According to Sharma (2016), “the success or failure that an individual or The decision table also known as payoff table

payoff table as illustrated in table 2 depicts the

organization experiences, depends to a large extent, on the ability to make alternatives and states of nature. While the conditional values are represented by
acceptable decisions on time.” You are what you are today because of the the outcomes.
decisions you made in the past. This is not about blaming anyone but more about
learning from the experience. Table 2. Payoff Table

So what differentiates a good from a bad decision? According to Render, et.

al. (2015), “A good decision is one that is based on logic, considers all available
data and possible alternatives, and applies the quantitative analysis.” Otherwise, it
is a bad decision.

Decision theory is the systematic manner of arriving with decisions. It follows

certain procedures that consider the degree of knowledge and compare it to
expected consequences from varied strategies. It considers both quantitative and
qualitative perspectives as shown in Figure 6.
It doesn’t matter how big or small your decision is. To arrive at a good decision,
you will undergo the same steps as follows:

For this illustrative example of the decision theory steps, we will use the LMS
Figure 6. Decision Analysis Food Café Case.

To have a better understanding of decision theory, let us define the usual Step 1. Ms. Santos is considering the re-designing of the operations of the café.
terms we will encounter in this module:
Step 2. Ms. Santos identified three alternatives namely, (1) open 24-hours (2)
An alternative pertains to a course of action or choice or strategy. open usual 8-hours, or (3) do not open.

The states of nature refer to the circumstances where the decision maker has Ms. Santos has to make sure she identifies all important courses of action. Failure
little or no power to control. to identify some may be crucial. While some strategies may seem of little value, to
your surprise it could be your best choice.
The conditional values pertain to the payoffs (profits or costs) following from each
possible combination of alternatives and states of nature. These are numerical in Step 3. Ms. Santos determines that there are only two possible outcomes: the
nature. market of the café could be favorable, meaning that there is a high demand for
the product, or it could be unfavorable, meaning that there is a low demand of the Type 1: Decision making under certainty
market.
Decision maker has the complete knowledge of the consequences of every
Just like the alternatives, it is important that Ms. Santos consider all possible alternative or decision choice. An example is saving your money in a bank with a
circumstances. One has to learn to carry all the hats. Be optimistic and known interest.
pessimistic as well.
Type 2: Decision making under uncertainty
Step 4. Because Ms. Santos wants to maximize her profits, she can use
the profit to evaluate each outcome. She has already evaluated the potential The decision maker is unable to specify the probability for occurrence of particular
profits associated with the various outcomes. state of nature. An example is probability of a person to become the President of a
country.
With a favorable market, she thinks opening for 24-hours would result in a net
profit of P60,000 a month. This P60,000 is a conditional value. The conditional Type 3: Decision making under risk
value if the market is unfavorable would be a P20,000 net loss. Opening the usual The decision maker does not have perfect knowledge about possible outcome of
8-hours would result in a net profit of P30,000 in a favorable market, but a net loss every decision alternative. This could be due to having more than one states of
of P10,000 would occur if the market was unfavorable. Finally, not opening would nature. In a such a case the decision maker makes an assumption of the
result in P0 profit in either market. probability for occurrence of particular state of nature.
Having all the available information, the best way to show an understanding Decision Making Under Uncertainty
of the problem is to create the payoff table. Table 3 shows the payoff table for
LMS Food Café. There are several models available for making decisions under conditions of
uncertainty as follows:

1. Optimistic (Maximax or Minimin); largest

Table 3. Payoff Table of LMS Food Café
2. Pessimistic (Minimax or Maximin); smallest

3. Criterion of realism (Hurwicz); largest

4. Equally likely (Laplace); and largest

5. Minimax regret (Salvage). smallest

Optimistic (Maximax or Minimin)

The Optimistic criterion ensures that the decision-maker selects the

alternative that represents the largest possible profit (maximax) for maximization
problems or the lowest possible cost (minimin) for minimization problems. The
Steps 5 and 6. The last two steps are to select and apply a decision theory model analytical method is summarized as follows:
to the data to come up with a decision. Choosing the model depends on the
knowledge of the environment and the amount of risk and uncertainty.
(a) Determine the maximum (or minimum) conditional values corresponding to
Types of Decision Making Environments each decision alternative.

As mentioned in the previous lesson, model selection depends on the

environment and the amount of risk and uncertainty involved. According to (b) Choose a decision alternative with best conditional value (maximum for profit
Sharma (2016), there are three types of decision-making environments as follows: and minimum for cost).
 Following the case of LMS Food Cafe that wants to maximize profit, table 4 Criterion of realism (Hurwicz)
shows the payoff table for a positive manager:
The Criterion of realism (Hurwicz) ensures that the decision-maker selects
Table 4. Payoff Table of LMS Food Café - Optimistic the alternative with a combination of optimism and pessimism. A coefficient of
realism, designated by the symbol α , is chosen at the beginning depending on the
decision maker’s state of positivity and negativity. The lowest α that can be
chosen is 0, which is an indication that the decision maker is 100% pessimistic
about the future. While the highest α is 1, indicating that the decision maker is
100% optimistic about the future.

According to Render, et.al., (2015), for a maximization problem, the best

payoff for an alternative is the highest value in the row, and the worst payoff is the
lowest value in the row. This value is computed for each alternative, and the
alternative with the highest weighted average is then chosen. In contrast, for
minimization problems, the best payoff for an alternative would be the lowest
Therefore, the decision will be to operate for 24 hours. payoff and the worst would be the highest payoff. The alternative with the lowest
weighted average is then selected.
Pessimistic (Minimax or Maximin)
The analytical method is summarized as follows:
The Pessimistic criterion ensures that the decision-maker selects the
alternative that represents that he would earn no less (or pay no more) than some (a) Determine the coefficient of optimism (α) and then coefficient of pessimism (1
specified amount. The analytical method is summarized as follows: – α).

(a) Determine the minimum (or maximum in case of profit) conditional value in (b) Calculate the weighted average with the formula:
case of loss (or cost) data corresponding to each decision alternative.
Hurwicz = α (Maximum in column) + (1 – α )
(Minimum in column)
(b) Choose a decision alternative with the best conditional value (maximum for
profit and minimum for loss or cost). (Eq.2)

Following the case of LMS Food Cafe, payoff table 5 will be for a negative (c) Choose an alternative with highest weighted average conditional value.
thinker manager:

Table 5. Payoff Table of LMS Food Café - Pessimistic For the case of LMS Food Cafe, Ms. Santos is a more positive manager. So we
will be using α closer to 1. Using a = 0.7, please find below the computation :

For the 24-hours alternative: (0.7)(60,000) + (1 – 0.7)(–20,000) = 36,000

For the 8- hours alternative: (0.7)(30,000) + (1 – 0.7)(–10,000) = 18,000

Table 6 presents the payoff table for a manager who compromise between
optimism and pessimism.

Table 6. Payoff Table of LMS Food Café – Hurwicz

Therefore, the decision will be to not operate.
 Minimax regret (Salvage)

The salvage criterion is based on opportunity loss (regret). Such loss is

computed by subtracting the actual payoff received from the best payoff.
Basically, this is finding the alternative that minimizes the maximum opportunity
loss (regret).

The analytical method is summarized as follows:

(a) From the given payoff matrix, construct an opportunity-loss table as follows:
(i) Find the best payoff corresponding to each state of nature.
Therefore, the decision will be to operate for 24 hours. (ii) Subtract all other payoff values in that row from this best payoff.

Equally likely (Laplace) (b) For each decision alternative identify the worst (or maximum regret) payoff
value. Record this value in the new row.
The criterion of equally likely considers equal probabilities of occurrence for
the states of nature. This is following the idea that probabilities of states of nature (c) Select a decision alternative resulting in a smallest anticipated opportunity-loss
are unknown. Equal probability value to each state of nature using the formula: value.
1 ÷ (number of states of nature).

The analytical method is summarized as follows:

Let us first recall the pay-off presented in table 3 in the previous pages:
(a) Determine the average payoff for each alternative

For the 24-hours alternative: [(60,000) + (–20,000)]/2 = 20,000

For the 8- hours alternative: [(30,000) + (–10,000)]/2 = 10,000

(b) Choose the alternative with the highest average

Result of this analysis is depicted in Table 7.

Table 7. Payoff Table of LMS Food Café – Laplace

Source: Table 3. Payoff Table of LMS Food Café

The best payoff for is P60,000 and P0 for favorable market and unfavorable
market respectively. Hence, to construct an opportunity-loss table, we will do the
following computations as presented in Table 8.

Table 8. Opportunity Loss Computation Table of LMS Food Café

Therefore, the decision will be to operate for 24 hours.

 The expected monetary value (EMV) for given alternatives is computed by
getting the summation of the payoff values multiplied by the probabilities
associated with each state of nature. For the analytical method to solve for EMV,
we can use the formula below :

EMV (alternative i) = (payoff of first state of nature) x (probability of first

state of nature) + (payoff of second state of nature) x (probability of second state
of nature) + … + (payoff of last state of nature) x (probability of last state of
nature)

(Eq.3)

This can also be written as:

Resulting from Table 8, we can now create our payoff table for the
minimax regret criterion. This is depicted in Table 9.

Table 9. Payoff Table of LMS Food Café – Minimax Regret

(Eq.4)

Following the case of LMS Food Cafe, Ms. Santos can redesign their
operations by opening for 24 hours which will earn P60,000 or may lose P20,000.
If she decides to operate for 8 hours, she will earn P30,000 or may lose P10,000.
There is a 60% chance that the market is favorable. Below shows the computation
After getting the maximum in each row, we will choose the minimum in the for the EMV:
column. Therefore, the decision will be to operate for 24 hours. For the 24-hours alternative: [(60,000*.60) + (–20,000*.40)] = 28,000
Decision Making Under Risk For the 8- hours alternative: [(30,000*.60) + (–10,000*.40)] = 14,000
Under this decision-making environment, the decision maker does not have The result is presented in table 10.
perfect knowledge about possible outcome of every decision alternative. This
could be due to having more than one states of nature. In a such a case the Table 10. Payoff Table of LMS Food Café – EMV
decision maker makes an assumption of the probability for occurrence of
particular state of nature. According to Sharma (2016), "knowing the probability
distribution of outcomes (states of nature), the decision-maker needs to select a
course of action resulting a largest expected (average) payoff value. The expected
payoff is the sum of all possible weighted payoffs resulting from choosing a
decision alternative."

The commonly used criterion for evaluating alternatives under risk is the
Expected Monetary Value (EMV).

xpected Monetary Value (EMV)

 Therefore, the decision will be to operate for 24 hours. It is known as chance branch if it branches away from a states of nature node and
represents a set of chance events.
Decision Trees
(e) Conditional Values or Payoff can be positive or negative. It can be computed
Decision trees can be used to present decision tables graphically. This is following either decision or state of nature branches.
preferred to be used when the decision maker intends to make a sequence of
interrelated decisions. To have a better understanding of decision trees, let us Render, et. al (2015) identified five steps to analyzing problems with decision
provide the following guides on this topic: trees:

(a) A tree starts from left to right that contain decision (act) nodes and state-of-
nature (chance) nodes. Refer to figure 7.

Let’s try creating a decision tree for LMS Food Café.

Analyzing LMS Food Café using a Decision Tree

1. Define the problem.

The problem identified is the same ---- that is the presence of COVID -19.
Figure 7. Decision Tree

Please take note that a certain decision may lead to a state of nature or another
decision. A state of nature may lead to making another decision or another state 2. Structure or draw the decision tree.
of nature.

(b) Squares represent decision nodes from which one of several alternatives may
be chosen

(c) Circles represent states of nature nodes out of which one state of nature will
occur

(d) Lines or branches connect the decisions nodes and the states of nature. It is
called decision branch if it branches away from a decision node and represents an
alternative that can be chosen at a decision point.
 Figure 8. Decision Tree Structure of LMS Food Cafe Figure 10. Decision Tree Payoffs of LMS Food Cafe

3. Assign probabilities to the states of nature 5. Solve the problem by computing expected monetary values (EMVs) for each
state of nature node.
Let us recall our EMV computation where there is a 60% chance that the
market is favorable.

Figure 11. Decision Tree EMVs of LMS Food Cafe

Figure 9. Decision Tree Probabilities of LMS Food Cafe
Comparing the calculated EMVs of P28,000, P14,000 and P0, the decision will be
4. Estimate payoffs for each possible combination of alternatives and states of to open for 24 hours.
nature.