MANAGEMENT SCIENCE

DECISION THEORY
 DECISION THEORY
✓ Deals with methods in determining the optimal course of
action, when a number of alternatives are available and
their consequences cannot be forecast with certainty.

Decision Guide for o Highest profit or revenue

Financial Outcomes o Lowest cost or loss
 ELEMENTS OF TYPICAL BUSINESS PROBLEMS
▪ ALTERNATIVE COURSES OF ACTION
✓ Set of available alternatives or options to be made by the decision
maker in order to achieve the goals of the organization

▪ STATES OF NATURE
✓ CALLED AS “EVENTS” that could be state of economy, currency fluctuations;
✓ Random factors that are outside the control of the decision maker;
✓ Determined the situation that will be found when decision is executed
ELEMENTS OF TYPICAL BUSINESS PROBLEMS
▪ PROBABILITIES OF OCCURRENCE OF THE
STATES OF NATURE
✓ Likelihood of the possible states of nature based on the initial
information that the decision maker have(EQUALS 100%)

▪ PAYOFFS
✓ Is the quantitative measure of the value to the decision maker of the
consequences of the outcome;
✓ In most cases, expressed as a monetary value, such as profit
Situation:
Because of the COVID 19 lockdown, the management team of a furniture factory in
Laguna was concerned about the delivery of pending orders from international and
local clients. The lockdown was extended and some areas were put under Modified
General Community Quarantine(MGCQ), General Community Quarantine(GCQ),
and Modified Enhanced Community Quarantine(MECQ).

The factory Administrator, after considering the expenses and possible sales that
would be incurred among the three alternatives, presented a decision table based
on the projected profit margin ratio during the three types of community
quarantine.
 Quarantine Types and Guidelines
Quarantine MGCQ GCQ MECQ
Guidelines
Capacity of Alternating work 75% workforce 50% workforce
Workforce from home/office

Transportation Public transpo Govt workers and Essential workers

resumes other allowed only
sectors
Who are allowed to All sectors Barangays without Essential workers
Work confirmed cases only
 Decision on “Quarantine Operations”
STATES OF NATURE
Alternatives Courses of
MGCQ (s1) GCQ (s2) MECQ (s3)
Action probabilities
0.20 0.30 0.50
a1 Selected employees to stay in the 6 7 4
factory
a2 Transportation provided to few 8 5 3
employees residing near the factory
only
a3 Transportation provided for 7 6 2
employees residing near and far from
the factory
 Decision on “Quarantine Operations”

MGCQ (s1) GCQ (s2) MECQ (s3)

0.20 0.30 0.50
a1 Selected employees to stay in the 6 7 4
factory
a2 Transportation provided to few 8 5 3
employees residing near the factory
only
a3 Transportation provided for 7 6 2
employees residing near and far from
the factory
ROLE AND DESCRIPTION OF ELEMENTS
ELEMENTS DESCRIPTION

ALTERNATIVES COURSES OF Independent, decision variables

ACTION
STATES OF NATURE Independent, uncontrollable variables

PROBABILITIESS OF THE Independent, uncontrollable variables

OCCURRENCE OF THE STATE OF
NATURE
PAYOFFS Dependent, result variables
TYPES OF DECISION SITUATION (Based on the degree of information)
1. Decision Situation under Certainty
• Said to be “deterministic situation”
• There is availability of complete information
2. Decision Situation under Risk
• Also known as Probabilistic or stochastic decision situation”
• The decision maker is presented with several options with corresponding probability of occurrence

3. Decision Situation under Uncertainty

• The decision maker does not have knowledge of the probability of occurrence of possible
states of nature.
• Cant be considered as total ignorance because states of nature are known
Decision Under Certainty
STATES OF NATURE
Alternatives Courses of MGCQ GCQ (s2) MECQ
Action (s1) (s3)
0.20 0.30 0.50 probabilities

a1 Selected employees to stay 6 7 4

in the factory Decision will choose a1
under GCQ because it
a2 Transportation provided to 8 5 3 has highest payoff of 7
few employees residing near
the factory only
a3 Transportation provided for 7 6 2
employees residing near and
far from the factory
 SOLUTION TO DECISION UNDER RISK

1. Multiply the payoff by the associated probability and

sum the results
Example: 6 x 0.20 + 7 x 0.30 + 4 x 0.50 = 5.3%

8 x 0.20 + 5 x 0.30 + 3 x 0.50 = 4.6%

7 x 0.20 + 6 x 0.30 + 2 x 0.50 = 4.2%

Expected value

DECISION – The factory administrator should choose first alternative (a1)

SOLUTION TO DECISION UNDER UNCERTAINTY
✓ There is unavailability of the estimates of probabilities of occurrence
✓ Arise when there is new phenomenon, new product or new processes
STATES OF
NATURE
5 Criteria of Choice Alternatives Courses of Action
MGCQ
(s1)
GCQ
(s2)
MECQ
(s3)

1. EQUAL PROBABILITIES 0.2 0.30 0.50

2. MINIMAX 0
3. MAXIMAX a1 Selected employees to stay in the 6 7 4
factory
4. COEFFICIENT OF OPTIMISM
a2 Transportation provided to few 8 5 3
5. CRITERION OF REGRET employees residing near the factory only
a3 Transportation provided for employees 7 6 2
residing near and far from the factory
SOLUTION TO DECISION UNDER UNCERTAINTY
1. EQUAL PROBABILITIES
✓ The decision maker assumes that all states of nature have
equal probabilities to occur, and the highest expected payoff
is selected
Example: 6 x 1/3 + 7 x 1/3 + 4 x 1/3 = 5.7%

8 x 1/3 + 5 x 1/3 + 3 x 1/3 = 5.3%

7 x 1/3 + 6 x 1/3 + 2 x 1/3 = 5.0%

• The probabilities of 1/3 will be applied to each

 SOLUTION TO DECISION UNDER UNCERTAINTY
2. CRITERION OF PESSIMISM (MAXIMIN OR MINIMAX)

✓ The decision maker assumes that the worst will STATES OF NATURE
happen from all of the available alternatives
Alternative Courses of MGCQ GCQ (S2) MECQ Worst Best of
✓ The lowest payoff in every alternative is selected Action (S1) (S3) Worst
and entered into a new column labelled as
WORST; a1 Selected employees to stay 6 7 4 4 4
✓ From the new column, the highest value of the in the factory

BEST OF THE WORST is selected. a2 Transportation provided to

few employees residing near
8 5 3 3

the factory only

a3 Transportation provided for 7 6 2 2
WEAK AREAS – Disregard of valuable information employees residing near and
far from the factory
since the lowest payoff were considered in making
decision and ignoring possible opportunities.
 SOLUTION TO DECISION UNDER UNCERTAINTY
3. CRITERION OF OPTIMISM (MAXIMAX OR MINIMIN)

✓ It is the reverse of the pessimism; STATES OF NATURE

✓ The decision maker assumes that the most
Alternative Courses of MGCQ GCQ (S2) MECQ BEST Best of
favorable outcome will occur, thus choosing the Action (S1) (S3) bEST
best possible payoff
a1 Selected employees to stay 6 7 4 7
in the factory
a2 Transportation provided to 8 5 3 8 8
few employees residing near
the factory only
a3 Transportation provided for 7 6 2 2
A GAMBLER– Risks are disregarded and only employees residing near and
far from the factory
focusing on opportunities
 SOLUTION TO DECISION UNDER UNCERTAINTY
4. COEFFICIENT OF OPTIMISM (HURWICZ CRITERION)
✓ Suitable for decision maker who are neither
completely pessimistic nor optimistic STATES OF NATURE
✓ Alpha (a) - used as degree of optimism from 0-1
Alternative Courses of MGCQ GCQ (S2) MECQ BEST
scale; 0-completely pessimistic and 1 – (S1) (S3) ALTERNA
Action
completely optimistic; TIVE

✓ The highest weighted value (WV) is the best for

maximization problems a1 Selected employees to stay 6 7 4 6.4
in the factory
✓ DIFFICULTY – is the measurement of alpha
a2 Transportation provided to 8 5 3 7 MAXIM
few employees residing near UM
WVa = a best + (1-a) worst the factory only
a3 Transportation provided for 7 6 2 6
employees residing near and
WV (a1) = 0.80 x 7 + (1- 0.80) x 4 = 6.4% far from the factory
WV (a2) = 0.80 x 8 + (1- 0.80) x 3 = 7%
WV (a3) = 0.80 x 7 + (1- 0.80) x 2 = 6%
 SOLUTION TO DECISION UNDER UNCERTAINTY
5. CRITERION OF REGRET (SAVAGE’S CRITERION) Using new data
STATES OF NATURE
✓ It is based on the concept of opportunity cost,;
✓ An opportunity loss is incurred whenever the MGCQ GCQ (S2) MECQ (S3) Lowest
decision overlook the best alternative; Alternative Courses of Action (S1)
Regret
✓ The decision maker should make an effort to
minimize the largest anticipated regret
2 STEPS IN DERIVING REGRET AND SELECTING BEST a1 Selected employees to stay in the 9–6=3 12 – 12 = 0 14 – 14 = 0 3
ALTERNATIVE factory

1. In each column, each payoff is deducted from the largest a2 Transportation provided to few 9-9=0 12 – 5 = 7 14 – 3 = 11 11
payoff in the column; employees residing near the factory
2. Find the worst regret in each row. Then select the lowest only
regret in the new column.
a3 Transportation provided for 9–7=2 12 – 6 = 6 14 – 2 = 12 12
employees residing near and far
Decision maker has to choose a1 Alternative which from the factory
minimizes the anticipated regret as it would gurantee
that such regret would not be greater than 3
 DECISION TREE
• A graphical representation of sequential decision processes or a
multi-period process, which happens when a decision should be
made based on several other interconnected future decision
• ADVANTAGE – provides simplified analysis of the results of a series of
decision
A decision tree is a support tool with a tree-like
structure that models probable outcomes, cost of
resources, utilities, and possible consequences.
Decision trees provide a way to
present algorithms with conditional control
statements. They include branches that represent
decision-making steps that can lead to a favorable
result.

Decision Tree - Overview, Decision Types, Applications

(corporatefinanceinstitute.com)
 DECISION TREE
STRUCTURE / ELEMENTS
✓ Includes DECISION POINTS, ALTERNATIVES, CHANCE POINTS, STATES
OF NATURE, PAYOFFS)

DECISION POINTS
▪ Symbolizes by SQUARE
▪ In this elements, the decision maker must select
from one alternative curses of action
▪ Each alternative is represented by a branch
originating from the right side of the decision
point.
▪ The cost to be incurred with the alternative must
be reflected on the branch.
▪ An alternative that will not be chosen should be
marked with
▪ Each alternative branch may result to a payoff,
another decision or a chance point
 DECISION TREE
STRUCTURE / ELEMENTS
CHANCE POINT POINTS
▪ Represents and event that is about to come
to pass in the process. It means one of the a
finite number of states of nature will occur.
▪ The states of nature are presented as
branches coming out of the right side of the
chance point.
▪ The probabilities of the states of nature
should be placed above the branches
▪ Each state of nature must be followed by
payoffs, decision points or more chance
points
Activity 2
1. Define Decision Theory
2. What are the 2 decision guides
for financial outcome?
3. What are the 4 Elements of
Typical Business Problems and
give brief description?