PROBABILITY AND

DECISION-MAKING
 PROBABILITY
• Is the rate of the probability or chance that an incident will occur.
• The probability of an event occurring is somewhere between impossible and
certain.
• The higher the probability of an event, the more evident that the event will
transpire.

- Numerous events cannot be foretold with absolute certainty. The best can
say is how likely they are to happen, using the concepts of probability.
Example:
Throwing a dice (when a single die is thrown, there are six viable result)
The probability of any one of them is

Tossing a coin (when a coin is tossed, there are two possible outcome head/ tails)
The probability of the coin landing tails , head .

Answer may be shown in the following ways:

As a fractions
As a decimal
As a percentage
Probabilityof anevent percen 𝐓𝐀 ≥¿
Event one or more of the possible outcomes of doing something.
Event can be Independent each is not affected or influenced by other event.
Dependent where an event is affected by other events, also called
“conditional”.
Mutually Exclusive event can’t happen at the same time.
 BASIC LAW OF PROBABILITY
• The probability of any event occurring is greater than or equal to zero and less
than or equal to one. 0< P <1
• The summation of the simple probabilities for all probable outcomes of an
action/ activity must be equal to 1.
• ERM plays an important role in a such decision-making process by
institutionalizing the presentation of information about “downside risk”
associated with a decision, an executive, such as a risk officer can facilitate the
presentation of important information to help inform the decision-making
process.
 DECISION THEORY
• Also known as theory of choice
• It is concerned with distinguishing the values, uncertainties and other
pertinent matters that are significant and applicable in each decision,
its rationally and the consequential optimal decision.
• There are techniques presented in decision theory in calculating risk
and uncertainties to minimize the negative impact.
SIX STEPS IN DECISION THEORY
1. Rationally define the problem at hand
2. List the potential options or alternatives
3. Recognize the possible outcome
4. List payout or profit of each combination of alternatives or
outcomes.
5. Opt for one of the mathematical decision models
6. Apply the model and make a decision.
 PERMUTATION
• Is the number of ways a set can be arranged or the number of ways things can be
arranged.
• With a permutation, the order of numbers matters.
• The main types of permutations are those with repetition and those without, although
other less common types include permutations with multi-sets and circular
permutations.
• It is possible to have multiple permutations from a single combination.
• Are distinct from combinations, which is a selection of data from a group where order
doesn't matter.
 COMBINATION
• Combinations don't rely on ordering or sequencing, which
means the data in a group can be ordered in any way, even
randomly. Having said this, there is no intention when it
comes to setting combinations. They are totally random.
Think of choosing items from the lunch menu at your local
diner for your meal
 Differences Between Permutations and Combinations

Permutations Combinations

Data is chosen from a list Data is chosen from a group

There is an arrangement of data There is a selection of data

The order matters The order doesn't matter

Multiple permutations are possible from One combination is possible from one
one combination permutation
 FORMULA FOR PERMUTATION

P(n,r) = n! ÷ (n-r)!
Where:
n = total items in the set;
r = items taken for the permutation;
"!" denotes taking the factorial

The generalized expression of the formula is, "How many ways can you arrange 'r' from
a set of 'n' if the order matters?"
FORMULA FOR COMBINATION

nCr = number of combinations

n = total number of objects in the set
r = number of choosing objects from the set
COMPUTATION OF EXPECTED VALUE

Ev= P(X)

Where: P= probability value

X= represent the amount of money
If the event has a number of possible outcomes, then
Ev = P1 (X1) + P2 (X2) + P3 (X3)+ ……….+ Pn (Xn)
Note: Expected value may negative
Example 1
Mrs. B is in a dilemma whether to put up a small business or not. If she decides
to go for it, she may gain Php300,000 incase its succeed. However, she may lose
php200,000 if it fails. The probability that it will succeed is pegged at 35%. Find the
expected value incase Mrs. B decides to venture in business.
Solution
Let P1 = 0.35 X1= php300000
P2 = 0.65 X2= -php200000
Ev = 0.35 (300000) + 0.65 (-200000)
=105000 – 130000
= - ₱25000, which mean Mrs. B is a bound to lose
Example 2
Company XYZ generates a profit of $40 for each laptop they sell. The company
losses $500 for every laptop that is returned due to some defect. If 3 out of every 100 laptops
that they produce is defective. What is the expected value of profit per laptop?

Solution
Let P1 = 0.97 X1= $40
P2 = 0.03 X2= -$500
Ev = 0.97 (40) + 0.03 (-500)
= 38.8 – 15
= $23.80 / $24 expected value per laptop
 EXPECTED MONETARY VALUE (EMV)
• EMV analysis is a statistical concept that calculates the average outcomes when
the future includes scenarios that may or may not happen.
• It is an important concept in project risk management which is used for all types
of project to make a qualitative risk
• Expected monetary value calculation relies on the meaning probability and
impact of each risk. Probability refers to possibility of occurrence of a condition
or an event.
Example 1
• Suppose you are into production of cement. Weather, cost of materials, and
labor problems are key production risk found in most assembly line operations
management:
• Risk 1 – Weather, there is a 10% chance of excessive rain that’ll delay the
production for one and a half weeks which will, in turn. Cost of the P250000.
(negative)
• Risk 2 – Cost of Production Materials there is an 8% probability of the price
construction materials dropping, which will save the production P300000.
(positive)
• Risk 3 – Labor Disorder there is 6 % probability of production coming to half
go on strike. The impact would lead to loss of P420000 (negative)
 COMPUTATION FOR EXPECTED
MONETARY VALUE
Production risk Computation EMV
Weather 0.1 (-250000) -P25000
Cost of Production materials 0.08 (300000) P24000
Labor Disorder/ Setback 0.06 (-420000) -P25200

The operation’s Expected Monetary Value based on these production

risks is:
EMV = (-25000) + 24000 + (-25200)
= - Php26200
Therefore, if all risk occur in the production, the operation would lose
P26200. In this situation, the production manager can include P26, 200
to the funds or budget to compensate for this.
CASE 1. BELOW IS A PAYOFF TABLE. CALCULATE FOR EMV

Economy
Alternatives Growing Stable Declining
(in 000) (in 000) (in 000)
Townhouse 55 60 20
Condominium 85 45 -2
Apartment 68 60 -10
Probability 0.2 0.5 0.3

To compute for Expected Monetary Value:

Townhouse= 0.2 (55000) + 0.5 (60000) + 0.3 (20000)
EMV= 47000
Condominium= 0.2 (85000) + 0.5 (45000) + 0.3 (-2000)
EMV = 38900
Apartment= 0.2 (68000) + 0.5 (60000) + 0.3 (-10000)
EMV= 40600

Decision: INVEST IN TOWNHOUSE

CASE 2. BELOW IS A PAYOFF. CALCULATE
FOR EMV
Alternatives Growing Stable Declining
(in 000) (in 000) (in 000)
Bonds 45 45 5
Stocks 70 35 -12
Mutual Funds 57 55 -5
Probability 0.3 0.4 0.3

To compute for the Expected Monetary Value:

Bonds= 0.3 (45000) + 0.4 (45000) + 0.3 (5000)
EMV= 33000
Stocks= 0.3 (70000) + 0.4 (35000) + 0.3 (12000)
EMV= 31400
Mutual Funds= 0.3 (57000) + 0.4 (55000) + 0.3 (-5000)
EMV = 37600

Decision: INVEST IN MUTUAL FUNDS

 EXPECTED VALUE OF PERFECT
INFORMATION (EVPI)
• EVPI is the cost or price that one would be willing to shell out to acquire access
to perfect information.
• EVPI helps to determine the worth of an insider who possesses perfect
information. The expected value with perfect information is the amount of profit
foregone due to uncertain conditions affecting the selection of a course of action.
• EVPI maximum payment for additional Information.
 CATEGORIES OF PERFECT INFORMATION
A. Perfect Information – the supposition that for a chosen (defined) phase of time the
decision maker can establish with conviction, prior to making the decisions, which state
of nature is going to transpire.
B. Expected value w/o Perfect Information – termed as the sum of weighted payoff
value parallel or corresponding to the best decision for the state of nature.
C. Expected Value w/ Perfect Information – the decision maker recognizes for sure that
one or more states of nature will take place, opt for the decision alternatives for each of
these states of nature, and based om identified and proven subjectively selected
probabilities for the state of nature is computing the expected value of the decision
strategy with perfect information.
• Expected Value of Perfect Information places a higher border on what
an individual would disburse for extra supplementary information.

• Technically, it is the expected value with perfect information minus

the maximum EMV.
Formula : EVPI = EV with PI – maximum EMV
Note: Maximum EMV = EV without PI

Where:
EVPI = expected value of perfect information
EV with PI = expected value of maximum payoffs for each outcome.
Maximum EMV = maximum expected monetary value
 Example 1: Below is a payoff table. Calculate the EMV and EVPI
Process

Alternatives Growing Stable Declining

(in 000) (in 000) (in 000)
Townhouse 55 60 20
Condominium 85 45 -2
Apartment 68 60 -10
Probability 0.2 0.5 0.3
Step 1: To Compute for EMV

Alternatives EMV
Townhouse 0.2 (55000) + 0.5 (60000) + 0.3 (20000) 47000
Condominium 0.2 (85000) + 0.5 (45000) + 0.3 (-2000) 38900
Apartment 0.2 (68000) + 0.5 (60000) + 0.3 (-10000) 40600
Step 2: To Compute for EV with PI

EV with PI = 85000 (0.2) + 60000 (0.5) + 20000 (0.3)

= P17000 + P30000 + P6000
EV with PI = P53000

Step 3: To Compute for EVPI

EVPI = EV with PI – maximum EMV

= P53000 – 47000
EVPI = Php6000
 EXAMPLE 2: BELOW IS A PAYOFF TABLE.
CALCULATE FOR THE EMV AND EVPI
Process
Alternatives Growing Stable Declining
(in 000) (in 000) (in 000)
Bonds 45 45 5
Stocks 70 35 -12
Mutual Funds 57 55 -5
Probability 0.3 0.4 0.3

Step 1: To Compute for EMV

Alternatives EMV
Bond 0.3 (45000) + 0.4(45000) + 0.3 (5000) 33000
Stocks 0.3 (70000) + 0.4 (35000) + 0.3 (-12000) 31400
Mutual Funds 0.3 (57000) + 0.4 (55000) + 0.3 (-5000) 37600

Therefore, Maximum EMV=

37600
Step 2: To Compute for EV with PI
EV with PI = 70000 (0.3) + 55000 (0.4) + 5000 (0.3)
= P21000 + P22000 + P1500
EV with PI = P44500

Step 3: To Compute for EVPI

EVPI = EV with PI – maximum EMV
= 44500 - 37600
EVPI = 6900
 EXPECTED OPPORTUNITY LOST
Minimizing the expected opportunity loss.
Expected Opportunity Loss, also known as Regret, is the difference between the payoffs from
chosen alternatives given a state of nature.
A risk measure, introduced to quantify the potential loss of making an incorrect choice in risk-
based decision-making.

Expected Opportunity Loss= Expected Regret

Rules: Choose the alternatives with minimum EOL

EOL= best payoff – payoff received

EXAMPLE 1: BELOW IS A PAYOFF TABLE.
CALCULATE THE EOL.
Alternatives Growing Stable Declining
(in 000) (in 000) (in 000)
Townhouse 55 60 20
Condominium 85 45 -2
Apartment 68 60 -10
Probability 0.2 0.5 0.3

Expected Opportunity Loss= Best payoffs – Received payoffs

Steps 1: Construct a regret table

o Choose the highest value n the “Growing” column. It is 85,000
o Subtract highest value with that of the other values in the given
column
o Repeat the process for the remaining column
Hence,
For “Growing” state in nature (in 000)
Townhouse 85-55 30
Condominium 85-85 0
Apartment 85-68 17

For “Stable” state in nature (in 000)

Townhouse 60-60 0
Condominium 60-45 15
Apartment 60-60 0

For “Declining” in nature (in 000

Townhouse 20-20 0
Condominium 20-(-2) 22
Apartment 20-(-10) 30
 Regret table/ EOL table
Alternatives Growing Stable Declining
(in 000) (in 000) (in 000)
Townhouse 30 0 0
Condominium 0 15 22
Apartment 17 0 30

Step 2: Compute for EOL or Expected Opportunity Loss

Alternatives Growing Stable Declining
(in 000) (in 000) (in 000)
Townhouse 30 0 0
Condominium 0 15 22
Apartment 17 0 30
Probability 0.2 0.5 0.3

EOL (Townhouse) 0.2 (30) + 0.5 (0) + 0.3 (0) 6

Condominium 0.2 (0) + 0.5 (15) + 0.3 (22) 14.1
Apartment 0.2 (17) + 0.5 (0) + 0.3 (30) 12.4
 EXPECTED OPPORTUNITY LOSS
Economy
Alternatives Growing Stable Declining EOL
(in 000) (in 000) (in 000) (in 000)
Townhouse 30 0 0 6
Condominium 0 15 22 14.1
Apartment 17 0 30 12.4
Probability 0.2 0.5 0.3

Note: The Minimum Expected Opportunity Loss is 6

Min EOL Decision: INVEST IN TOWNHOUSE

EVPI = min EOL Min EOL Decision = Max EMV

Decision
6000= 6000 TOWNHOUSE= TOWNHOUSE
 DEFINITION OF TERMS
• Probability – Is the rate of the probability or chance that an incident will occur. The
probability of an event occurring is somewhere between impossible and certain. The
higher the probability of an event, the more evident that the event will transpire.
Numerous events cannot be foretold with absolute certainty. The best can say is how
likely they are to happen, using the concepts of probability.
• Decision Theory – Also known as theory of choice, it is concerned with
distinguishing the values, uncertainties and other pertinent matters that are
significant and applicable in each decision, its rationally and the consequential
optimal decision.
• Expected Value (EV) – defined as the difference between expected profits and
expected cost.
• Expected Monetary Value (EMV) – deals with maximizing the expected return
from any decision-making scenario.
• Expected Value of Perfect Information (EVPI) – is the cost or price that
willing to pay in order to acquire access to perfect information. Maximum
payment for additional information.
• Expected Opportunity Loss (EOL) - Minimizing the expected opportunity
loss. Expected Opportunity Loss, also known as Regret, is the difference
between the payoffs from chosen alternatives given a state of nature. A risk
measure, introduced to quantify the potential loss of making an incorrect choice
in risk-based decision-making.
 DECISION MAKING
UNDER UNCERTAINTY
Decision Making Approaches

MAXIMAX APPROACH
(OPTIMISTIC)
• Best of the best
• Maximizing the maximum
• An optimistic decision-making principle that prefers the alternative with the
utmost feasible payoff or return.
Example 1
Procedure: Locate the maximum payoff within each alternative and then pick the
one with the highest value.
Alternatives Growing Stable Declining Best
(in 000) (in 000) (in 000)
Townhouse 55 60 20 60
Condominium 85 45 -2 85
Apartment 68 60 -10 68
Probability 0.2 0.5 0.3

Decision: INVEST IN CONDOMINIUM

Example 2
Procedure: Locate the maximum payoff within each alternative and
then pick the one with the highest value.
Alternatives Growing Stable Declining Best
(in 000) (in 000) (in 000)
Bonds 45 45 5 45
Stocks 70 35 -12 70
Mutual Funds 57 55 -5 57
Probability 0.3 0.4 0.3

Decision: INVEST IN STOCKS

 MAXIMIN APPROACH
(CONSERVATIVE OR PESSIMISTIC)
• Best of worst
• Maximize the minimum payoffs
• A pessimistic decision-making criterion. This technique maximize the minimum
payoff. It is the best decision of the worst possible outcomes.
Example 1
Procedure: Locate the maximum payoff within each alternative and then pick the
one with the highest value.

Alternatives Growing Stable Declining Worst

(in 000) (in 000) (in 000)
Townhouse 55 60 20 20
Condominium 85 45 -2 -2
Apartment 68 60 -10 -10
Probability 0.2 0.5 0.3

Decision: INVEST IN
TOWNHOUSE
Example 2
Procedure: Locate the maximum payoff within each alternative and then pick the
one with the highest value.

Alternatives Growing Stable Declining Worst

(in 000) (in 000) (in 000)
Bonds 45 45 5 5
Stocks 70 35 -12 -12
Mutual Funds 57 55 -5 -5
Probability 0.3 0.4 0.3

Decision: INVEST BONDS

EQUALLY LIKELY (LAPLACE)

• Best of Average
• Maximize the average payoff
 Example 1
Procedure:

Townhouse = (55 + 60 + 20) /3 = 45

Condominium = (85 + 45 -2) /3 = 42.67
Apartment = (68+60 – 10) / 3 = 39.33

Alternatives Growing Stable Declining Average

(in 000) (in 000) (in 000)
Townhouse 55 60 20 45
Condominium 85 45 -2 42.67
Apartment 68 60 -10 39.33
Probability 0.2 0.5 0.3

Decision: INVEST IN TOWNHOUSE

 Example 2
Procedure:

Bonds = (45+45+5) /3 =31.67

Stocks = (70+ 35 – 120) /3 = 31
Mutual Funds = (57+ 55 – 5) / 3 = 35.67

Alternatives Growing Stable Declining Average

(in 000) (in 000) (in 000)
Bonds 45 45 5 31.67
Stocks 70 35 -12 31
Mutual Funds 57 55 -5 35.67
Probability 0.3 0.4 0.3

Decision: INVEST IN MUTUALS FUNDS

 CRITERION OF REALISM
• This approach finds a compromise between the Best and the Worst Payoff.
• It chooses the best Weighted Average Payoff based on a
• Co-efficient of Realism a, 0 ≤ a ≤ 1
• a close to 1 ----------- optimism
 Alternatives Growing Stable Declining Weighted
(in 000) (in 000) (in 000) Average
Townhouse 55 60 20 32
Condominium 85 45 -2 24.1
Apartment 68 60 -10 13.4
Probability 0.2 0.5 0.3
Decision: INVEST IN TOWNHOUSE
Example 1
a = 0.3 1 – a = 0.7

a (best payoff) + (1-a) (worst payoff)

Townhouse = 0.3 (60,000) + 0.7 (20,000) = 32,000

Condominium = 0.3 (85,000) + 0.7 (-2,000) = 24,100
Apartment = 0.3 (68,000) + 0.7 (-10,000)= 13,400
Example 2
Procedure: Locate the maximum payoff within each alternative and then pick the one with the
highest value.
Alternatives Growing Stable Declining Weighted
(in 000) (in 000) (in 000) Average
Bonds 45 45 5 21.8
Stocks 70 35 -12 22.44
Mutual Funds 57 55 -5 21.04
Probability 0.3 0.4 0.3

a = 0.42 1-a = 0.58

a (best payoff) + (1-a) (worst payoff)

Bonds = 0.42 (45,000) + 0.58 (5,000) =

21,800
Stocks = 0.42 (70,000) + 0.58 (-12,000) =
22,440
Mutual Funds = 0.42 (57,000) + 0.58 (-5,000) = 21,040

Decision: INVEST IN STOCKS

 MINIMAX REGRET
• This approach minimizes the Maximum Regret
• Regret = Best Payoff – Payoff Received
• Example 1
• Step 1: Choose the Highest Value in each column and get the difference.

Alternatives Growing Stable Declining

(in 000) (in 000) (in 000)
Townhouse 55 60 20
85 – 55 =30 60 – 60 = 0 20 – 20 = 0
Condominium 85 45 -2
85 – 85 = 0 60 – 45 = 15 20 – (-2) = 22
Apartment 68 60 -10
85 – 68 = 17 60 – 60 = 0 20 – (-10) = 30
• Step 2: Construct the Regret Table using the values generated in Step 1
Alternatives Growing Stable Declining
(in 000) (in 000) (in 000)
Townhouse 30 0 0
Condominium 0 15 22
Apartment 17 0 30

• Step 3: Choose the highest value in each row

Alternatives Growing Stable Declining Maximum
(in 000) (in 000) (in 000)
Townhouse 30 0 0 30
Condominium 0 15 22 22
Apartment 17 0 30 30
• Step 4: Choose the one with the lowest value

Alternatives Growing Stable Declining Maximum

(in 000) (in 000) (in 000)
Townhouse 30 0 0 30
Condominium 0 15 22 22
Apartment 17 0 30 30

Decision: INVEST IN CONDOMINIUM

Example 2

Step 1: Choose the Highest Value in each column and get the difference.
Alternatives Growing Stable Declining
(in 000) (in 000) (in 000)
Bonds 45 45 5
70 – 45 = 25 55 – 45 = 10 5–5=0
Stocks 70 35 -12
70 – 70 = 0 55 – 35 = 20 5 – (-12) = 17
Mutual Funds 57 55 -5
70 – 57 = 13 55 – 55 = 0 5 – ( -5) = 10

Step 2: Construct the Regret Table using the values generated in Step 1
Alternatives Growing Stable Declining
(in 000) (in 000) (in 000)
Bonds 25 10 0
Stocks 0 20 17
Mutual Funds 13 0 10
Step 3: Choose the highest value in each row

Alternatives Growing Stable Declining Maximum

(in 000) (in 000) (in 000)
Bonds 25 10 0 25
Stocks 0 20 17 20
Mutual Funds 13 0 10 13

Step 4: Choose the one with the lowest value

Alternatives Growing Stable Declining Maximum
(in 000) (in 000) (in 000)
Bonds 25 10 0 25
Stocks 0 20 17 20
Mutual Funds 13 0 10 13

Decision: INVEST IN MUTUAL

FUNDS