Lesson I

Decision Theory
Decision theory is an interdisciplinary approach to determine how decisions are made
given unknown variables and an uncertain decision environment framework. Decision
theory brings together psychology, statistics, philosophy and mathematics to analyze
the decision-making process. Decision theory is closely related to game theory and is
studied within the context of understanding the activities and decisions underpinning
activities such as auctions, evolution and marketing.

Terminology
● Payoff - Benefit received.
● Alternative - One of the two or more ways of achieving the same desired end or
goal.
● Outcome - Occurrence happening at a determinable time and place, with or
without the participation of human agents. It may be a part of a chain of
occurrences as an effect of a preceding occurrence and as the cause of a
succeeding occurrence.
● Decision Table - Decision analysis tool that summarizes pros and cons of a
decision in a tabular form.

Decisions Making Environments: Certainty, Uncertainty and Risk

1. Certainty:
In this type of decision making environment, there is only one type of event that can
take place. It is very difficult to find complete certainty in most of the business decisions.
However, in many routine type of decisions, almost complete certainty can be noticed.
These decisions, generally, are of very little significance to the success of business.

2. Uncertainty:
In the environment of uncertainty, more than one type of event can take place and the
decision maker is completely in dark regarding the event that is likely to take place. The
decision maker is not in a position, even to assign the probabilities of happening of the
events.

Such situations generally arise in cases where happening of the event is determined by
external factors. For example, demand for the product, moves of competitors, etc. are
the factors that involve uncertainty.

Sample Problem
Decision Table
Outcomes (in millions)

Alternatives Fast Slow Stagnant

Big Building (BB) 100 60 20

Small Building (SB) 70 45 20

Do Nothing (DN) 0 0 0

Methods under Uncertainty Environment

1. Maximax
In decision theory, the optimistic (aggressive) decision making rule under conditions of
uncertainty. It states that the decision maker should select the course of action whose
best (maximum) gain is better than the best gain of all other courses of action possible
in given circumstances.

Step 1: Pick the best payoff in each alternative.

Maximax BB: 100
Maximax SB: 70
Maximax DN: 0

Step 2: Decide base on the highest Maximax.

Maximax Decision: Build a Big Building.

2. Maximin
In decision theory, the pessimistic (conservative) decision making rule under conditions
of uncertainty. It states that the decision maker should select the course of action whose
worst (maximum) loss is better than the least (minimum) loss of all other courses of
action possible in given circumstances.

Maximin Decision: Build a Big Building.

3. Criterion of Realism (Hurwicz)

The Criterion of Realism decision rule is an attempt to make a tradeoff between
complete risk indifference (as in the Maximax rule), and total risk aversion (as in the
Maximin rule). With this procedure, the decision maker will decide how much emphasis
to put on each extreme.
To do this, he must choose a Coefficient of Realism, called alpha (α), which is a decimal
number between 0 and 1. This number provides the emphasis on the optimistic view.
The number (1-α), then, is the amount of emphasis that is placed on the most
pessimistic outcome.

4. Equally Likely (Laplace)

Concept in decision theory which assigns equal prior probabilities to all possible events
where nothing is known about the likelihood of their occurrence.

5. Minimax
The minimization of regret that is highest when one decision has been made instead of
another. In a situation in which a decision has been made that causes the expected
payoff of an event to be less than expected, this criterion encourages the avoidance of
regret.

3. Risk:
Under the condition of risk, there are more than one possible events that can take
place. However, the decision maker has adequate information to assign probability to
the happening or non- happening of each possible event. Such information is generally
based on the past experience.

Virtually, every decision in a modern business enterprise is based on interplay of a

number of factors. New tools of analysis of such decision making situations are being
developed. These tools include risk analysis, decision trees and preference theory.

Modern information systems help in using these techniques for decision making under
conditions of uncertainty and risk.

Methods under Risk Environment:

1. Expected Monetary Value
Total of the weighted outcomes (payoffs) associated with a decision, the weights
reflecting the probabilities of the alternative events that produce the possible
payoff. It is expressed mathematically as the product of an event's probability of
occurrence and the gain or loss that will result.

Formula
Expected Monetary Value (EMV) = Sum of payoff multiplied by its probability

Sample Problem
For example, if I'll bet Php 60.00 that you’ll roll a dice and you’ll come up on the number
4, and if not you will pay me Php 5.00, would you gamble?

Step 1: Create a Decision Table.

Decision Table
Outcomes

Alternatives Win Loss

Gamble 60 -5

Not to Gamble 0 0

Probabilities 1/6 5/6

Step 2: Compute the EMV for each alternative.

EMV for Gamble = (60 * 17%) + (-5 * 83%) = 10.2 + (-4.15) = 6.05
EMV for Not to Gamble = 0

Step 3: Decide by choosing the highest EMV.

Decision: Gamble

2. Expected Opportunity Loss

Expected opportunity loss (EOL) is a statistical calculation used primarily in the
business field to help determine optimal courses of action. Doing business is full
of decision making. Any decision consists of a choice between two or more
events. For each event, there are two or more possible courses of action that you
might take. Calculating the EOL is an organized way of using a mathematical
model to compare these choices and outcomes, to make the most profitable
decision.

Step 1. Convert Decision table into a Regret table. Find the highest payoff in each
outcome. Then deduct the payoff in each alternative.
 Decision Table
Outcomes (in millions)

Alternatives Fast Slow Stagnant

Big Building (BB) 100 - 100 = 0 60 - 60 = 0 20 - 20 = 0

Small Building (SB) 100 - 70 = 30 60 - 45 = 15 20 - 20 = 0

Do Nothing (DN) 100 - 0 = 100 60 - 0 = 60 20 - 0 = 20

Probabilities 35% 35% 30%

Regret Table
Outcomes (in millions)

Alternatives Fast Slow Stagnant

Big Building (BB) 0 0 0

Small Building (SB) 30 15 0

Do Nothing (DN) 100 60 20

Probabilities 35% 35% 30%

Step 2: Compute the EOL for each alternative.

EOL BB = 0 * 0.35 + 0 * 0.35 + 0 * 0.30 = 0
EOL SB = 30 * 0.35 + 15 * 0.35 + 0 * 0.30 = 15.75
EOL DN = 100 * 0.35 + 60 * 0.35 + 20 * 0.30 = 62

Step 3: Decide by choosing the lowest EOL.

Decision : Build a Big Building.

Simulation
Acting out or mimicking an actual or probable real life condition, event, or situation to
find a cause of a past occurrence (such as an accident), or to forecast future effects
(outcomes) of assumed circumstances or factors. A simulation may be performed
through (1) solving a set of equations (a mathematical model), constructing a physical
(scale) model, (3) staged rehearsal, (4) game (such as wargames), or a computer
graphics model (such as an animated flowchart). Whereas simulations are very useful
tools that allow experimentation without exposure to risk, they are gross simplifications
of the reality because they include only a few of the real-world factors, and are only as
good as their underlying assumptions.
Example: Basic Monte Carlo Simulation for Beginning Econometrics, Stata Monte Carlo
Simulation for Heteroskedasticity and Ricardian Explorer

Lesson II

Gantt Chart
Many people have never heard of a Gantt. Simply put, a Gantt chart is a visual view of
tasks scheduled over time. Gantt charts are used for planning projects of all sizes and
they are a useful way of showing what work is scheduled to be done on a specific day.
They also help you view the start and end dates of a project in one simple view
Network Model
The Network model is a database model that shows the relationships among the
objects. The schema of network model is viewed as a graph with nodes and connecting
links. In the network model, the objects are seen as nodes and the relationships
between the objects are depicted as the arcs. This network model does not have the
hierarchy or lattice; instead, it is replaced with a graph which shows the basic
connections between the nodes.

Advantages of a network model

• This model is known for its simplicity in designing.
• The network model can manage one-to-one relationship and many-to-many
relationship.
• Data accessing is easy compared to a hierarchical model.
• As the network model is shown in graphs with the relationships among the nodes,
there is always a link that exists between the parent node and the child node so that the
data integrity exists.

Disadvantages of a network model

• Records in this database model are maintained with pointers, which makes the
database more complex in structure.
• More pointers make the system complex, that is, usage of pointers for each operations
like insertion, update, delete.
• Small modifications in the structures lead to change in the whole application; this
makes it structure dependent.

1. Program Evaluation and Review Technique (PERT)

The Program Evaluation and Review Technique (PERT) is a widely used method
for planning and coordinating large-scale projects. As Harold Kerzner explained
in his book Project Management, "PERT is basically a management planning and
control tool. It can be considered as a road map for a particular program or
project in which all of the major elements (events) have been completely
identified, together with their corresponding interrelations'¦. PERT charts are
often constructed from back to front because, for many projects, the end date is
fixed and the contractor has front-end flexibility." A basic element of PERT-style
planning is to identify critical activities on which others depend
The chief feature of PERT analysis is a network diagram that provides a visual
depiction of the major project activities and the sequence in which they must be
completed. Activities are defined as distinct steps toward completion of the
project that consume either time or resources. The network diagram consists of
arrows and nodes and can be organized using one of two different conventions.
The arrows represent activities in the activity-on-arrow convention, while the
nodes represent activities in the activity-on-node convention. For each activity,
managers provide an estimate of the time required to complete it.
Since there is an uncertainty in the duration of an activity, you will use three
estimates to determine the PERT estimate for an activity so that the uncertainty
in the activity completion time can be reduced. These three estimates are as
follows:
● Most Likely Estimate
● Optimistic Estimate
● Pessimistic Estimate
Most Likely Estimate (Tm)
This is the time duration where there is a high probability of completing the task
within the given time duration.
 Optimistic Estimate (To)
In this scenario, the estimate is determined considering all favorable conditions;
i.e. it is a best-case scenario. In other words, you can say that this is the shortest
time in which you may complete the task.
Pessimistic Estimate (Tp)
Here, estimate is determined considering all unfavourable conditions; i.e. worst
case scenario. In other words, this is the longest time the activity might require to
complete.
The formula to calculate the PERT is as follows:
PERT Estimate = (To + 4Tm + Tp) / 6

Activity Predecessor Optimistic Measured Pessimistic Estimated

Time (Days) Time (Days) Time (Days) Time (Days)

a None 5 6 7 6

b None 4 5 18 7

c a 4 15 20 14

d b and c 3 4 5 4

e a 5 16 18 14.5

2. Critical Path Method (CPM)

The critical path method (CPM) is a step-by-step project management technique
for process planning that defines critical and non-critical tasks with the goal of
preventing time-frame problems and process bottlenecks. The CPM is ideally
suited to projects consisting of numerous activities that interact in a complex
manner.

Immediate Normal Normal Crash Crash

Activity Predecessor Time(weeks) Cost Time(weeks) Cost
__
A 10 30 8 70
B A 8 120 6 150
C B 10 100 7 160
D A 7 40 6 50
E D 10 50 8 75
F C, E 3 60 1 95

Name:
Schedule:

Assignment II

Complete the time table. Create a network. Generate the paths. Know the project
completion.

Time Estimates (Week)

Activity Predecessor Optimistic Most Likely Pessimistic

a none 4 5 12
b none 1 1.5 5

c a 2 3 4

d a 3 4 11

e a 2 3 4

f c 1.5 2 2.5

g d 1.5 3 4.5

h b, e 2.5 3.5 7.5

i h 1.5 2 2.5

j f, g, i 1 2 3