DECISION
THEORY PT.1
PRESENTATION
GROUP 3
Learning Outcomes
Define the terms: state of nature,
alternative course of actions,
payoff, and probability of
occurrence of a state of nature
Demonstrate the role and
structure of decision matrices.
Solve problems under certainty,
uncertainty, and risk.
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.
will only cover these problems with
financial outcomes: profit, revenue, cost,
and loss.
LESSON 3.2
DEFINITION OF STATE OF
NATURE, ALTERNATIVE
COURSES OF ACTION, PAYOFF,
AND PROBABILITY OF
OCCURRENCE OF A STATE OF
NATURE
Elements of a Typical
Business Problem
Alternative Courses of Action
Payoffs
Probabilities of Occurrence of the States of Nature
States of Nature
Alternative Courses of Action States of Nature
Decision-making is defined as the These are other situations that are beyond
cognitive process of selecting a course of the control of the decision-maker.
action, out of a set of available
alternatives, to achieve the goals of the
organization.
Probabilities of Occurrence of Payoffs
the States of Nature This can be found at the intersection of a
given alternative and the corresponding
An assumption is made about one of the state of nature.
given states of nature will happen in the
future.
LESSON 3.2
ROLE AND
STRUCTURE OF
DECISION MATRICES
Decision Matrix
a decision-making tool that lists options
through weighted criteria formulated in a
tabular structure
Clear outline of the options available
Prioritize crucial factors and tasks
Weigh pros and cons of each option
Decision Table Elements
ALTERNATIVE COURSES STATE OF NATURE
OF ACTION
independent independent
decision variables uncontrollable variables
Decision Table Elements
OCCURRENCE
PROBABILITY PAYOFFS
OF STATES OF NATURE
independent dependent
uncontrollable variables result variables
LESSON 3.3
PROBLEMS UNDER
CERTAINTY
UNCERTAINTY
AND RISK
Types of Decision
Situations
Decision Situation under Certainty
01
“deterministic situation”
decision-maker is a perfect predictor of
the future because of the availability of
complete information
Types of Decision
Situations
Decision Situation under Risk
02
“probabilistic or stochastic decision
situations”
decision-maker is presented with several
options with a corresponding probability
of occurrence and determine whether it
can be considered a calculated risk
Types of Decision
Situations
Decision Situation under Uncertainty
03
cannot estimate or does not have
knowledge of the probability of
occurrence of possible states of nature
should not be considered total ignorance
since the states of nature are known
LESSON 3.4
SOLUTION TO
DECISION
UNDER RISK
Expected Pay-off Criterion
defined as the sum of all possible payoffs of that alternative, weighted by
probabilities of occurrence of those payoffs
the most common approach where decision-maker has to select the
alternative with the highest expected payoff
LESSON 3.5
SOLUTION TO
SITUATION UNDER
UNCERTAINTY
Solution to
Situation under
Uncertainty
The decision situation under
uncertainty is the unavailability of the
estimate of probabilities of
occurrence. This situation typically
arises whenever there is a new
phenomenon (e.g., COVID-19 virus
scare of 2020), the development of an
innovative product, or new processes.
Five criteria of choice to help solve a
management problem under uncertainty:
01 Equal Probabilities
02 Minimax
03 Maximax
04 Coefficient of Optimism
05 Criterion of Regret
Table 3.5 presents
an example of a
decision situation
under uncertainty
wherein the
probabilities of the
occurrence of the
states of nature
are not given.
Criterion of Equal Probabilities
(Laplace)
In this criterion, the decision-maker assumes that all states of nature have
equal probabilities to occur. Then, the highest expected payoff is selected. To
compute for the expected payoffs, the probabilities of one-third will be
applied to each of the three states of nature.
Criterion of Pessimism
(Maximin or Minimax)
The decision-maker under this criterion assumes that the worst will happen
from all of the available alternatives. The lowest payoff in every alternative
(row) is selected and entered into a new column labeled as "Worst." From this
new column, the highest value or the "Best of the Worst" is selected.
Criterion of Pessimism
(Maximin or Minimax)
The weak areas of this criterion are the disregard of the valuable information
since the lowest payoffs were considered in making the decision and too
much attention to risks that it ignored possible opportunities.
The weak areas of
this criterion are
the disregard of
the valuable
information since
the lowest payoffs
were considered in
making the
decision and too
much attention to
risks that it ignored
possible
opportunities.
Criterion of Optimism
(Maximax or Minimin)
The criterion of optimism is the reverse of the criterion of pessimism. In this
criterion, the user always assumes that the most favorable outcome will
occur. Thus, he/she chooses the best possible payoff.
A "gambler" is how
the decision-
maker under this
criterion can be
described, owing
to the fact that the
risks are
disregarded while
focusing on
opportunities only.
Coefficient of Optimism
(Hurwicz Criterion)
The most suitable for decision-makers who are neither completely
pessimistic nor optimistic. Decision-maker will be using a degree of optimism
called alpha a, which is measured on a 0 to 1 scale (where 0 = completely
pessimistic and 1 = completely optimistic). Best alternative is one with the
highest weighted value (WV) for maximization problems.
Coefficient of Optimism
(Hurwicz Criterion)
Alternative a2 , is the highest; therefore, it is selected as the best alternative.
minimization problems, the lowest WV should be selected.
The Criterion of Regret
(Savage's Criterion)
The criterion of regret is based on the concept of opportunity cost. An
opportunity loss is incurred whenever the decision overlooks the best
alternative. According to Savage, the decision-maker should make an effort to
minimize the largest anticipated regret.
Step 1. In each column,
each payoff is deducted
from the largest payoff in
the column.
Step 2. Find the worst
regret in each row. Then,
select the lowest regret in
the new column.
This criterion is based on
limited information.
Conclusion
Decision theory uses a Decisions under risk, the decision-
standardized format for arranging maker acquires the information to
all relevant information regarding make a calculated estimate of the
a managerial problem. chances of the various outcomes.
Decisions under certainty, the Decision under uncertainty, which
payoff or the consequence of is characterized by the absence of
choosing an alternative is important date, should be avoided
assumed to be known. to prevent disastrous results.
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