MODULE 4: Decision Theories

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Supposing we have various options
with different profitability or
productivity values, how do we go
about deciding which one is the most
appropriate decision?

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 NOTE: Not
because it has
the highest
productivity or
profitability, It
makes the
option the best
among the
choices.

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Business decision making is very
dynamic owing to the situations
and environments present… so
not all decisions may be the
most optimum…. But not to
worry, as long as decisions are
supported by figures….

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 DIFFERENT ENVIRONMENTS IN WHICH DECISIONS
ARE MADE

• To help us understand how to make • UNDER CERTAINTY

the decision, we must first
understand the environments in
which our decisions are made • UNDER UNCERTAINTY

• UNDER RISK

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DECISION
MAKING UNDER
CERTAINTY

•Only one state of nature

exists that there is complete
certainty about the future.

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DECISION MAKING
UNDER UNCERTAINTY
•more than one state of nature exists
but decision maker has no knowledge
about various states, not even
sufficient knowledge to permit the
assignment of probabilities to the
states of nature.

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DECISION
MAKING UNDER •more than one state of nature but has information which will
support the assignment of probability values

RISK
 •List all variable alternatives.

•ALTERNATIVES – these are

decision options that you have
control of.

DECISION MAKING:STEP 1
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DECISION MAKING:
STEP 2
•Identify future events that may occur otherwise
called as STATES OF NATURE.

•States of Nature – events that you don’t have any

control over.

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 •Construct a payoff table
DECISION MAKING:
STEP 3 •PAYOFF TABLE – plotting the decision options vs the states of
nature in the same table.

STATES OF NATURE
1 2 3 4
DECISION A 1A 2A 3A 4A
MAKER’S
B 1B 2B 3B 4B
ALTERNATIVES
C 1C 2C 3C 4C
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 • For Decision Making Under Certainty you are now able
NOTE: to decide since there is only one State of Nature and
you have control over the alternatives.

STATES OF NATURE

DECISION A 1A
MAKER’S
ALTERNATIVES B 1B

C 1C

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DECISION
MAKING STEP 4
•Determine the criteria for the decision:

•FOR UNCERTAINTY:
• MAXIMAX / MINIMIN
• MAXIMIN / MINIMAX
• MINIMAX REGRET

•FOR UNDER RISK:

• HURWICZ OR CRITERION OF REALISM
• *NOTE: For decision making under Risk
– Probabilities may be derived from
historical figures or trending and
applied to the criterion.

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NOTES BEFORE WE
CONTINUE:
• In any business decision, our objective is either to
maximize profit or minimize costs
• MAX – abbreviation for Maximum
• MIN – abbreviation for Minimum
• SO:
•MAXIMAX – Maximum of the Maximum
•MINIMIN – Minimum of the Minimum
•MAXIMIN – Maximum of the Minimum
•MINIMAX – Minimum of the Maximum.

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 •ABC Company is faced with 3 alternatives namely whether:

• to expand in their present location

• To build a factory in another location

• Or to subcontract (subcon) to another company.

•However, they are not sure of how the economy will be due to the pandemic. They predict the economy to be in 4 different states
namely:

• High – if economy should improve a lot

• Moderate – should improve a little

• Low – if economy contracts a little

• Fail – If economy should fail

EXAMPLE

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MAXIMAX •First choose the maximum value for each alternative.

(Maximum of the •Then choose the maximum value from those maximum values
chosen.
Maximum / OPTIMISTIC •As per our example, decision is TO BUILD WITH GAINS OF
CRITERION) $700,000.00
 • First choose the maximum value for every alternative.
• Then choose the Minimum from among the previously
MAXIMIN chosen maximums.

CRITERION •AS PER EXAMPLE:

(maximum •Decision is to BUILD with a loss of -$800,000.00

of the
minimum /
PESSIMISTIC
CRITERION)

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 DLS CSB OPTNMGT: Francisco T. Africa

MINIMAX
REGRET
•REGRET - opportunity cost or the the loss of REGRET TABLE
potential gain from other alternatives when one
alternative is chosen.
• First prepare a regret table by:
1. First computing for the regret value by
choosing the maximum value for every state
of nature and then subtracting the other
values from the same state of nature (from
the maximum value.) So for our example: High
state of nature has 700,000 as maximum.
2. Do the same for the other states of nature.

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MINIMAX
REGRET
•Then from the REGRET TABLE
• choose the MINIMUM
values from each
ALTERNATIVES.
• Choose the MAXIMUM value
from the MINIMUM values
previously chosen.

•SO DECISION IS to Expand with

a value of $350,000.00

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DECISION MAKING
UNDER RISK

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HURWICZ (Criterion of
Realism)

•Just like the weather, most of the time we

are faced with two probable events.
•Only one event is going to occur.
•If one of those events should happen, the
other will definitely not occur.
•So if there is a 10% probability that an event
will occur, there is also a 90% probability that
it would not occur .
•Consequently:
•α is the alpha symbol and is also our symbol
for the COEFFICIENT OF OPTIMISM.
•1-α would thereforE be the COEFFICIENT OF
PESSISM.

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 •From the same example:
• Choose the Maximum and the Minimum from each alternatives(see highlighted
items)
•Note: If problem involves costs, maximum amount should be the smallest value.
• The maximum amounts will be the optimistic values while the minimum amounts will
be the pessimistic values.
• Then multiply the optimistic values by the α and the pessimistic values by (1-α).
•Note: for our purpose, α will be given since computing for it requires another science or
subject .
HURWICZ
CRITERION

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 •Then get the sum of the optimistic and pessimistic
values.
HURWICZ CRITERION •And finally get the maximum value from the sums.
SO DECISION IS: To Build with a value of 250,000.00

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 END OF MODULE 4:

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