MANAGEMENT SCIENCE
Manuel S. Enverga University Foundation
College of Business and Accountancy
Lucena City
DECISION THEORY
Prepared by:
RALYN E BERMUDEZ
MANAGEMENT SCIENCE
All about making decisions
.
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Definition
Decision-making
💁 to make a choice, judgment
or preferred course of action
among the given
alternatives
💁 a choice that you make
about something after
thinking about it
💁 the ability to make choices
quickly and confidently
💁 the particular end of a legal
or official argument
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Steps in decision-making
1. Define the problem clearly
2. Consider all the viable alternatives that must be considered in
decision-making
3. Evaluate the alternatives (Think of the future events or possible
outcomes that may occur. Remember that future events or
possible outcomes are beyond the control of the decision
maker)
4. Select the best alternative
5. Implement the chosen alternative
6. Monitor the implementation to ensure it is in accordance with
the organization’s objectives
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Decision Environments
1. Decision-making under condition of certainty
😉 The decision maker knows which state of nature will occur.
At this situation, he will decide definitely on the best
possible solution favorable to him because he knows
exactly what will happen.
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…
2. Decision – Making Under the Condition of Uncertainty
• When the decision maker has no information or estimates
of the probability of events, he will decide using any
different strategies under this condition
• The choice of strategy in decision-making reveals his
attitude based on his experience and the influence or
persuasion of the people in his environment
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DM under Condition of
Uncertainty
a. Maximax Strategy
§ Optimistic approach
§ The decision maker has to choose the alternative with the
maximum among the maximum payoffs
b. Maximin Strategy
§ Pessimistic approach
§ The decision maker has to choose the alternative with the
maximum among the minimum payoffs
§ In case the problem is minimization of cost, to apply this
strategy, one has to the select among the maximum payoff
for each alternative then finally, then choose the minimum.
Thus, this is called Minimax.
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DM under Condition of
Uncertainty
c. Laplace Strategy
• select the alternative with the maximum average payoff.
• Simply determine the average payoff for each alternative
and then choose the alternative with the maximum average
payoff
• For cost problem, simply do the same then finally, choose
the alternative with the minimum average payoff.
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DM under Condition of
Uncertainty
d. Hurwicz Criterion of Realism
• This strategy is a middle ground criterion between the
maximax and maximin
• The decision maker can assign a value for coefficient or
index of optimism symbolized by the Greek letter 𝛼 with the
value between 0 and 1. If a person assigns 𝛼 as 1, this
means that he is optimistic about nature.
Measure of Realism:
𝑀𝑅 = 𝛼 𝑏𝑒𝑠𝑡 𝑝𝑎𝑦𝑜𝑓𝑓 + (1 − 𝛼)(𝑤𝑜𝑟𝑠𝑡 𝑝𝑎𝑦𝑜𝑓𝑓)
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DM under Condition of
Uncertainty
e. Minimax Regret Strategy
• Concerning opportunity loss
• Choose the alternative that would minimize the maximum
regret.
• To apply this strategy:
1. Determine the regret payoff for each alternative under
each state of nature
2. Determine the maximum regret of loss payoff for each
alternative
3. Select the minimum among the maximum regrets.
Profit: Regret Value = Highest column entry – every column entry
Cost : Regret Value = Every column entry – lowest column entry
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Example:
ABC Company is planning to manufacture its own new PC-based
system, which intends to be marketed by next year under its own
brand. One particular concern of the company has something to do
with the keyboard that will be used in the system, which will be
having a special feature on function keys.
The following are the different decision alternatives identified by the
management:
a. The company can manufacture its own unique keyboard
b. The company can buy the keyboards from a local manufacturer
c. The company can buy keyboards from Japan.
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Cont…
The payoff table is given below. The profit contribution is in
thousand
Alternatives Future Low Sales Moderate Level High
Manufacture -30 20 110
Buy from local 20 60 50
Buy from Japan 10 45 80
The decision-maker has to consider the different costs and benefits
of each of the given alternatives. He has to assess the advantages
and disadvantages of each. Manufacturing would require major
investment in the new production paraphernalia. Buying from local
supplier would be better if demand will not be as high as expected.
However, buying from Japan would be of high quality but the
problem might be in delivery schedule
Decision under Condition MANAGEMENT SCIENCE
of Certainty
Alternatives Future Low Sales Moderate Level High
Manufacture -30 20 110
Buy from local 20 60 50
Buy from Japan 10 45 80
If the management is certain that the economic condition is LOW,
then the best decision is to buy from local manufacturer
If the condition of the economy is MODERATE, the best decision is
to acquire units from local manufacturer
However, if the economic condition is HIGH, it is best to
manufacture own units
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Maximax Strategy
Future Sales Level Maximum
Alternatives Low Moderate High Values
Manufacture -30 20 110 110 maximax
Buy from local 20 60 50 60
Buy from Japan 10 45 80 80
Decision:
Since the maximum among the three maximum values refers to the
alternative of manufacture, therefore the ABC Company should
manufacture its own keyboard
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Maximin Strategy
Future Sales Level Minimum
Alternatives Low Moderate High Values
Manufacture -30 20 110 -30
Buy from local 20 60 50 20 Maximin
Buy from Japan 10 45 80 10
Decision:
Since the maximum among the three minimum payoffs refers to the
decision on buying from local suppliers, therefore the ABC
Company buy the keyboards from local suppliers
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Laplace Strategy
Future Sales Level Row
Alternatives Low Moderate High Average
Manufacture -30 20 110 33.33
Buy from local 20 60 50 43.33
Buy from Japan 10 45 80 45
!"#$%#$&&#
Manufacture: = 33.33
"
%#$'#$(#
Buy from Local: = 43.33
"
&#$)($*#
Buy from Japan: "
= 45
Decision:
The maximum average refers to the third alternative, which is to buy
units from Japan.
MANAGEMENT SCIENCE
Hurwicz Strategy
Future Sales Level
Alternatives Low Moderate High
Manufacture -30 20 110
Buy from local 20 60 50
Buy from Japan 10 45 80
Let 𝛼 = 60% as coefficient of realism
Manufacture : (0.60)(110) + (0.40)(-30) = 54 ✅
Buy from local : (0.60) (60) + (0.40)( 20) = 44
Buy form Japan : (0.60) (80) + (0.40)( 10) = 52
Decision: The best alternative is to manufacture
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Minimax Regret Strategy
• Compute the opportunity loss of each alternative under each
economic condition
Future Sales Level
Alternatives Low Moderate High
Manufacture -30 20 110
Buy from local 20 60 50
Buy from Japan 10 45 80
REGRET TABLE
Alternatives Future Sales Level Maximum
Low Moderate High Regret
Manufacture 50 40 0 50
Buy from local 0 0 60 60
Buy from Japan 10 15 30 30
MANAGEMENT SCIENCE
Exercise
Mary is the Market Analyst of Nestle and she is asked to present an expansion plan for the
company to the senior managers, which is either to construct a plant, open a distribution
center, or do nothing. She was able to determine the expected payoff depending on the
decision and type of market, which may be favorable, average, or unfavorable to the
business. If the decision is to construct a plant, the company will gain P80,000 if the market
turns out to be favorable, lose P10,000 if the market turns out to be average, and lose
P50,000 if the market turns out to be unfavorable. If the decision is to open a distribution
center, the company will gain P40,000 if the market turns out to be favorable, gain P20,000 if
the market turns out to be average, and lose P30,000 if the market turns out to be
unfavorable. If the decision is to do nothing, the company will gain nothing whether the
market turns out to be favorable, average, or unfavorable.
Mary noted that the decision of each manager is affected by his or her personality. She
described each manager as follows:
1. Edward is an optimistic person
2. Agnes is very conservative
3. William thinks there is a 75% chance that the market is favorable.
4. Jane thinks that each type of market has an equal chance of occurring.
5. Joel does not want to regret making a wrong decision.
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Answer
Manager’s Decision:
1. Edward is an optimistic person
Maximax Strategy: 8, Construct a plant
2. Agnes is very conservative
Maximin strategy: 0, Do nothing
3. William thinks there is a 75% chance that the market is favorable.
Hurwicz Criterion: Maximum 4.75: Construct a plant
4. Jane thinks that each type of market has an equal chance of occurring.
Laplace Criterion: Maximum 1: Open a distribution Center
5. Joel does not want to regret making a wrong decision.
Minimax regret: Minimum 4: Open a distribution Center
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3. Decision–making under condition of Risk
• Decision making is risky if one state of nature can happen
out of few possible states
• Conditions:
§ The payoff for each alternative is known
§ There are few states of nature
§ Probability of occurrence of each state of nature is
known
§ The cost of perfect information is known
