Batangas State University

ARASOF-Nasugbu Campus
The National Engineering University

Module 6:
Decision Analysis

Prepared by: John Rafael R. Pelo, CPA

 Objectives
introduce the concept of decision theory and understand its
relevance to making better decisions

Make decisions using payoff table under situations of certainty,

uncertainty and under risk

Make decisions using decision tree.

Focus
Decision
Theory
• Decision theory is a field of study that focuses on
the process of making decisions, particularly in
situations involving uncertainty and complexity.
Example
• Suppose a distribution company is considering purchasing a
computer to increase the number of orders it can process and
thus increase its business. If economic conditions remain good,
the company will realize a large increase in profit; however, if the
economy takes a downturn, the company will lose money. In this
decision situation, the possible decisions are to purchase the
computer and to not purchase the computer. The states of nature
are good economic conditions and bad economic conditions. The
state of nature that occurs will determine the outcome of the
decision, and it is obvious that the decision maker has no control
over which state will occur.
 Categorization of Decision Situations

1. Decision under uncertainty

• Situations in which probabilities cannot be assigned to
future occurrences.

2. Decision under certainty

• Situations in which probabilities can be assigned.
 Components of Decision Making
1. Decision itself
• the action or process of deciding something

2. States of nature
• actual event that may occur in the future in which the decision
maker is uncertain which states of nature will occur in the future
and has no control over them.

3. Outcome of the decision

• The result of taking a decision
 Understand the problem

Steps for
making Develop a payoff table

decision in
business and Determine decision-
making environment
management
Make a decision
1 Define the problem
• Understand what the problem is all about.
• Defining what are your options
2 Develop a Payoff Table
• It is a table that expresses payoff for each combination of
alternatives and states of nature.

Alternatives States of Nature

actions that a decision outcomes that a decision
maker wants to choose maker has no control over.
(things that we want to do) (things that will happen)

Payoff
other term for “profit”
2 Develop a Payoff Table

2.1 Identify alternatives (things that we want to do)

2.2 Identify states of nature (things that will happen)

Build the table. Put the alternatives in the first

2.3 column and states of nature in the first row.

Identify profits for each combination of alternative

2.4 and states of nature. Write the profits in the table.
 3 Determine a Decision-Making Environment

Under Certainty Under Uncertainty Under Risk

Decision maker does not Decision maker does not

Decision maker knows what
know what will happen and know what will happen but
will happen and will straight
does not know the knows the probability of the
away make a decision
probability of the outcomes. outcomes.

• Maximax • Expected Monetary Value

• Maximin • Expected Opportunity Loss
• Minimax Regret • Expected Value of Perfect
• Equal Likely Approach Information
• Realism Approach
 Sample Problem
Miya wants to invest. Her options are to invest in stocks,
bonds or mutual funds. The economic conditions for
investing can be growing, stable or declining. If Miya
invests in stocks, she will gain 40 if the economy is growing,
45 and 5 if the economy is stable and declining respectively.
In addition, if Miya invests in bonds, she will gain 70 if the
economy is growing, 30 if stable and -13 loss if the economy
is declining. Finally, if Miya invests in mutual funds, she will
gain 53 if the economy is growing, 45 if stable and -5 loss if
the economy is declining.
 Decision under Certainty
• the decision maker selects the decision that will result in
the maximum payoffs for the particular state of nature
that will certain to happen.
Alternatives Growing Stable Declining
Bonds 40 45 5
Stocks 70 30 -13
Mutual Funds 53 45 -5
BONDS/
DECISION STOCKS BONDS
MUTUAL FUND
 Sample Problem
Miya wants to invest. Her options are to invest in stocks,
bonds or mutual funds. The economic conditions for
investing can be growing, stable or declining. If Miya
invests in stocks, she will gain 40 if the economy is growing,
45 and 5 if the economy is stable and declining respectively.
In addition, if Miya invests in bonds, she will gain 70 if the
economy is growing, 30 if stable and -13 loss if the economy
is declining. Finally, if Miya invests in mutual funds, she will
gain 53 if the economy is growing, 45 if stable and -5 loss if
the economy is declining.
 Maximax (Optimistic Approach)
• the decision maker selects the decision that will result in
the maximum of the maximum payoffs. (best of the
best)
• The decision maker assumes that the most favorable state
of nature for each decision alternative will occur.
Alternatives Growing Stable Declining BEST PAYOFF
Bonds 40 45 5 45
Stocks 70 30 -13 70
Mutual Funds 53 45 -5 53

• Decision: Invest in STOCKS

 Maximin (Pessimistic Approach)
• the decision maker selects the decision that will result in
the maximum of the minimum payoffs. (best of the
worst)
• The decision maker assumes that the worst favorable state
of nature for each decision alternative will occur.
Alternatives Growing Stable Declining WORST PAYOFF
Bonds 40 45 5 5
Stocks 70 30 -13 -13
Mutual Funds 53 45 -5 -5

• Decision: Invest in BONDS

 Minimax Regret
• the decision maker selects the decision that will result in
the minimum of all maximum regrets across
alternative.
• Regret- opportunity loss. Difference of the best payoff in
each particular state of nature and actual payoff received.
Alternatives Growing Stable Declining Maximum
Bonds 70-40= 30 45-45= 0 5-5= 0 30
Stocks 70-70= 0 45-30= 15 5- (-13)= 18 18
Mutual Funds 70-53= 17 45-45= 0 5 – (-5)= 10 10

• Decision: Invest in MUTUAL FUNDS

 Minimax Regret
Regret Table
Alternatives Growing Stable Declining MAXIMUM
Bonds 30 0 0 30
Stocks 0 15 18 18
Mutual Funds 17 0 10 17

• Decision: Invest in MUTUAL FUNDS

 Equal Likely or (Laplace) Approach
• weights each state of nature equally, thus assuming that
the states of nature are equally likely to occur.
• Multiplies the decision payoff for each state of nature by an
equal weight.
• Or simply add the payoff in decision alternative and divide
the by the number of states of nature.
Alternatives Growing Stable Declining Average
Bonds 40 45 5 40+45+5 / 3 = 30
Stocks 70 30 -13 70+30+(-13) / 3 = 29
Mutual Funds 53 45 -5 53+45+(-5) / 3 = 31
• Decision: Invest in MUTUAL FUNDS
 a = 0.3
Realism (Hurwicz) Approach1 – a =
• 0.7
Finds a compromise between the best and worst payoffs.
• We choose the alternative with the best weighted average payoff based on the
coefficient of realism a wherein it is the measure of decision maker’s
optimism.
• 0<a <1
• a close to 1 = optimistic
• A close to 0 = pessimistic
• The Hurwicz criterion multiplies the best payoff by a , and add the worst
payoff by 1-a for each decision, and the best result is selected.
Alternatives Growing Stable Declining Sum
Bonds 40 (0.3)*45= 13.5 (0.7) * 5= 3.5 17
Stocks (0.3)*70= 21 30 (0.7)*-13 = -9.1 11.9
Mutual Funds (0.3)*53= 15.9 45 (0.7)*-5= -3.5 12.4
• Decision: Invest in BONDS
 Sample Problem
Miya wants to invest. Her options are to invest in stocks,
bonds or mutual funds. The economic conditions for
investing can be growing, stable or declining. If Miya
invests in stocks, she will gain 40 if the economy is growing,
45 and 5 if the economy is stable and declining respectively.
In addition, if Miya invests in bonds, she will gain 70 if the
economy is growing, 30 if stable and -13 loss if the economy
is declining. Finally, if Miya invests in mutual funds, she will
gain 53 if the economy is growing, 45 if stable and -5 loss if
the economy is declining. The likelihood that the economy will
be good is 20%, stable economy is likely to be 50% and the
probability that the economy will be declining is 30%.
 Expected Monetary Value (EMV)
• Expected value is computed by multiplying each decision
outcome under each state of nature by the probability of its
occurrence and then summing these products.
• We will choose the maximum expected monetary value.

Alternatives Growing Stable Declining BEST PAYOFF

Bonds 40(0.2) 45(0.5) 5(0.3) 32
Stocks 70(0.2) 30(0.5) -13(0.3) 25.1
Mutual Funds 53(0.2) 45(0.5) -5(0.3) 31.6
Probability 20% 50% 30%

• Decision: Invest in BONDS

 Expected Opportunity Loss (EOL)
• Expected loss is computed by multiplying the regret
under each state of nature by the probability of its
occurrence and then summing these products.
• We will choose the minimum expected opportunity loss.
Alternatives Growing Stable Declining
Bonds 40 45 5
Stocks 70 30 -13
Mutual Funds 53 45 -5
Probability 20% 50% 30%

• Decision: Invest in
 Expected Opportunity Loss (EOL)
• Expected loss is computed by multiplying the regret
under each state of nature by the probability of its
occurrence and then summing these products.
• We will choose the minimum expected opportunity loss.
Regret Table
Alternatives Growing Stable Declining MAXIMUM
Bonds 30(0.2) 0(0.5) 0(0.3) 6
Stocks 0(0.2) 15(0.5) 18(0.3) 5.4
Mutual Funds 17(0.2) 0(0.5) 10(0.3) 3.4
Probability 20% 50% 30%
• Decision: Invest in MUTUAL FUNDS
 Expected Value of Perfect Information
•
(EPI)
It refers to the maximum amount you would be willing to pay for additional
information about decision problem. If we have a perfect information about the
states of nature before a decision is made, how much is this information worth?
• EVPI = EVwPI – EVwoPI
• EVwPI= Select the best alternative per each states of nature and multiply for
the probability of outcome.
• EVwoPI = EMV
Alternatives Growing Stable Declining Total EVwPI (with
highlight)= 38
Bonds 40 45(0.5) 5(0.3)
Stocks 70*(0.2) 30 -13 Total EVwoPI= 32
Mutual Funds 53 45 -5
EPI= 36-32= 6
Probability 20% 50% 30%

• Decision: Invest in
4 Make a decision
• Decision can be made
From payoff table
From decision tree
 Decision Tree
• Constructing a decision tree
• Make decision using expected monetary value
 Expected Monetary Value (EMV)
• Expected value is computed by multiplying each decision
outcome under each state of nature by the probability of its
occurrence and then summing these products.
• We will choose the maximum expected monetary value.

Alternatives Growing Stable Declining BEST PAYOFF

Bonds 40 45 5
Stocks 70 30 -13
Mutual Funds 53 45 -5
Probability 20% 50% 30%

• Decision: Invest in
 Decision Tree
Two types of nodes:
• Square Node- decision nodes from which decision
alternative branches will originate.
• Circle Node- chance nodes from which states of
nature or outcome of branches emanate.
 Batangas State University
ARASOF-Nasugbu Campus
The National Engineering University

Thank You
For Your Attention