DECISION THEORY

• Steps in Decision Theory Approach:

o List all the viable alternatives.
o Identify the future events (states of nature) that may occur.
o Construct a payoff table, a table which shows the payoffs
which are expressed in profits or any other measure of
benefit appropriate to the situation.

• Environments in which decision-making occurs:

o Under conditions of certainty
o Under conditions of uncertainty
o Under conditions of risk

DECISION MAKING UNDER CONDITIONS OF

UNCERTAINTY

1.) Maximax Criterion—an optimistic criterion which maximizes

the maximum payoff

2.) Maximin Criterion—a pessimistic criterion which maximizes

the minimum payoff

3.) Minimax Regret Criterion—a criterion which selects that

decision alternative which minimizes the maximum regret

4.) Criterion of Realism—a middle ground criterion between

maximax and maximin which requires the decision maker to
specify a coefficient, or index of optimism denoted by α.
Sample Problem: Read and analyze the problem below and
answer the questions that follow.

Given below is a payoff table showing four states of nature of

demand: high, moderate, low or failure; three decision alternatives:
expand, build or contract. Should you be the manager facing this
problem, which alternative is best to choose using:
a.) maximax criterion
b.) maximin criterion
c.) minimax regret criterion
d.) criterion of realism if α = 0.3
e.) criterion of realism if α = 0.7

Alternative Expand the Build a Subcontract

s Plant new plant

States of Nature
High Demand P500,000 P700,000 P300,000
Moderate Demand P250,000 P300,000 P150,000
Low Demand -P250,000 -P400,000 -P10,000
Failure -P450,000 -P800,000 -P100,000
 DECISION MAKING UNDER CONDITIONS OF RISK

1.) Expected Value Criterion (Bayes’ criterion)—a criterion

which requires the decision maker to calculate the expected
value for each alternative and then to choose that decision
which has the highest expected value among all of the
available decision alternatives

2.) Criterion of Rationality (Principle of Insufficient Reason)

—a criterion used when all the states of nature are assumed
equally likely

3.) Maximum likelihood criterion—a criterion which selects

that state of nature which has the highest probability of
occurring and picks the decision alternative which yields the
highest payoff for that state
Sample Problem: Read and analyze the data given below and answer
the questions that follow.
A veterinarian purchases rabies immunization vaccine on Monday of each
week. Because of the characteristics of this vaccine, it must be used by
Friday or disposed of. The vaccine costs P9 per dose, and the vet charges
P16 per dose. In the past, the vet has administered vaccines in the following
quantities:

Quantities used per week Number of weeks occurrence

25 15
40 20
50 10
75 5

a.) Compute the probabilities of occurrence for each demand level.

b.) Setup the conditional profit (or payoff) table.
c.) How many vaccines must be purchased if the expected value
criterion were to be used?
d.) Calculate the expected profit with perfect information, the
expected profit with perfect certainty about the occurrence of the
states of nature.
e.) What is the worth or value of expected information for the
veterinarian?
f.) What do you call the loss the vet incurs when he has more
vaccines than the demand for them? Refer to the conditional
profit table, which profits suffer from such?
g.) What do you call the kind of loss the vet incurs when he has
fewer vaccines than the demand for them? Refer to the
conditional profit table, which profits suffer from such?
h.) Using the criterion of rationality, how many vaccines must the
vet stock?
i.) Using the criterion of maximum likelihood, how many vaccines
must the vet stock?