Unit 2.

Decision Theory
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Unit 2. Decision Theory (6 hrs.)

Introduction

In this unit, you will learn the

different decision environments
and decision rules for making good
decisions. Managers make
decisions and their decisions is
strongly influenced by how much
knowledge or information they
have about the situation.

The quality of the decisions made

in an organization is based on the
success or failure of the business. So all the available information and
alternatives must be studied carefully before doing the important decision. The
process of decision making will help a great deal. Many organizations
succeeded for doing a good and sound making decisions.

In this unit you will learn the 3 different decision environments namely,
certainty, uncertainty and risk.

Learning Outcomes
At the end of the unit, the student should be able to:

1. identify different decision environments and its use

2. apply different decision environments into a wide variety of problems

Activating Prior Learning

When you buy something at the

mall, for instance a pair of
shoes? What is the first thing you
consider? List them in a sheet of
paper and discuss, why?

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Topic 1: Introduction to Decision Methods

Learning Objectives
Upon the completion of this topic, you are expected to:

1. list the steps in decision making environments

2. apply the steps in making decisions

Presentation of Contents

Definitions

Decision-Making is the act of selecting a preferred course of action among

alternatives.

The following are the steps in decision-making:

1. Identify the problem.
To make decision, first, identify the problem you need to solve. Cleary
define your decision to achieve your goal. To achieve your goal, make
sure your goal is specific, measurable and timely.
2. Determine the criteria that can solve the problem.
Gather relevant information relevant to your choice. You may also do
an internal assessment seeing where your organization succeeded or
failed in areas related to your decisions as basis in making decisions.
Also, seek information from friends, experts, external sources including
related studies. Assets and resources are also part of the organization as
criteria that could also solve the problem. Avoid too much information
as this would only complicate the process.
3. Search for the different possible alternatives.
With the relevant information that you have gathered, you may now
identify possible solutions to your problem. Usually, there are more than
one option to consider when trying to meet a goal. For example, if your
company is trying to gain more engagement in social media, your
alternatives could include (1) paid social advertisement, (2) change your
social media strategy (2) or (3) a combination of the two.
4. Evaluate each alternative.
Once you identified multiple alternatives, the next thing to do is to
evaluate each alternatives. This is done by weighing the evidence
against the said alternatives. Identify pitfalls for each alternatives, and
weigh those against the possible alternatives. You may also consider
advantages and disadvantages of choosing such alternative.

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5. Select the best alternative.

This the most important part of the decision making process where you
make decisions. After you identified and clarified what decisions need
to be made, gather all relevant information, and developed and consider
potential paths to take. Then you may now ready to choose the best
alternative to take.
6. Implement the chosen alternative.
Once you have made your decision, act on it. Develop a plan to make
your decision tangible and achievable. You may also develop a project
plan related to your decisions.
7. Monitor the implementation.
To monitor the implementation, you need to review the plan or decision.
Take an honest look back at your decisions. Did you solve the problem?
Did you meet your goals?
If yes, take note what worked to be done for further reference and
improvement. If not, learn from your mistakes and begin the decision
making process again.

Application

In this part, I will show to you how to apply the different steps in decision-
making by giving a particular scenario.

1. Identify the problem.

Mr. X was offered a new job by two companies, Company A and
company B for the position of accountant. The goal of Mr. X now is to
identify what company could give him the best job he wants to. Which
among these two company should he accept?
2. Determine the criteria that can solve the problem.
Mr. X may now gather relevant information that could solve his
problem. To do this, he may lay down possible offers of these two
company such as his basic monthly salary, benefits, incentives, payable
overtime and many more. He may also consider his expenses upon
getting this job. Is it far from his residence? Is yes, how much is the
travelling cost? All of these must be considered.
3. Search for the different possible alternatives.
There are only two alternatives in this case: (1) ACCEPT company A or
(2) accept company B offer.
4. Evaluate each alternative.
Weigh the two companies. If Mr. X accept the offer of company A, how
much is the basic salaries, benefits, incentives, expenses and many more.
Try also to consider the workplace and your co-employees. You have to

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know also your job description before accepting the offer. You have to
evaluate everything before choosing your goal.
5. Select the best alternative.
Example, Mr. X chooses company’s A
6. Implement the chosen alternative.
Mr. X accepts company’s A offer.
7. Monitor the implementation.
To monitor Mr. X decisions’ he needs to assess himself if he really get
what he wants on his job. Is Mr. X happy for the job? If yes, then
perhaps, he must be continue working at the company and do his job
with honest and integrity. If not, the must quit the job and apply for
another job again.

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Feedback/ Assessment

Name: _________________________________ Date: ________________

Course: ________________________________ Score: _______________

Exercise 2.0

Problem. Company A would like to offer a new product (product A) in the

market. What should the company do? How should the company introduce the
product to the market? Try to list down at least 3 alternatives applying the 7
steps in decision making process. Please enumerate the steps 1 by 1. Discuss
briefly.

(20 points)

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Topic 2: Decision Making Environments

Learning Objectives
Upon the completion of this topic, you are expected to:

1. determine the correct decision making environments under

certainty
2. select appropriate decision rule under uncertainty
3. apply each of the decision rules or techniques for uncertainty
4. apply expected monetary value decision when operating decision
under risk

Presentation of Contents

Definitions

1. Decision- Making under the Condition of Certainty

The decision maker knows which state of nature will occur. At this situation, he
will decide definitely on the best possible solution favorable for him because he
knows exactly what will happen.

2. Decision- Making under the Condition of Uncertainty

When the decision maker has no information or estimates the probability of the
events, he will decide using any of the different strategies under this condition.

The following strategies are applicable under this condition:

(a) Maximax Strategy (Optimistic Approach)
This strategy is used to select the maximum payoff for each alternative,
and then among the maximum payoffs choose the alternative with the
maximum payoff. In case the problem is cost minimization, to apply this
strategy, one has to select the minimum payoff for each alternative then
finally choose the minimum. Thus, this called “minimin” for cost.
(b) Maximin Strategy (Pessimistic Approach)
This strategy is used to select the minimum payoff for each alternative
then among the minimum payoffs choose the alternative with the highest
payoff. In case the problem is minimization of cost, to apply this
strategy, one has to select the maximum payoff for each alternative then
finally, choose the minimum. Thus, this called “minimax”.
(c) Laplace Strategy
This strategy is used to select the alternative with the maximum average
payoff. To apply this strategy, determine the average payoff for each
alternative and then choose the alternative with the maximum average

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payoff(profit). For cost problem, simply do the same then finally, choose
the alternative with the minimum payoff.
(d) Minimax Regret Strategy
To apply this strategy, first determine the regret payoff for each
alternative under each state of nature, and finally selecting the minimum
among the maximum regrets.
(e) Hurwicz Criterion of Realism
This strategy is a middle ground criterion between the maximax and
maximin. The decision maker can assign a value for coefficient or index
of optimism symbolized by the a Greek letter α(alpha) with a value
between 0 to 1.

Measure of Realism:
MR = α (best payoff)+(1-α)(worst payoff)

Where α is the coefficient or index of optimism.

3. Decision –Making under the Condition of Risk

In this situation, the decision maker does not know exactly which one
among the different states will occur but can estimate that any one state
will occur.

Application

Example:

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.
a. The following 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.

Future Sales Level

Alternatives
Low Moderate High
Manufacturer -P30 P20 P110

Buy from local 20 60 50

Buy from Japan 10 45 80

Manufacturing would require a major investment in the new production

paraphernalia. Buying from local supplier would be better if demand will not be

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as high as expected. However, buying from Japan would be of high quality but
the problem might be in delivery schedule.
A convenient way to visualize the relationships between acts, events, and the
consequences of any combination of act and event is to prepare a payoff table.
The column headings of the table indicate the various acts from which the
decision maker may choose. The row headings show possible events, or states
of nature, that may exist after the act has been executed.

The following are the decisions of the management applying the

abovementioned strategies:
1. Decision –Making Under the Condition of Certainty.
If the management is certain that the condition of the economy is
LOW, the best decision is to buy from the local manufacturer.

If the condition of the economy is MODERATE, the best decision

is to buy the units from local manufacturer. However, if the
condition of economy is HIGH, the best decision is to manufacture.
2. Decision –Making Under the Condition of Uncertainty.
(a) Maximax Strategy, we choose the maximum for every
alternative then finally, select the maximum.
Alternatives Maximum
Manufacture 110
Buy from local 60
Buy from Japan 80
Payoff: P110,000.00
Decision: Since the maximum among the maximum values refers to the
alternative of manufacture, therefore ABC Company will manufacture
its own unique keyboard.

(b) Maximin Strategy, we choose the minimum of each alternative

then finally, select the maximum.

Alternatives Minimum
Manufacture -30
Buy from local 20
Buy from Japan 10

Payoff: P20,000.00

Decision: since the maximum among the minimum payoffs refers to the
decision on buying the suppliers, therefore ABC Company will buy the
keyboards from local suppliers.

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(c) Laplace Strategy

We get the average payoff for each alternative then choose the
maximum.

Alternatives Row Total Row Average

Manufacturer 100 33.33

Buy from local 130 43.33

Buy from Japan 135 45.00

Payoff: P45,000.00

Decision. The maximum average refers to the third alternative, which is

to buy the units from Japan.

(d) Minimax Regret Strategy makes us the concept on regret or

known as opportunity loss. To apply this strategy, we have to
compute the opportunity lost for each alternative under each
economic condition by simply getting the difference of the
highest entry for each column and entry on each column.

Future Sales Level

Alternatives
Low Moderate High
Manufacturer -30 20 110
Buy from
20 60 50
local
Buy from
10 45 80
Japan

Regret Table
Future Sales Maximum
Alternatives Level High
Low Moderate Regret
Manufacturer 50 40 0 50
Buy from
0 0 60 60
local
Buy from
10 15 30 30
Japan

Payoff: P30,000.00

Decision: Applying the Minimax Strategy, the decision of the company

should be based on the alternative with the minimum regret. Thus, from

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the MAXIMUM REGRET column, the minimum is 30 indicating that

the best decision under this strategy is to buy the units from JAPAN.
(e) Hurwicz Strategy with α=60% as the coefficient of realism:
Manufacture = (.60)(110) + (.40)(-30) = 54
Buy from local = (.60)(60) + (.40)(20) = 44
Buy from Japan = (.60)(80) + (.40)(10) = 52

Payoff: P54,000.00

Decision. The best alternative is to manufacture.

3. Decision-Making under the Condition of Risk.

To apply this strategy, the mathematical expectation (ME), or expected value

(EV) has to be computed by getting the product of the probability of an event
and the amount to be received upon the occurrence of that event.

EV = P(X)
Let us consider the table below showing the assessed probability on each state
of nature.
State of
Low Moderate High
Nature
Probability 25% 60% 15%
The expected value for each alternative can be computed as follows:

Alternatives Expected Value

1. Manufacture (.25)(-30)+(.60)(20) + (.15)(110) = 21.0
2. Buy from local (.25)(20) + (.60)(60) + (.15)(50) = 48.5
3. Buy from Japan (.25)(10) +(.60)(45) + (.15)(80) = 41.5

Payoff: P48,500.00

Decision: Under this strategy, the best decision is to buy from local supplier
because it has the highest expected value.

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Topic 3: Decision Tree

Learning Objectives
Upon the completion of this topic, you are expected to:

1. Construct decision tree

2. Apply decision tree analysis in solving problems

Presentation of Contents

Definition

A decision tree is a schematic model of decision-making showing the available

alternatives for the decision maker including the possible consequences. There
are two (2) types of nodes that can be used in making a tree diagram. A square
represents the decision point and a circle represents a chance event.

Example 1

Owel is planning to open up a new branch of Engrande Lechon at a new location

in Pasig or expand the existing branch located in mArikina City. Demand on the
new location is expected to be 60% high and 40% low. Fixed cost will reach the
amount of P150,000.00. if the demand becomes high, he expects to have a
revenue of P250,000.00, however if the demand becomes low, he could only
expect a revenue of P20,000.00. Upon analyzing the situation in his existing
branch, he believes that by introducing new recipes the sales will reach the
amount of P120,000 if the demand becomes high. However, if the demand
becomes low, he could only expect P80,000 revenue. Projection on high
demand in the existing branch tends to be 50% and upon computing the fixed
cost it would reach the amount P50,000.

If you were the consultant of Owel, what would you advise?

Solution:
Future Sales
Alternatives Revenue Expenses
Low Moderate
P250,000
Open a new H
60% 40% P150,000
branch P200,000
L
P120,000
100%-
Expand the H
55% 55% P50,000
existing branch P80,000
=45%
L

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For opening a new branch in Pasig:

EV = (P250,000 – P150,000)(.60) + (P200,000 – P150,000)(0.40) = P80,000

For expanding the existing branch in Marikina City:

EV = (P120,000-P50,000)(.55) + (P80,000-P50,000)(.45) = P52,000.

Definitely, Owel should open a new branch in Pasig because it has greater
expected value.

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Feedback/ Assessment

Name: _________________________________ Date: ________________

Course: ________________________________ Score: _______________

Exercise 2.1

1. Next year, the lease contract of Parrenos’ Grill Restaurant is about to expire.
Steve, the owner, must decide whether to renew the contract for another five
(5) years or relocate near the site of a proposed restaurant. The city engineer
is currently confused on the merits of granting approval to the restaurant. A
business consultant has estimated the present value of the Parrenos’ Grill
Restaurant as shown below for the two alternatives.

Alternatives Approve Disapprove

Renew the contract P750,000 P4,500,000
Relocate the restaurant P6,500,000 P300,000
Probability 55% 45%

1. What course of action would you recommend using each of the

following strategies? State the pay-off and decision. (40
points)
a. Maximax
b. Maximin
c. Laplace
d. Minimax Regret Strategy
e. Hurwicz (assume α = 65%)
f. Construct a Decision tree

2. What course of action would you recommend using decision making

under certainty?

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Summary

Decision-making is the act of selecting a preferred course of action among

alternatives. Many organizations succeeded in achieving their goals due to
sounds and good decision making.

There are 3 different decision environments namely, certainty, uncertainty and

risk.

Decision- making under the condition of certainty knows which state of nature
will occur. At this situation, decision maker will decide definitely on the best
possible solution favorable for him because he knows exactly what will happen.

On the other hand, decision maker under decision- making under the condition
of uncertainty has no information or estimates the probability of the events, he
will decide using any of the different strategies under this condition.

When a decision maker is able to determine the likelihood of events happening,

he is in a much better position to make a good decision. In this scenario, the
decision-maker applies decision making under the condition of risk.

Reflection

In this unit, please make a reflection on the following questions:

Did you learn what you expected to learn?

What do you still want to learn?

How might you use what you learned in the future in your life or profession?

References:

1. Arao, et.al. Quantitative Approaches in Decision-Making with Computer

Applications. Rex Books Store. 2010.
2. Anderson, et.al. Quantitative Methods for Business, 12th Edition. Cencage
Learning Asia Pte Ltd. 2015.
3. Anderson, David R., Dennis J. Sweeney and Thomas A. Williams.
Essentials of Modern Business Statistics with Microsoft Excel 2e. South-
Western CollegePublishing, Mason OH, 2004, ISBN 0-324-18452-2
4. Heizer, Render and Barry. Operations Management, 9th edition. Prentice
Hall Publishing Company. 2008
5. lucidchard.com

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