, Marginal Analysis
(Continued)

Requirements:
1. Employ DM under uncertainty to solve the the
problem. Use alpha=0.7 for realism.
2. How will the solution look like under DM under
risk approach?
3. Apply marginal analysis to obtain optimal
solution.
 Criteria for DM under uncertainty

1. Maximax - optimist, “best of the best”,

highest among highest payoffs in alternatives

2. Maximin - pessimist, “best of the worst”

highest among lowest payoffs in alternatives
3. Equally likely - best of average payoffs in each alternatives
4. Minimax regret - minimizes maximum opportunity loss
5. Realism - Middle ground between maximax and maximin
[(alpha) x (maximum in alternatives)]+
[ (1- alpha)(minimum in alternatives)]
Decision Making Under Uncertainty

CONDITIONAL PROFIT TABLE

Stock Option
Demand Proby 100 105 110 115 120
-------- ------- --------- --------- --------- --------- ---------
100 0.2 750.00 727.50 705.00 682.50 660.00
105 0.3 750.00 787.50 765.00 742.50 720.00
110 0.2 750.00 787.50 825.00 802.50 780.00
115 0.1 750.00 787.50 825.00 862.50 840.00
120 0.2 750.00 787.50 825.00 862.50 900.00
 Criteria for DM under risk

1. Expected value criterion

2. Criterion of rationality – assumes all states equally likely

3. Maximum likelihood criterion – select state with highest

probability; choose decision with highest payoff
Expected Monetary Value (EMV) or EV
Combination: probability event will occur
amount of money to receive

Computation:
P - probability value, X - amount of money
EV = P x X
Several events with corresponding monetary value
EV = P1X1 + P2X2 + … + PnXn

e.g. Coin toss game: H --> P4, T --> -P6

P(H) = 50% P(T) = 50%

e.g. Bid offer: Success = P2M, Fail = -P1.5M

P(Suc) = 30% P(Fail) = 70%
 Decision Making Under Risk
Expected Value Criterion
CONDITIONAL PROFIT TABLE
Stock Option
Demand Proby 100 105 110 115 120
-------- ------- --------- --------- --------- --------- ---------
100 0.2 750.00 727.50 705.00 682.50 660.00
105 0.3 750.00 787.50 765.00 742.50 720.00
110 0.2 750.00 787.50 825.00 802.50 780.00
115 0.1 750.00 787.50 825.00 862.50 840.00
120 0.2 750.00 787.50 825.00 862.50 900.00
 Decision Making Under Risk
Expected Value Criterion
EXPECTED VALUE TABLE

Sto ck Op tion
Demand Proby 100 105 110 115 120
-------- ------- --------- --------- --------- --------- ---------
100 0.2 150.00 145.50 141.00 136.50 132.00
105 0.3 225.00 236.25 229.50 222.75 216.00
110 0.2 150.00 157.50 165.00 160.50 156.00
115 0.1 75.00 78.75 82.50 86.25 84.00
120 0.2 150.00 157.50 165.00 172.50 180.00
--------- --------- --------- --------- ---------
750.00 775.50 783.00 778.50 768.00
===== ===== ===== ===== =====
optimal
Conditional Profit of Aling Mary with Salvage Value

Supposed that the extra number of kilos of lanzones

cannot be sold by Aling Mary the next day, since the
fruit will not be fit for human consumption. Suppose
also that a factory which manufactures fertilizer
buys overripe lanzones at Php 2.00 per kilo for
conversion to fertilizer. If Aling Mary can sell her
left-over lanzones at the end of the day at a salvage
value of Php 2.00 per kilo, contruct her conditional
profit table with salvage value.

Note:
If she has a stock of 120 kilos, but demand is only
100 kilos, then 20 kilos will be sold at a salvage
value of Php 2.00 per kilo which should be added to
her profit without salvage value.
 Decision Making Under Risk
Expected Value Criterion
CONDITIONAL PROFIT TABLE with SALVAGE VALUE
Stock Option
Demand Proby 100 105 110 115 120
-------- ------- --------- --------- --------- --------- ---------
100 0.2 750.00 737.50 725.00 712.50 700.00
105 0.3 750.00 787.50 775.00 762.50 750.00
110 0.2 750.00 787.50 825.00 812.50 800.00
115 0.1 750.00 787.50 825.00 862.50 850.00
120 0.2 750.00 787.50 825.00 862.50 900.00
Decision Making Under Risk
Expected Value Criterion
expected value TABLE with SALVAGE VALUE
Sto ck Op tion
Demand Proby 100 105 110 115 120
-------- ------- --------- --------- --------- --------- ---------
100 0.2 150.00 147.50 145.00 142.50 140.00
105 0.3 225.00 236.25 232.50 228.75 225.00
110 0.2 150.00 157.50 165.00 162.50 160.00
115 0.1 75.00 78.75 82.50 86.25 85.00
120 0.2 150.00 157.50 165.00 172.50 180.00
--------- --------- --------- --------- ---------
750.00 777.50 790.00 792.50 790.00
===== ===== ===== ===== =====
optimal
Profit with Perfect Information

Suppose that there is a man who can tell Aling Mary

information on the actual orders of the vendors, what
is the right amount that should be given to him?

If Aling Mary had perfect information about the

demand of lanzones for the day, she would always
purchase exactly the right amount. Thus if the
demand for the day is 100 k., she would purchase only
100 k.
Decision Analysis by Minimizing the Value of Loss or Regret

If Aling Mary purchases 110 k. and the demand is

actually 105 k. then she will “regret” purchasing 5
more k. The amount of regret is the difference
between the purchasing action taken and the “perfect”
purchasing decision.

If the demand is for 105 k. and 110 were purchased

there will be a profit of P765. If Aling Mary knew
beforehand that the demand was 105 k. and purchased
only 105 k., the profit is P787.50. Thus the amount of
regret is P787.50 – P765 = P22.50.
 Criteria for DM under risk

1. Expected value criterion

2. Criterion of rationality – assumes all states equally likely

3. Maximum likelihood criterion – select state with highest

probability; choose decision with highest payoff
 Decision Making Under Risk
Criterion of Rationality
Conditional Profit Table

Stock Option
Demand Proby 100 105 110 115 120
-------- ------- --------- --------- --------- --------- ---------
100 0.2 750.00 727.50 705.00 682.50 660.00
105 0.2 750.00 787.50 765.00 742.50 720.00
110 0.2 750.00 787.50 825.00 802.50 780.00
115 0.2 750.00 787.50 825.00 862.50 840.00
120 0.2 750.00 787.50 825.00 862.50 900.00
Decision Making Under Risk
Criterion of Rationality
EXPECTED VALUE under CRITERION OF RATIONALITY
Sto ck Op tion
Demand Proby 100 105 110 115 120
-------- ------- --------- --------- --------- --------- ---------
100 0.2 150.00 145.50 141.00 136.50 132.00
105 0.2 150.00 157.50 153.00 148.50 144.00
110 0.2 150.00 157.50 165.00 160.50 156.00
115 0.2 150.00 157.50 165.00 172.50 168.00
120 0.2 150.00 157.50 165.00 172.50 180.00
--------- --------- --------- --------- ---------
750.00 775.50 789.00 790.50 780.00
===== ===== ===== ===== =====
optimal
 Decision Making Under Risk
Maximum Likelihood Criterion
CONDITIONAL PROFIT TABLE
Stock Option
Demand Proby 100 105 110 115 120
-------- ------- --------- --------- --------- --------- ---------
100 0.2 750.00 727.50 705.00 682.50 660.00
105 0.3 750.00 787.50 765.00 742.50 720.00
110 0.2 750.00 787.50 825.00 802.50 780.00
115 0.1 750.00 787.50 825.00 862.50 840.00
120 0.2 750.00 787.50 825.00 862.50 900.00
 Marginal Analysis

DM technique, uses marginal profit and

marginal loss, determine optimal decision
policies

Used when number of alternatives and

states of nature is large
 Marginal Analysis
Some rules:

1. Marginal profit, MP  profit made by selling an

additional unit

2. Marginal loss, ML  loss caused by stocking, but not

selling, a unit

3. Given an inventory level, add additional unit to

inventory
level  expected marginal profit >= expected marginal
loss
 Marginal Analysis
Let P = probability demand will be >= a given supply (or
probability of selling at least one additional unit)

1-P = proby that demand will be less than supply

Then, expected marginal profit  P(MP)

expected marginal loss  (1-P)(ML)

Optimal decision rule: P(MP) >= (1-P)(ML)

Solve for P in terms of MP and ML -

P >= ML
---------------
MP + ML

  Stock additional unit as long as P >= above ratio.

 Marginal Analysis

PROBLEM:

Café du Donut is a dining spot with specialty of coffee and

doughnuts. It buys the donuts fresh daily from a large
industrial bakery. It pays P4 for each carton (containing two
dozen doughnuts) delivered each morning. Any carton not
sold at the end of the day are thrown away since they will not
be fresh enough to meet the café’s standards. A carton
sells for P6 each.

From past sales, the café’s manager estimates that daily sales
will follow the probability distribution as shown below. Based
on the facts presented, determine the optimal number of
cartons of doughnuts to order each day.
 Marginal Analysis

CAFÉ DU DONUT DAILY SALES AND PROBABILITY

Daily Sales Probability That Sales Probability That Sales will

(in cartons) will be at This Level be at This Level or Greater
-------------- -------------------------- --------------------------------
4 0.05 1.00 >= 0.66
5 0.15 0.95 >= 0.66
6 0.15 0.80 >= 0.66
7 0.20 0.65
8 0.25 0.45
9 0.10 0.20
10 0.10 0.10
 Utility Theory
Allows decision makers to incorporate their risk preference,
other factors into decision making process

Condition EV vs. bet, Decision?

------------------------------------------ ------------------------------------------
Bet of P10, 90% chance to win P100: 0.90 x 100 = 90>10
accept bet?
100, 1000: 0.90 x 1000 = 900>100
accept bet?

1000, 10000: 0.90 x 10000 = 9000>1000

accept bet?

P1M, 5M: 0.90 x 5M = 4.5M>1M

decline bet?

Total assets Utility

Utility - value of certain outcome or payoff to someone
- pleasure or displeasure that person would derive
from that outcome

Utility curve –
1. Graph that plots utility values versus monetary values
2 Shape depends on decision maker and
a. the specific decision being considered;
b. his psychological frame of mind; and
c. his expectations about the future.
3. Assessment of utility values completely subjective
personal
situational
4. Range of values: 0 <= utility <= 1
5. Curve may show –
a. Risk seeker
b. Risk avoider
c. Risk indifference
UTILITY AS A DECISION-MAKING CRITERION
Utility Theory - Scenario 1:
1. Determination of utility: U(-P1,000) = 0.05
U(0) = 0.15
U( P1,000) = 0.30

2. Determine expected value of utility:

E(Play the game): (0.45)(0.30) + (0.55)(0.05)
0.135 + 0.027 = 0.1625

E(Don’t play) : 0.15

Conclusion: 0.1625 > 0.15, therefore play the game.

Versus EV approach -

E(Play the game): (0.45)(1000) + (0.55)(-1000)

450 – 550 = -100

E(Don’t play) :0

Conclusion: -100 < 0, therefore don’t play the game.

Utility Theory - Scenario 2:
1. Determination of utility: U(-P1,000) = 0.25
U(0) = 0.40
U( P1,000) = 0.50

2. Determine expected value of utility:

E(Play the game): (0.45)(0.50) + (0.55)(0.25) = 0.225

E(Don’t play) : 0.40

Conclusion: 0.225 < 0.40, therefore don’t play the game.

Versus EV approach - (note: same as Scenario 1)

E(Play the game) = -100 < E(Don’t play) = 0
Conclusion: don’t play the game.
 Utility Theory
Utility Curve
Utility Scenario 2 – Risk Avoider
0.5
0.4
0.3 Scenario 1 -
0.2 Risk Taker
0.1
-2,000 -1,000 0 1,000 2,000
Monetary Outcome
 Decision Tree Analysis
• Physical representation of decision situation
 graphical representation of decision table

• Provides overview of total decision process

• Helps decision maker examine possible outcomes

• Combination of probability and monetary values

 expected values

• More appropriate when there are sequence of

decisions that need to be made
Decision Trees: BASIC SHAPES

Decision point; a place where a choice must be made

State of nature or chance event; possible outcomes

beyond control of decision maker

Branch alternatives
Decision Trees

You have P100,000 which you can invest for one year
in either stocks or bond. Your income from either
will depend on whether the market rises or falls.
Probability that market will rise is 70%; that it will fall
is 30%. Your stock will be worth P140,000 if the
market rises and only P80,000 if it falls. The bond
pays 5% interest in either condition. Where do you
put your money?
 Game Theory

o State of nature: non-thinking, non hostile opponent

Decision Making under uncertainty, risk

o Active, intelligent opponent trying to win over us

general situations of conflict over time

competitors

success of one at the expense of others

 Type of Games

I. Two-Person Zero-Sum Games

2 participants, equal in intelligence
choice of strategies
known payoff for combination of strategies

zero-sum game: sum of gains = sum of losses

A. Pure Strategies with Saddle Points

Payoff matrix – pure strategy you play all the time
Value of the game - payoff obtained, players play pure strategy
corresponds to where saddle point is situated

Rule of thumb to find saddle point: smallest value in row

largest value in column
 Player Y
----------------------------------
Player X Strategy Q Strategy R

Strategy M X wins 2 pts. X wins 3 pts.

Strategy N Y wins 1 pt. Y wins 2 pts.

Payoff matrix
Y
+  payoff to X (column) X 2 3
-  payoff to Y (column) -1 -2
GAME MATRICES
 Type of Games
(cont.. of no.1 types of games)

B. Mixed Strategies
Play combination of rows, columns
Proportion of time X plays each row
Y plays each column

C. Games by Dominance
Avoid entire rows (columns) when other rows (columns)
better to play
 Type of Games

II. Non-Zero Sum Games

- both players win
- both players lose
- one or other can win or lose
- players can cooperate, produce max payoff for both v.s. max
payoff for one player

III. N-Person Games

- more than 2 players
- collusion, negotiation

IV. Negotiable Games

- negotiations, coalitions
Game Theory - Constraint to Operational Use

1. 2-person to n-person games

zero-sum to non-zero sum games  theoretical
foundation becomes weaker

negotiate, bargain, coalesce

2. Conflicts rarely involve just 2 parties

3. Difficult to specify payoff in quantitative terms

4. Dynamism of real world

Values of Game Theory

1. Intuitive appreciation of conflicts

2. Insights into logical reasoning process

 Game Theory Applications

Group Scenario
1 Government – CPP/NPA conflict
2 EDSA 1986 people power
revolution
3 Israeli-Palestinian conflict
4 RP-China West Phil. Sea row
5 Apple vs Samsung
6 Coke vs Pepsi (cola wars)