Decision Theory

Mathematical Expectation Mathematical Expectation (ME) or Expected Value (EV) is the amount one is expected to receive or gain to pay (Loss) for the occurance of event.

ME=

px p x
i 1

1 1

p2 x2 ... pn xn

Example IN a game involving rolling a single die, The following rules were suggested. I pay P 2 for each roll of die. IF a 5 comes out I receive P2.50, if a six comes out, I receive P 4.0, if 4 comes out I receive P 1.50 . I receive nothing if 1,2 and 3 comes out.

Example A side walk vendor usually earns P500 (net )on a fair day. When it rains he stands to lose P300 for he day. What is the mathematical expectation if the probability of the rain is 1/3?

If the concert is to be held outdoors, the promoter stands to lose P 5000 if it rains or gains P35000 if it does not rain. If the concert is to be held inside a gymnasium he gains P32000 if it rains and lose P 4000 if it does not rain. Which choice has a higher mathematical expectation.

Decision Tree Analysis Decision tree is a graphical representation of decision situation. It is agraphic tool that facilitates the decision process by giving a clear picture of he decision problem, thereby helping the decision makers analyze the possible outcomes.

A decision tree has two nodes, a square node representing a decision point or a point where a choice has to be made.A circle node representing the chance event or an expected value. The branches of the tree emanating froma square represents alternatives and branches emanating from circle nodes represent the possible outcomes that are beyond the control of the decision maker.

Example A canteen concessionaire has to decide whether to prepare a bid or not for the canteen concession whether to prepare a bid or not for the canteen concession of a university. The cost of preparing a bid P 200. IF the bid is submitted it has a 60-40 chance that the concession will be awarded to her. If she gets the contract she may earn a monthlyincome of P52000 if it succeeds (that is if the students patronize the canteen) or incurs a monthly loss of P 13000 if it fails. The concessionaire estimated the probability of successs to be 75%. Should she bid or not?

An investor who would like to invest in the Philippines has to decide whetehr to build a large plant or a small plant which is expected to hasve a market lije of 10 years to manufacture their own porducts. The cost of building a large plant and putting it putting into operation is P 280 M while a small plant is P 140. The investor estimates the distribution of sales over the 10 year period is as follows.

High demand Moderate demand Low demand

Probability=0.49 Probability=0.31 Probability=0.20

The investor made surveys and investigations abd come up with the following: A large plant with high demand would yield an annual profit of P100 M while that witha moderate demand would yield P 60 M. A large plant whith a low demand would lose P 20M annually due to production inefficiencies. A small plant with a high demand would yield only P 25 M annual profit due to loss sales because of insufficient supply, while a moderate demand would yield an annula profit of P 45 M. A small plant with a low demand would yield P 55 M annually since the plant size match the market size. Armed with these information, should the investor build a large plant or a small plant if he is to base his decision on expected profit.