| CHAPTER lo Decision Theory Decision theory j is constitutes a particular branch js lO defined as the analysi et hodology for makin Of operati ‘Ations res "9 managem, j Ons research/decisi lent decisi assumed. Most of the ti SIS Of decis Search/decision sci sions which ime deci ion situations in which cern ision inty cannot be 1 tion in an att | of ac empt to optimize ty ] maker Sacha the problem of ry hs Ascision process, Decisi must be noted that decisi ing compk ss. Decision theory aid " ion theory mar plex choices unde s the decision ely under uncertain condition is. It several alternative strategies. steps in Decision Making 1 cont define the problem. 2. List all the possible alternati f ative 3 Determine all possible oieone. o mal may oe 4. Identity the profit/loss of each combi combinati i $. Choose one mathematical deciion theory “a %. Apply the model and make the decision. 10.1 Decision Making Criterla 10.1.1 Maximax Criterion/Optimistic Approach 10.1.2 Maximin Criterion/Conservative Approach 10.1.3. Minimax Regret Criterion \ proach Maximax Criterion/Optimistic API 10.1.1 s for the different decisions offs of each altemative decision. The ‘he largest maximum payoffs. Te sing aitemative decisions. The maximax criterion maximizes the maximum payoff fing with the identification of the maximum pay aed ion is that decision which yields maximax decisi ision_ whi maximax rule isan extremely optimistic criterion for choo: 10.1.2 Maximin Citerion/Conservative Approach it ‘izes the minimum payofts given the various rin citon PM op ff table has been decisions that are Pp is to identify the minimum pay vay ston Move ore formulated. The first step 8 10 (CT cyoff. The rosin . the lorae® i ates of nature. thot fence oe gistic view on the various st 295i | 10.1.3. Minimax Regret Criterion The minimax regret criterion involves the construction of an opportunity jy regret mattx prior to applying the minimax rule. Constuct an opportunity fo Ya transforming each element in the payoff table to an opportunity loss. The degree of el opportunity loss for a given element is the loss incurred by not selecting the opin alternative decision given a state of nature. Converting a payoff table to Gn opportyn loss table is composed of two-step iterative process, The fist step is to tind the wen element in the fist column. The element represents the best decision given o panes! state of nature. The second step is fo sublkact each element in the column fons larges! element to compute the opportunity loss. The minimax regret le sole? igenty the maximum regret (opportunity Iss) for each decision and then choose in® decision with the smallest maximum regret. Example 10.1: A farmer in Region 2 must decide which crop to plant next year on his land: com, peanuts, or soybeans. The retum from each crop will be determines by whether a new trade bill with Hongkong posses the Senate. The profi! the farmer wy realize from each crop given the two possible results on the trade bills shown in he following payoff table. Trade Bill Crop Pass Fail ‘Com 2,000,000 700,000 Peanuts 1,100,000 500,000 [Soybeans | 1,400,000 [1,200,000 Determine the best crop to plant using the following decision criteria. a. Maximax b. Maximin c. Minimax Regret Solution: @. Maximax Criterion Step 1. Select the column with maximum payott. Trade Bill Crop Pass Fail Com 2,000,000 700,000 Peanuts 1,100,000 500,000 |_Soybeans 1,400,000 1,200,000 ft Maximum payoff 296identify the highest maximum — off, eeu L100000 7] = "axiom ‘eybeans | 14001000 : The planting of cx gecision ‘omn will result in a maxi 1aximax payoff of 2,000,000 yp, Max sep |. Step 2. Decisio! cc. Mini Step 1. imin Criterion Select the column wi th minimum payott Trade Bill Crop Pass. ‘Com 2,000,000 __|~ 700,000 Peanuts | 1,100,000 | 500,000 Soybeans | 1,400,000 | 1.200.000 ft Identify the lowest mir Minimum payott inimum payoff [Crop __| Minimum Payofts Corn 700,000 Peanuts 500,000 canine Soybeans 1,200,000 The planting of peanuts wil result imox Regret Criterion Determine the larges ina minimum payott of 500,000. 4 element in first column. Trade Bill Fail Pass 2,000,000 1,100,000 [400.000 | 2972. Subtract every element from the largest payoff in both columns, (step 2. Pass 2,000,000 - 2,000,000 = 0 Com = Peanuts > Soybeans => Fail Com = Peanuts > Soybeans => Trade Bill ‘Crop Pass Fail Com 0 500,000 Peanuts 700,000 700,000 Soybeans 600,000 oT Step 3. Identify the Maximum regrets, Crop Maximum Regrets Com 500,000 i minimum Peanuts 900,000 Soybeans $00,000 Decision: The Planting of com will result in, at most, 500,000 in regret. 10.2 Expected Value (EV) /Mathematical Expectation (ME) The Expected Value, or Mean, sometimes called M discrete random variable is very important in character Example 10.2.1: if a man Purchases a raffle ticket, he will win a first prize of P500,000 oro second prize of P200,000 with Probabilities 0.0001 and 0.0005, What should be a fair prize to pay for the ticket? Solution: EV = (500,000)/0.0001) + (200,000)(0.0005) = 50+ 100 = P150 i The fair price of the ticket is P150, 29810.2.2: A gambler tosses (Pleo g A tuins adie. fal, 3, | a 2. 089 ums up, he will lose P9; and if 6 , or 5 appet | 8 Zation of the gambler and if 6 is showing, FS maarivonadee he 12, Determine the 2 probability of 1,3,0r5 Spabilty of 2 oF 4 wil ee probability of 6 ill oppecr ala) nat there are six fa cre six faces of a requar le which sen probabilities of A,B, and C are as el serves x he pose Pa) = 2/6: pic) = 16 29 P(A) -9 P(B) + 12 PIC) = 9(3/6) ~ 9(2/6) * 1211/6) 245-342 =P35 Ev ne gambler expects to win P3.5 per toss of a die. is a Decision Tree. '" 5 ‘an determining n tree, the jo.3 Decision Trees 1 technique for analyzing ation i of node’ ome] a Another useful a.graphical diagram the probability of user computes th these expect©' The decision-making PF, volves and to unders lecision nodes tive decisions ‘ents ina decision tne squares are d and the br possibl situation. of the decision 299b. Expected Valve of Perfect Information Step 1. Determine the expected value given perfect information, Expected value given perfect information = 50,000,000 (0.75) + 20,000,000 (0.25) = 37,500,000 + 5,000,000 = 42,500,000 Step 2. Compute for the expected value without perfect information Expected value without perfect information = 50,000,000 (0.75) - 7,500,000 (0.25) = 37,500,000 - 1,875,000 = 35,625,000 Step 3. Solve for the expected value of perfect information Expected value of Perfect information (EVP!) EVPI = 42,500,000 - 35,625,000 = 6,875,000 The expected value of the perfect information, 6,875,000, is the maximum amount that the investor would pay to purchase perfect information from some other SOUICES, Such g3 rconomic forecaster. Usually, the decision maker would be willing to Pay some amount less than 6.875.000, depending on how accurate (close to Perfection) the decision maker believes the information is. ¢. Decision Tree Step I. Construct a decision tree. Good conditions 30,000,000 (0.75) Bad conditions 20,000,000 (0.25) Good conditions 50,000,000 Maintain status quo -7,500,000 15,000,000 Bad conditions 15,000,000 (0.25) 302wo compute for the expected valve of the nodes 8 les B, C and D. 30,000,000 ; 2 000,000 (0.75) + wo? = 22,500,000 + 8} #20.000000 (0.25) = 27,500,000 , c = 50,000,000 (0.75) ose 2 .75) - 7,500,000 (0. 7,500,000 - 1,875,000 al = 35,625,000 ode? = 15,000,000 (0.75) + 15,000, 1,250,000 + 3,750,000 pono 2") 5,000,000 Good conditions 199,000,000 Bad conditions 20,000,000 (025) Good conditions ‘50,000,000 Maintain status quo Bad conditions’ -7,500:000 (0.75) Sell Good conditions 15,000,000 (0.75) 15,000,000 1 13000000 0d conditions (025) nd make the decision 625,000. is ne be made, the pected ighest solution among the circle nodes o mointain status ae , wher in the 2 epee ied valu Ms citerion. When only © rays yield the som ¢ decision and xP will al poyoft of 35, ne decision is 10 ected payort as the &s Step 3. select the hi the decision is ¥ same result in decision tree value criterion. 303v d. Decision Trees with Posterior Probabilities Step 1. Construct a decision tree with positive and negative reports, Good conditions Bad-conditions Expand Good conditions Maintain status quo 8ad conditions Positive Good conditions Report Bad conditions Good conditions Bad conditions Good conditions Maintain status quo Bad conditions Good conditions Bad conditions 304 00.45 20,000,099 0.000.056 7.00.09 48:000,000 15,000.00, 0.000.000 20,000,000, 50,000,000 7,500,000 15,000,000, 15.000000| pute for th eric , 1€ posterio i " Probabilities with table: Ond by | -omputation of Posterior Probabilities for poe, he Use of form C (Or Positive Result “ Grate of Prior C Nalure_| Probab sntlonal Good Pla) = 0.75 erste conan pai j PIP/g) = OB To retonal Probab roster Conditions| | 0.80 PIP) = 0.40 lity | Probabities | bad Pid) =0.25 | Po soat - Conditions 1025 | PIPIe)=039 PPO) = OTS ao 1 Po/P}= 0.11] j - PIP /g) « Pig) | pal?) = S57 pas PPT 19/"!~ BP 7g) « Pla) + PP /b) Pb) _ (0.80}(0.75) (0.80) (0.75) + (0.30) (0.25) | ___ 0.60 0.60 + 0.075 PIP /) « Pb) pip/p) = ———_PIP/b]«Fo)]_ ) = BP 7b) Flo) «PP / al Pla) (0.30)(0.25) * (0:30)(0.25) + (0.80) (0.75) 0.075 Computation of Posterior Probabilities for Negative Result State of Prior Conditional | _ Prior Probablity x Posterior | Nature _| Probabilities | Probabilities Conditional Probability | Probabilities Good Pig)=0.75 | PIN/g) =0.20 PING) = 0.15 Pig/N) = 0.46 Conditions ; Bad Ppp =025 | PINTD)=0.70 PND) = 0.175 PION) =08# | Conditions 305PIN/ 9) « Pig) P(g/N) = PINT al* Pig) +PIN/ B) =P) (0.20)(0.75) "2070751 +(0.7075.35 oe = 0.15 ~ 0.325~ = 0.46 PIN/b) « Pi) meine PINT) « «FN Fa (0.70)(0.25) * B7RT029 B= ~ oe ae 0.15 _ 0.175 ~ 0.335) = 0.54 306g | th wo? Determine © Pose robtityo © decision tree, PlarP) = 0.89 00 ¢00 20,000,000 $0,600,000 PIbIP) = 07 7.500.000 Postive Report Flor} = 089 15.000,000 1.000.000. PIGIN) = 0.46, 30,000.00 Report PN) =OB 29.000.000 PIGIN) = 0.46 ‘Sa000000 ‘ Maintain status quo Plo) = 050 7.500.000 PIQIN) = 0.46 $s000.00, PIO/N) = 0.54 15:000.000 t Step 4. Solve for circular nodes from D to |. Node D = (0.89)(30,000,000) + (0.11}(20,000,000) = 26,700,000 + 2,200,000 8,900,000 307£89)(50,000,000) + (0.11) (-7,500,000) 14,500,000 ~ 825,000 Node F = (0.89)(15,000.000) + (0.11)(15,000,000) = 13,350,000 + 1,650,000 15,000,000 Node G = (0.46)(30,000,000) + (0.54)(20,000,000) 3,800,000 + 10,800,000 4,600,000 PlarP) = 089. 30,000,099, aa Plb/P) = 0.17 22,0000 P(g/P) = 0.89 0,000,009 P(b/P) = 011 7,500,009 report Plo/P| = 089 "S000 Plb/P) = 0.17 15.000 000 P(g/N) = 0.46. 30,000,000 im i P(b/N) = 0.5: 20,000,000 P(Q/N) = 0.46 Sooo. Maintain status quo Plb/N) = 0.58 7.500000 PIGIN) = 0.46, — PlbIN) = 0.54 15,000.00 308 °50,000,000) + (0.54)(-7.500, 00 - 4,050,000 Fae) (15,000,000) + (0.54)(15. t+ 8,100 ) (15,000,000) ‘odes D, E, and F for node B and also the largest wot identity the largest valve inn value among nodes G, H, ani ode G to node 8 I for C, The value in node E will be caried to @ 30,000,000 node B an PigiP) = 088 78,900,000 Pibje) =017 a tppand }=0. zo000.000 Plas?) = 088 9.000000 136750, [| Maintain status QUO prb(e)= 017 7.500.000 positive - 130000 — Plait) = 982 pioiP)=O1" 1.000000 pigin = 048 3.000000 negative PIbini =O" 79,900.00 Report 0.900000 pibin) =054 7.00000 15000000 pigin) = 048 500000 15.0000” (pin) =|port. 4. compute *ne probability for positive report and negative re step 6 zp(p/g) Pig) + p(P/b) P(e) PIP) (0.801(0.75) * (0.30)(0.25) 2 0,60 + 0.075 . 2 oegs = probability of positiv P(N) = PIN/O) P(g) + PIN/D) P(b) (0.20)(0.75) + (0.70) (0.25) 0.15 +0.175 0325 3 probability of ne: e report gative report P(g/P) = 0.89 30,000,000 P(b/P) = 0.17 expand, Hl lines P(g/P] = 088 0,000,000 P(b/P} = 0.11 snow Positive Pig/P} = 0.89. 15,000,000 P(b/P} = 0.11 eon P(g/N) = 0.48 30,000,000 Negativa\ 0: Report ae P(b/N) = 0.5 saootts P(g/N) = 24,600,005 (G/N) = 0.46 50,000,000 P(b/N) = 0.54 7,500,000 P(g/N) = 0.46 15,000,000 P(b/N) = 054 seni 310for node A compute fc 0 generat gf 1 given additional information, Ine expected vove Of decision strategy «= (0.675)(43.675,000) + (0.325) 24,4 eh = 480,625 + 7,995,000 (440000 537,475,625 e that the amount 37,475,625 is the ve given that a report forecastin es mic analyst. @ ae expected valve of the investor's decision 1g future economic condition is generated by the somnn.o00 Plb/P| = 0.17 70,000,000 Pig/P| = 089 0,000,000 ‘Maintain status quo P(b/P) =0.17 7,500,000 15,000,000 postive sell P(giP) = 088 1.675, Report / 0: PlbiP) =0.17 1.000.000 8 30,000,000 PigiN) = 0.46 20,000,000 0,000,000 -7,500,000 15,000,000 PigIN) = 0.48 | 15000008 roi) = 054 gone j } 3summary of Steps in Posterior Probabilities Yrs s Obtain conditional sample outcome probabilities. Obtain the sample outcome. Calculate the posterior probabilities of the events. The numerator iS-the py, Prior probability times the likelihood; the denominator is the predicti f ive i Use the posterior probabilities calculated in step 3 to determine the boven’ leCision, 312eee . wre Date: ————__ Score Exercise 10,1 er in Bulacan is consideri i farmer In sidering either leasi ings cettificates eal i sai nd vil llow ‘ne fone bark weber canes aes net yer be a mer to have orc Jood next year, the ions are bad, the J xcellent harvest. How apa return regain neo money. The savings ConncHes ll eo ‘n : ler Conditions. The return { i ven each type of weather condition is shown in the following payot ible — Weather Decision Good Bad Lease Land 450,000_| -200,000 [Buy Savings Certificates [50000 | 50.000 select the best decision using the following decision criteria. a. Maximax b. Maximin 3137 Date: — —____5 Name:_____ Core: Exercise 10.1 2. A bellboy at the Alpha Hotel in Manila, has been offered a management Although accepting the offer would assure him a job if there were rec, economic condition prevailed ne would actually make less money as q sy than 95 a bellboy (because of the large fips he gets as a bellboy). His solar the next five years for each job given each future economic condition i following payoff table Posit ESSION, it goo eNisoy Surin SS Shown in the Economic Conditions Decision Good Recession Bellboy 2,000,000 1,100,000) Supervisor 1,500,000 1,500,000 Select the best decision using the following decision criteria. a. Maximax b. Maximin 314Dat : je; Scove;_ ST yon" Exercise 10.1 of the Beta Constructic jc ot pment, conshuctng on coma must decide among building a ro company. }opping center, or leasing ll the company's halk pany. The profit that will result from each altemative will ‘er material costs remain stable or increase. The profit from en the two possibilities for material Costs is shown in the following It ne owner 3 pousin de equi ment b determine by wl ach ‘alternative giv’ povott table. ‘Material Costs Decision stable Increase Houses, 3,500,000, ‘Shopping Center 5,250,000, Leasing | 2,000,000, feria. Determine the best decision using the following decision crite a. Maximax b. Maximin a, cc. Minimax Regret 315<= +4 Deter —__ Scor o Te Exercise 10.1 4. An investor is considering investi Ing in stocks, or conditions. The payoff table bonds under un Of returns for the in below. Certain ¢, vestor's decision : On Situation jg cic hom Economic Conditions Decision Good Stable Poor Stocks __|' 250,000 [350,000 150,000 Bonds _{ 200,000 |” 200,000 | 200,000 Real Estate | -100,000 | 500.000 300,000 Determine the best investment using the following decision criteria, a. Maximax ©. Maximin ¢. Minimax Regret 316 /Date;__ Score: a ne " Exercise 10.1 9 three alternative investments: 0 ‘ater will be relatively stable under cted by the availability 1ows the profit je investor in Cebu is considerin nt, or a motel, Profits from the the fits from the restaurant or motel wil be affe ists. The following the payoff table sh ol rea! estat } A rer a restaurar tne? conditions: Pro! an “s0line and the number of touris 6 08s tat could result from each investment. Shortage 300,000 [”300,000_| 100,000. | -400,000 | g decision ceric. termine the best investment using the following peter Maximox Maximin Minimax Regret 317 ¥___ Score: __ pate: —— Name. 7 7 - exercise 10.2 an make a profit of 3,000 with probability 0.75 ine her expectation. or lady C' Determit s venture a I ability 0.25- _ Inagiven busines: toke a loss of PI with probs ona certain stock is % ang make a profit of P5,000 Determine the expectation estor will of P2,500 is %. bility that an inv he will take a [Oss The proba! he ors the probability that of the investor. fle. The probability that she can win the ity that she can win the second prize of her to pay the ticket? for a certain raf .d the probabil ible prize for ‘A woman purchases ticket first prize of 10,000 is 0.005 an 5,000 is 0.05. What is the reasonal businessman will make a profit of P2,000 on a given item during d the probability that he might loss of P500 is 1/3. ected profit. The probability that a the Christmas holidays is 2/3 an Determine the businessman's exp Th e esc to wea ks pt oS 80, and the probabili i P3,000 is 0.20. Determine the expectation of Mnctroces that he wil toke os 318Date: ___ Score ’ nl Exercise 10.3 jer of fiction Yo one of nes ‘A movie company and a TV network be th os! popula wor if she signs with the etwork she signs with the movie company the arket response 10 the movie. Sofia’s gi. de on exclusive rights will receive a single lump sum, iI eceive depends on the m sne i a mount she wi pools are summarized below (in thousands) Decision with Movie Co! sign in with TV. Network ) = 0.25, Pimediv™) * if the probability estimates for the states of nature ale P(small 0.60, Pliage) = 0.15, fo whom should Sofia sell the fight? What is the ™r Sofia be willing t0 PAY to learn what size of the box office would be before she decides with whom to sign’ a, yd‘Make Component | 11 35 | 55 Buy Component | 17_| 29 46 The states of nature have probabilities P(low) = 0.40, P( medium) = 0.35, and P(high) = 0.25. Draw a decision tree and use it to decide whether Kappa should make or by the component. 7 320gf a Dai _ Score: Exercise 10.3 as developed a table that shows payoffs for fe store. The payo shows payoffs for a future The poy’ ayorts anagel hi ie size of the st fore and the strength of demand (in thousands) am Aapenon th hi 4 20st to set D Kappa is jemand 7 is Store Siz set Up to e | tow _| High | ibe Seva 1,500 _| 2.500 ' manager arge 500_| 4.000 levels of the manager estimates that the probabil re ty of ands 050. probability of low demand is 0.50, and the The manager could request that a local research firm conduct a survey (cost toner) ed ee ae indicate whether demand will be low oF high. In ‘aeabb wi ich firm, the manager has Teamed the following about the rev lity of Surveys conducted by the fire: about the ekobly © P(high) = xe or buy ‘Actual Result Was use the survey: what would the revised ‘ould be used for suey probabilities sh lecide to \d, and wha! ger should d for deman results? Construct a tree dliagram for this problem cc. Would you recommend that the manager use the survey? 321—_____ Date: Exercise 10.3 ‘Actual Forecast |" stable | Changing \ : Stable 0.90 0.30 Changin, 0.10 [0.70 a. Using the criterion of maximizing expected payoff, what st manager select without using the a gency? rategy would the If the manager decides to use the agency, what would be the revised Probabilities for the economy for each forecast po: sibility? Prepare a tree diagram that illustrates the problem, If the agency fee is P150,000, would you recommend using the agency? 322Date: __ —— Exercise 10.3 ;core:_ inc., IS planning to bi i RESO wild a recreati oat ‘gered, dependit recreational res § peind core ional ‘sci os ng on ti ol the eso ond fe to Four plans ore jan 1) fo an Be ke These plans ein number of sporting sive, fl sence reso" (lon 4) ele rag |. Demand for the o Croll (O° 9s is expected fo b esol’ 5 ‘ 10 be low, medium, oF 1051935, cel. The pave fables shown Oe 20, 0.45, sands) , Plan r Demand ‘ow [Medium | High 1 4,000 | 4250 High 213500 | 4750 | 5000 5 T3.000_| 4250 | 7.500 7 3.000 | 3.500 [12.500 J formation. p, Suppose pelt, inc., conducts © market research study cand obtains an anoiyss Srnich will denote by |. The “conditional likelinoods of | are as follows: Piijiow) = 0.10, piijmedium) = 0.50, and pii/nigh) = (0.40, Determine ‘the posterior Bayes a decision. a! a. compute the expected valve of perfect in c. ItDelta Resort, INC. paid 750,000 for the report. did they P°Y tomuch? 323<= ————~ Score: Date: Exercise 10.3 6. A real estate development company, Omega, inc., is Considering the one of three “packages” put together by its director of marketing. Each chase of contains a different combination of land acreage by type of land, zon cck9ge geographic location. The value of the investment will depend on which ond population growth patterns occurs in the next few years. The Payoff table is OF four below (in millions): 5 Given Demand Plan low [Medium | High 4,000,000 | 4,250,000 | 4,500,000 3,500,000 | 4,750,000 5,000,000 3,000,000 [4,250,000 | 7,500,000 2,000,000 [3,500,000 | 12,500,000 Jeo |no | Q. Determine the Bayes decision, given the following Probability density: P(s,) = 0.95 P{S2) = 0.25, P(Ss) = 0.45, and P(S«) = 0.10. b. Compute the expected value of perfect information c. Suppose the marketing director spends P5,000,000 on market study and obtains some information, which we denote by |. The conditional likelihood Probabilities of | are as follows: P(I/S1) = 0.10, P(I/S2) = 0.30, P(I/S3) = 0.35, P(/S4) = 0.25, Determine the posterior Bayes decision. Was the P5,000,000 well spent?