LESSON I: THE DECISION THEORY

Learning Objectives:
At the end of this lesson, students are expected to:
1. Understand the basic concepts of probability;
2. Understand concepts of Mathematical Expectation (ME) or Expected Value (EV);
3. Make decision analysis using conditional profit and expected value;
4. Draw decision trees.

The Decision Theory

Decision - means to make a choice or judgment or come to a conclusion. The decision of

a person makes in early life may affect his entire future. That is why, for a sound decision, a
thorough and careful examination of all available data and pertinent information as well as of
the different alternatives and possible outcomes and their consequences must be made.

Decision Theory - refers to a logical and systematic approach to decision making. It is

concerned with selection of the best course of action from a number of available options or
alternatives.

STEPS IN DECISION MAKING

 Define the problem clearly

 List all the viable alternatives that must be considered in making decision.
 List the future events or possible outcomes that may occur. (These future events or
possible outcomes are beyond the control of the decision makers).
 List the profits or any other measure of benefits resulting from each possible combination of
decision alternative and possible outcome.
 Apply any one of the decision criterion and make the decision.

The Concepts of Probability

Probability - means “ the extent to which something is probable; the likelihood of something
happening or being the case.” - Oxford dictionary
` - in mathematics, it is define as the likelihood of the occurrence of an event.

Examples of event can be:

◎ Tossing a coin with the head up
◎ Drawing a red pen from a pack of different coloured pens
◎ Drawing a card from a deck of 52 cards

Probability is a measure of certainty. Its value ranges from zero to one (1.00). A probability
of zero (0) means the event will never (or impossible) to occur, like for example, a man flying
without the aid of machines, whereas, a probability of one (1.00) means that the event is certain
to occur, like for example, death. Death is a certainty.
In symbol:Ps + Pf = 1 and Ps = 1 - Pf or Pf = 1 - Ps

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 Basic formula of probability:
P(A) = No. Of ways A can occur
Total no. of possible outcomes

where: A = event P(A) = probability of the occurrence of the event

Probability can be expressed as a decimal, as fraction or as percent.

Example:
A. When a coin is tossed the possible outcomes are Head and Tail.
The probability of head each time you toss the coin is 1/2 (0.50) same as the probability of
tail.
B. When a single die is rolled, the sample space is {1,2,3,4,5,6}. So the probability of rolling
a particular number when a die is rolled = 1/6 (0.167).
C. In a deck of card, the probability of drawing particular card for every draw is = 4/52 or
1/13.

Mathematical Expectation(ME) or Expected Value (EV)

Mathematical expectation (ME) or expected value (EV) is the amount one is expected to
receive(gain) or to pay (loss) for the occurrence of an event
ME is dependent on two factors; the probability that an event will occur and the amount
expected to be received.

If X represents the amount to be received and P the probability that an event will occur,
then, ME=PX and if several events are expected to occur, then

ME=P1X1 + P2X2 + ..... PnXn

Sometimes the expected value is negative (-) if instead of receiving an amount for the
occurrence of an event, one may have to pay or lose.
In a fair and equitable game, Me=0

Example:
a. In a game involving the roll of a single die, the following rules were suggested. I pay P2
for each roll of the die. If a 5 comes out, I receive P2.50, Of 6 Comes out, I receive P4, and if a
4 comes out, I receive P1.50. I receive nothing if 1, 2, or 3 comes out.
Solution:

X1 = (2.5 - 2.00) = 0.50 x P1 = 1/6 = 0.083

X2 = (4.00 - 2.00) = 2.00 x P2 = 1/6 = 0.33
X3 = (1.50 - 2.00) = -0.50 x P3 = 1/6 = (-0.83)
X4 = (0-2.00) = -2.00 x P4 = 3/6 or 1/2 = + (-1.00)
ME = ₱ -0.67

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 b. A sidewalk vendor usually earns P500 (net) on a fair day. When it rains hard to lose
P300 for the day. What would be his expectation if the probability of rain is 1/3?
Solution:
X1 = 500 ; X2 = -300 P1 = 2/3 ; P2 = 1/3
ME = (500 x 2/3) + (-300 x 1/3) = ₱ 240

c. If the concert is to be held outdoor, the promoter stands to lose P5,000 if it rains, or gain
P35,000 if it does not rain. If the concert is held in the gymnasium he stands to gain P32,000 if
it rains and lose P4,000 if it will not rain. Which choice has a higher expectation of the
probability of rain is 43%.
Solution:

Outdoor a Gymnasium
X1 = 35,000 P1 = 57% 19,950 X1 = 32,000 P1 = 43% = 13,760
X2 = - 5,000 P2 = 43% + (-2,150) X2 = - 4,000 P2 = 57% +(- 2,280)
ME = ₱17,800 ME = ₱11,480

d. What is a fair price to join a raffle if one can win a refrigerator worth P20,000 with a
probability of 0.002 and a cash of P10,000 with a probability of 0.02?
Solution:

X1 = 20,000 x P1 = 0.002 = 40
X2 = 10,000 x P2 = 0.02 = 200
X3 = 0 x P3 = 0.978 =+ 0
ME = ₱240

e. Art bought a raffle ticket for P200 which has a 60% chance of winning P1million. What is
his expected value?
Solution:

X1 = (1,000,000 - 200) = 999,800 x P1 = 60% = 599,880

X2 = (0 - 200) = -200 x P2 = 40% =+ (-80)
ME = ₱599,800

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EXERCISES

Direction: Solve the following problems by finding the Mathematical Expectation (ME) or
Expected Value (EV).

1) In a given business transaction, Ariel can gain P50,000 with a probability of 0.70 or take a
loss of P12,500 with a probability of 0.30 What is his expectation?

2) The primary contractor of a road project in Pampanga has a deadline to meet. he has to
decide whether to accept or not a bid from a subcontractor. if he accepts the bid and
succeeds in meeting the deadline he stands to gain P3M, but if he fails to meet the
deadline, he stands to lose P2.2M. The probability of success is 49%/ Find his expectation
of he accepts the bid.

3) In a game of cards, your opponent offers to give you P40 if you draw an ace, and P20 if
you draw a king. Any other draw means you pay P10. What is your ME?

4) A man buying a raffle ticket worth P100 can win a first prize of P100,000 or a second prize
of P60,000 or a third prize of 30,000 with probabilities of 0.0001, 0.0002 and 0.0003
respectively. What is his ME?

5) A garment exporter was offered a shipment of imported assorted items for P1 million and
the probabilities are 0.22, 0.47, 0.26 and 0.05 that she will be able to sell it for P1.2M,
P1.5M, P1.0M or 0.9M respectively. If she accepts the offer, what is her expected gross
profit?

6) The two finalists in tennis tournament, has the winner bagging P0.50M and the runner-up
getting P0.20M. What are the two player’s mathematical expectation if:
a. They are evenly matched?;
b. Their probabilities of winning are 3/4 and 1/4

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Decision Tree Analysis

Decision Tree - is a graphical representation of a decision situation. It is a graphic tool that

facilitates the decision process by giving a clear picture of the decision problem, thereby
helping decision makers analyze possible outcomes.

Two nodes of Decision theory:

- representing the decision point or the point where a choice must be made

- representing the chance event or expected value represent alternatives and branches
emanating from circle nodes represent the possible outcomes that are beyond the control
of the decision maker.

Example:
a. Because the lead actor in a new TV program of a local TV network is involved in a drug
related controversy and is generating bad publicity, the management of the local TV Network
has to decide whether to show the new program on TV or not. The cost of producing the
program is P1M. If the the program is shown, the network may earn an income of P3M (for
advertisements) if it is accepted by the viewers regardless of the bad publicity.If it fails to be
accepted by the viewing public it has to be shelved and the network stands to lose 1.3M. The
network estimated that there is a 59-41 chance the program being accepted. Should the
network go ahead and show the new program?

Solution:

A B success
₱ (3M-1M) (59%) ₱ 1,180,000
To show
₱ 237,000
Decision
failure
₱ (-1M-1.3M) (41%) ₱ (-943,000)
Not to ₱( -1,000,000)
show EV =₱ 237,000
(0-1m)

The final alternatives are ₱ 237,000 and ₱( -1,000,000).

Decision:
The local TV network should decide to show the new program since they will still
gain profit.

b. A canteen concessionaire has to decide whether to prepare a bid or not for the canteen
concession of CCAT. The cost of preparing the bid is P200. If the bid is submitted it has a 60-
40 chance that the concession will be awarded to her. If the she gets blue contract she may
earn a monthly income of P52,000 if it succeeds, (That is, if the students patronize the canteen)
or incurs a monthly loss of P13,000 if it fails. The concessionaire estimated the probability of
success to be 75%. Should she prepare the bid or not?

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`
C Success
Solution: awarded (35,550- (52,000-200) (75%)
B 200) (60%) ₱ 38,850
21,210
A ₱ 35,550
To prepare
₱ 21,130 Failure (-3,550)
Decision (-13,000-200) (25%)

Not awarded (0-

200) (40%) EV = 35,550
Not to prepare -80

EV = 21,130

The final alternatives are to prepare the bid with an income of ₱21,130 and not to prepare
with no income at all.

Decision: The canteen concessionaire should prepare to bid.

c. An investor who would like to invest in the Philippine has to decide whether to build a
large plant or a small plant which is expected to have a market life of 10 years to manufacture
their own products. The cost of building the large plant and putting it into operation is P280M,
while that of the small plant is P140M. The investor estimates that the distribution of sales over
the 10 year period is as follows:
Annual Profit
Large Plant Small Plant
High Demand Probability = 0.49 P 100 M P 25 M
Moderate Demand Probability = 0.31 60 M 45 M
Low Demand Probability = 0.20 -(20 M) 55 M

Solution: B
High demand (1B x 49%) P 490M

Moderate demand (600M x 31%) 186M

A
Build large ₱ 356M
Low demand (-200M x 20%) (-40M)
plant
636M-280M = ₱ 356M
Decision C
High demand (250M x 49%) P 122.5M

Build small Moderate demand (450M x 31%) 139.5M

plant ₱ 232M
Low demand (550M x 20%) 110M
372M-140M = ₱ 232M

The final alternatives are ₱ 356M for large plant and ₱ 232M for small plant.
Decision:
The investor should decide to build large plant over small plant since this will be
favorable for the company in terms of profit.

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EXERCISES

Direction: Draw a decision tree analysis for each respective problems below.

1. Maylene, the owner of novelty store is considering moving from downtown to a new
shopping mall. She thinks that if she moves there is a 20% chance her business will
decline by P100,000, a 30% chance it will remain stable and a 50% chance it will increase
by P175,000. On the other hand, the city is planning to build a plaza in front of her store. If
the plan push through, Maylene estimates there is a 70% chance her business will
increase by P200,000, however, if the plaza will not be built, her business will decline by
about P50,000. On the basis of expected profit, what should her decision be?

2. The ARDEL Company owns a lease granting it the right to explore for oil on a certain
location in Palawan. The company owner has to decide whether to sell the lease for
P150M, or drill for oil. The four possible drilling outcomes are listed below together with the
probabilities and monetary expected values.

Possible Outcomes Probabilities Expected Values

Drywell 16% P100M
Gas well only 40% 50M
Gas and oil combination 24% 100M
Oil well 20% 200M

Compute the expected monetary values (EV). Should the company sell or drill?

3. Ariel has to decide whether to resign or not from his present job paying him P30,000
monthly. He also has to decide whether to go abroad or transfer to another company. If he
decides to resign and goes to Taiwan, his probability of success to get a remuneration of
P100,000 is 90%, if he fails he loses P60,000. On the other hand, before he could transfer
to another company he has to resign first and pass the qualifying exam given to applicants.
If he passes the exam he will be taken in immediately with monthly salary of P40,000. He
estimates his probability of passing to be 90%. On the basis of expected value, what
course of action should Ariel take?