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DECISION THEORY

and
EXPECTED VALUE

Prepared by
Mirafuentes, Adami, Fabriga, Omongos & Quimno
Objectives:
To know and understand the following:
(1) Decision Theory
(2) Mathematical Expectation (ME) or Expected Value (EV)
(3) Value Information
(4) Degree of Certainty in Decision Making
- Decision Under Complete Certainty
- Decision Under Uncertainty
- Decision Under Risk
(5) Expected Value of Perfect Information (EVPI)
(6) Decision Tree Analysis
Introduction

Decision is the act of deciding


what single act among all
alternatives is to be taken into
account.
Steps to process:

Clearly define the problem.


Identify the possible alternatives and their
outcomes.
List the profit for each combination of
alternatives and outcomes.
Select one mathematical decision theory
model.
Apply the model and make your decision.
The success or failure that persons, companies, and
management experience depends on the decision they
make.
Making use of quantities in decision-making helps a
great deal in minimizing mistakes and failures.

Methods should therefore be learned.


Decision Theory
 It is a general approach to decision.
 Useful in many different aspects of operations
management.
 It provides a framework for analysis of decision.
 Includes number of different techniques that can classify
according to degree of uncertainty.
Mathematical Expectation(ME)
or Expected Value(VE)
 Depends on the probability that the event will happen
and the quantity of money to acquire.
Probability Concept
 Measure of sureness.
 Value of probability ranges 0 to 1.
 If an event is sure to happen the probability is 1 or 100%.
 But if otherwise, then it is zero(0).
 The probability of success and failure is equal to 1 or
100%.
Examples:
 The probability that FOREVER is true is 75%, the
probability that it is not is 25%.
 The probability that this class will pass is 55%, the
probability that this class wont pass is 45%. 
 The probability that change is coming in our country is
70%, the probability that it will not is 30%.
To compute for the Mathematical
Expectation(ME) or Expectation Value(EV)
 Let P= be the probability value
X= be the amount of money
EV= P(X)
 For several events that are expected to happen, the
amount of probability is,
EV=P1(X1) + P2(X2) + ……….Pn(Xn)
 Expected value is sometimes negative, when it will tend
to lose not to gain.
Example:
1. A fair coin will be tossed. If the coin lands head, Fred will get 1000
pesos, and pay 800 pesos if it lands tail. Find the EV.
Solution:
There are only two possibilities, head or tail, so the probability of head
is ½ and that of tail is also ½. Hence,
P1=1/2 X1=1000
P2=1/2 X2=800

EV =1/2(1000)+1/2(800)
=500 -400
=100

This means that the game is fair for the person.


2. Mr. JudeDe Jesus, the manager of ABC company has to decide
whether to accept a bid or not. If he accepts the bid, the company
may gain 2.5 million if it succeeds, or lose 1.5 million if it fails. The
probability that it will succeed is 40%. Find the EV if he accepts the
bid.

Solution:

P1= 40% X1=2.5 million

P2= 60% X2=1.5 million

EV=40%(2.5million) – 60%(1.5million)

= 1,000,000 – 900,000

EV= 100,000

This means that the company will gain.


Value Information

Payoff Table
Shows the expected payoffs for each
alternative under the various possible states of
nature.
Facilitates comparison of alternatives.
Example:
Stereo Industries, Ltd., a company that plans to expand its
product line, must decide to build a small, medium, or a
large facility plant to produce the products.

Alternatives Possible Future Demand


Low Inadequate High
Small Facility 350 350 350
Medium 245 420 420
Facility
Large -140 70 560
Facility
Degree of Certainty in Decision Making

 Decision Under Certainty


 Decision Under Uncertainty
 Decision Under Risk
Decision Under Certainty
 Choose the alternative with the highest payoff under the
state of nature.

Example:
What is the best alternative in the previous payoff table, if it
is known with certainty that the demand will be:
a. Low
b. Moderate
c. High
Solution:
Thus, if we know that the demand will be low, we
would choose to build a small facility with a payoff
of P350,000. If the demand will be moderate a
medium facility with the highest payoff of P420,000
should be chosen. For high demand, a large
facility with the highest payoff should be chosen.
Decision Under Uncertainty

there is no available information on how


likely the various states of nature are.
Four possible criterions:

Maximin
-takes into account only the worst possible
outcome for each alternative
Maximax
-takes into account only the best possible
outcome for each alternative
Laplace
- takes into account only the best average
possible outcome for each alternative
Minimax Regret
-determines the worst regret for each
alternative, and chooses the alternative with the
“best worst”
Examples:

Stereo Industries, Ltd, a company that plans to


expand its product line, must decide to build a
small, medium, or a large facility plant to
produce the products. The payoff table will
illustrates the capacity planning of the
company.
Alternatives Possible Future Demand
Low Inadequate High
Small 350 350 350
Facility
Medium 245 420 420
Facility
Large -140 70 560
Facility
Solution:

Maximin
- the best of the worst is 350; it leads to
building the small facility

Maximax
- the overall best is 560; it leads to building
the large facility
Laplace
Row Total Row Average
Small facility 1,050 350
Medium facility 1,085 361.67
Large facility 490 163.33

The highest average is 361.67, thus the medium


facility would be chosen
Maximax Regret
Alternative Regrets
Low Inadequate High Worst
Small Facility 0 -70 -210 -210
Medium -105 0 -140 -140
Facility
Large Facility -490 -350 0 -490

The lowest regret is 140, thus medium facility will


be constructed
Decision Under Risk
 In developing the criteria for decisions under risk, it is assumed
that the probability distributions are known.
 A widely used approach under this decision is the “expected
monetary value criterion”(EMV).
 The expected value is computed for each alternative, and the one
with the highest expected value is selected.
EXAMPLE: Identify the best alternative for the payoff table using
the EMV with the following probabilities:

LOW = 35%
MODERATE = 40%
HIGH = 25%
Possible Future Demand
Alternatives
Low Moderate High

Small facility 350 350 350

Medium facility 245 420 420

Large facility -140 70 560


SOLUTION:
2. Sum their products.
1. Find the expected value EV(small) = 122.5 + 140 + 87.5 = 350
of each alternative by
multiplying the EV(medium) = 85.75 + 168 + 105 = 358.75
probability of
EV(large) = -49 + 28 + 140 = 119
occurrence for each
nature by the payoff:

EV(small) = 35%(350) + 40%(350) + 25%(350) Hence, choose the medium-


size facility because it has the
EV(medium) = 35%(245) + 40%(420) + 25%(420) highest expected value.

EV(large) = 35%(-140) + 40%(70) + 25%(560)


EXPECTED VALUE OF PERFECT INFORMATION
( EVPI )
There are two ways to determine the EVPI:
1. Take the difference between the expected payoff
under certainty and the expected payoff under conditions
of risk.
2. Use the regret table to compute for the EVPI.
EXAMPLE: Based on the information in the preceding
examples, determine the expected value of perfect
information using the first and second methods.

SOLUTION: FIRST METHOD


35%(350) + 40%(420) + 25%(560) = 430.50
The expected payoff under risk is 358.75.
The EVPI is 430.50 – 358.75 = 71.75
SOLUTION: SECOND METHOD

Alternatives
Low Moderate High

Small facility 35%(0) 40%(70) 25%(210) = 80.5

Medium facility 35%(105) 40%(0) 25%(140) = 71.75

Large facility 35%(490) 40%(350) 25%(0) = 351.5

The lowest expected regret is 71.75, which is the same in the


first method solution.
THANK YOU! 