According to the Dictionary of Cybernetics,

decision theory is a body of knowledge and

related analytical techniques of different
degrees of formality designed to help the
decision-making choose from a set of
alternatives in light of their possible
consequences.
1. The first action that a decision-maker must do is
to list all the feasible alternatives that must be
considered in the decision.
2. The decision-maker should enumerate all future
events affecting the demand that may occur.
3. The decision-maker should construct the payoff
table containing the relationship between pairs
of decision elements.
• 1. Decision-making under conditions of uncertainty. In
this criterion, more than one state of nature exists but the
decision-maker has no knowledge of the various states
nor sufficient data to permit the assignment of
probabilities to the state of nature.
• 2. Decision-making under conditions of risk. In this
situation, more than one state of nature exists, but the
decision-maker has information which will support the
assignment of probability to each of the possible states.
• 3. Marginal analysis with discrete distribution.
This condition is used if there are many
alternatives and state of nature.
• 4. Marginal analysis with normal distribution.
This condition is used when there are infinitely
many alternatives and state of nature.
 1. Maximax criterion. This criterion for
decision-making is optimistic.
 2. Maximin criterion. This criterion gives
a pessimistic or conservative outlook.
 3. Minimax regret criterion. This is the
basis for choosing an alternative for
decision-makers who want to minimize
opportunity of losses.
 4. Criterion of realism. This criterion for
decision-making is a middle ground between
maximax and maximin; that is, between optimism
and pessimism.

Measure of realism = α (maximum payoff) + (1- α)

(minimum payoff)

 5. Laplace (equally likely). This criterion

presumes all alternatives have an equal chance of
occuring.
Jack, the market analyst of Nestlé is asked to present an
expansion plan for the company to the senior managers
(John, Bodgick, Meden, Gallo and Garry). The plan is either
to construct a plant, open a distribution center, or do nothing.
He was able to determine the expected payoff depending on
the decision and the type of market which may be favorable,
average, or unfavorable to the business. From the plant
construction, the company will gain ₱80,000 if the market
turns out to be favorable, lose ₱10,000 if the market turns
out to be average, and lose ₱50,000 if the market turns out to
be unfavorable.
From opening a distribution center, the company will gain
₱40,000 if the market turns out to be favorable, gain of
₱20,000 if market turns out to be average, and loss of
₱30,000 if market turns out to be unfavorable. If the decision
is to do nothing, the company will gain nothing regardless of
the market turnout. The market analyst has noted that the
decision of each manager is affected by his/her personality.
He described each manager as follows:

1. John is an optimistic manager.

2. Bodgick is a pessimistic or conservative manager.
3. Meden thinks that there is a 70% chance that market is
available.
4. Gallo thinks that each type of market has an equal chance
of occurring.
5. Garry does not want to regret making a wrong decision.
 A. Solve the problem step by step.
Expansion plan Type of Market
payoff
Favorable Average Unfavorable
(in thousand pesos)
Construct a plant 80 -10 -50
Open a distribution 40 20 -30
center
Do nothing 0 0 0
Criterion of realism 70%
B. The next is to solve the problem according to the
personality attribute observed.

Consider the first manager, John, who is an optimistic

person.

For the Maximum payoff per row:

max(80 -10 -50) = 80
max(40 20 -30) = 40
max(0 0 0) = 0

For the maximum payoff of the maximum column:

max(80 40 0) = 80
 Maximax Criterion Table

Manager John Decision Criterion Maximax

Expansion plan Type of Market

payoff Maximum
(in thousand pesos) Favorable Average Unfavorable

Construct a plant 80 -10 -50 80

Open a distribution 40 20 -30 40
center
Do nothing 0 0 0 0
Maximum 80
Decision Construct a plant
Decision:
John will decide to construct a plant for he is expecting a
payoff of ₱80,000.

Next, consider the second manager, Bodgick, who is

conservative or pessimistic.

For the Minimum payoff per row:

min(80 -10 -50) = -50

min(40 20 -30) = -30
min(0 0 0) = 0
For the maximum payoff of the minimum column:
max(-50 -30 0) = -50
 Maximin Criterion Table

Manager Bodgick Decision Criterion Maximin

Expansion plan Type of Market
payoff Maximum
Favorable Average Unfavorable
(in thousand pesos)
Construct a plant 80 -10 -50 -50

Open a distribution 40 20 -30 -30

center
Do nothing 0 0 0 0
Maximum 0
Decision Do nothing
Decision:
Manager Bodgick will do nothing and expect no payoff.

Next is the third manager, Meden. She is neither optimistic nor

pessimistic and is just a realistic person. Meden uses the criterion
of realism. Here, she has set a 70% chance that the market is
favorable. (α= 0.7)

1. Determine the expected payoff per row corresponding to

each alternative, where:
Pf represents payoff if the market is favorable (optimistic)
Pᵤ represents payoff if the market is unfavorable
(pessimistic)
α represents the probability that the market is favorable
1 – α represents the probability that the market is unfavorable
Criterion of realism = α(Pᵳ) + (1 – α)(Pᵤ)

CR = 0.7(80) + (1 – 0.7)(-50) = 56 – 15 = 41
CR = 0.7(40) + (1 – 0.7)(-30) = 28 – 9 = 19
CR = 0.7(0) + (1 – 0.7)(0) = 0 – 0 =0

2. Find the maximum criterion of realism:

max(41, 19, 0) = 41
 Criterion of Realism Table

Manager Meden Decision Criterion Realism

Expansion plan Type of Market
payoff Favorable Average Unfavorable Maximum
(in thousand pesos)

Construct a plant 80 -10 -50 41

Open a distribution 40 20 -30 19

center
Do nothing 0 0 0 0

Maximum 41
Decision Construct a plant
Decision:
Manager Meden, using the criterion of realism, will decide
to construct a plant with an expected payoff ₱41,000.

Proceed to the fourth Manager, Gallo, who thinks that all

outcomes have an equal chance of occurring. He belongs
to Laplace criterion. In order to arrive at this decision,
compute for the average payoff per row corresponding to
each alternative. That is:
[80+ −10 + −50 ]
= 6.67
3
[40+20+ 30 ]
= 10
3
[0+0+0]
=0
3
Next, find the maximum of the average column.
max(6.67, 10, 0) = 10
 Laplace Criterion Table

Manager Gallo Decision Criterion Laplace

Expansion plan Type of Market
payoff Favorable Average Unfavorable Maximum
(in thousand pesos)
Construct a plant 80 -10 -50 6.67
Open a distribution 40 20 -30 10.00
center
Do nothing 0 0 0 .00
Maximum 10.00
Decision Open a distribution center
Decision:
Manager Gallo will decide to open a distribution center nad
expect a payoff of ₱10,000.

1. The fifth manager, Garry, wants to choose an alternative

that will minimize losses. He will set up the minimax
criterion by doing the following:

Mf represents payoff if market is favorable

Mₐ represents payoff if market is average
Mᵤ represents payoff if market is unfavorable

Mf = max(80, 40, 0) = 80
Mₐ = max(-10, 20, 0) = 20
Mᵤ = max(-50, -30, 0) =0
2. Find the losses where:
Of represents loss if the market is favorable
Oₐ represents loss if the market is average
Oᵤ represents loss if the market is unfavorable

Of = Mf - payoff
80 – 80 = 0
80 – 40 =40
80 – 0 = 0

Oₐ = Mₐ - payoff
20 – (-10) = 30
20 – 2 = 0
20 – 0 = 20
Oᵤ = Mᵤ - Payoff
0 – (-50) = 50
0 – (-30) = 30
0–0 =0
3. Determine the maximum opportunity loss per row
corresponding to each alternative.
max(0 30 50) = 50
max(40 0 30) = 40
max(80 20 0) = 80
4. Identify the minimum opportunity loss of the maximum
column.
min(50 40 80) = 40
 Minimax Criterion Table

Manager Gallo Decision Criterion Laplace

Expansion plan Type of Market
payoff Favorable Average Unfavorable
(in thousand pesos)
Construct a plant 80 -10 -50
Open a distribution 40 20 -30 Maximum
center
Do nothing 0 0 0
Maximum 80 20 0
Opportunity loss
Construct a plant 0 30 50 50
Open a distribution 40 0 30 40
center
Do nothing 80 20 0 80
Minimum 40
Decision Open a distribution center
Decision:
Manager Garry will decide to open a distribution center and
expects an opportunity loss of ₱40,000.
When making a decision under conditions of risk, data
that enable one to provide probabilities for the various
states of nature are necessary.

Under this section, the following conditions should be met:

1. The payoff for each alternative is known.

2. There are few states of nature.
3. The probabilities of each state of nature are known.
4. The cost of perfect information is known.
The possible approaches that can be used to solve
these problems are the following:
The expected monetary value (EMV)
approach, otherwise known as Baye’s criterion
and
The minimizing expected opportunity losses
(EOL) approach.
The former is classified as either EMV without
perfect information or EMV with perfect
information.
Consider the problem in the first example. The market
analyst of Nestlé was able to determine further the
probability of occurrence of each type of market. The
probability of occurrence is 60% that the market is
favorable, 25% that the market is average, and 40% that the
market is favorable. He also found out that he can buy the
information on what will really happen to the market from
JBC Market Association for ₱2,000.
What should be the market analyst’s decision?
How much gain or loss will he expect for the company?
Should he buy the perfect information? Why or why not?
What will he do to minimize opportunity cost?
 The data are summarized in the table below:

Expansion plan Type of Market

payoff
Favorable Average Unfavorable
(in thousand pesos)
Construct a plant 80 -10 -50
Open a distribution 40 20 -30
center
Do nothing 0 0 0
Probability 60% = 0.60 25% = 0.25 40% = 0.40
Step 1. a. Find the expected monetary value (EVM) of
each alternative for each state of nature.

Use formula EVMᵢⱼ = Ʃ Mᵢⱼ Pᵢ

where:
Mᵢⱼ represents the payoff in the alternative iᵗʰ
row and jᵗʰ column
Pⱼ represents the probability in jᵗʰ column
EVMᵢⱼ represents the expected monetary
value in the iᵗʰ row and jᵗʰ column
EMV₁₁ = 80(0.60) + (-10)(0.25) + (-50)(0.40) = 25.5
EMV₁₂ = 40(0.60) + 20(0.25) + (-30)(0.40) = 17.0
EMV₁₃ = 0(0.60) + 0(0.25) + 0(0.40) = 0.0

b. Find the maximum EVM from the above value:

Maximum EVM = max(25.5, 17.0, 0) = 25.5

Decision:
Construct a plant with an expected gain ₱25,500.00.
What if he considers the perfect information offered by
JBC Market Association to remove his uncertainty?
Will the company still gain profit if he buys the
information?

The following solution will help him decide and answer his
question.

Step 1. a. Find the maximum payoff per column

corresponding to the type of market, denoted by Mⱼ of jᵗʰ
column.

M₁ = max(80 40 0) = 80
M₂ = max(-10 20 0) = 20
M₃ = max(-50 -30 0) = 0
b. Find the value with the perfect information
(Vw PIⱼ).
Vw PIⱼ = Mⱼ Pⱼ
where:
Mⱼ represents the type of market of jᵗʰ
column
Pⱼ represents the probability of jᵗʰ column

Vw PI₁ = 80(0.60)= 48
Vw PI₂ = 20(0.25)= 5
Vw PI₃ = 0(0.40)= 0

c. Find the expected value with the perfect

Information (EVw PI) Using the formula:

EVw PI= Ʃ Vw PIⱼ

Thus, EVw PI = 48 + 18 + 0 = 53.

This means that the expected value is ₱53,000 if

the perfect information is purchased.

d. Find the expected value with the perfect

information (EVPI) using the formula:

VPI = EVw PI – EMV

= 53,000 – 25,500
= ₱27,500 is the value of the perfect
information
 e. Find the net gain with the perfect information
(NGw PI) after deducting the cost of information
(CPI)

NGw PI = EVPI – CPI

= 27,500 – 2,000
= ₱25,500

Step 2. a. Find the maximum payoff per column

corresponding to each type of market Mⱼ of jᵗʰ
column.

M₁ = max(80 40 0) = 80
M₂ = max(-10 20 0) = 20
M₃ = max(-50 -30 0) = 0
 b. Find the opportunity loss (Oᵢⱼ) of iᵗʰ row and jᵗʰ
column from payoff (Pᵢⱼ) of iᵗʰ row and jᵗʰ column.
Oᵢ₁ = M₁ - Pᵢ₁
= 80 – 80 = 0
= 80 – 40 = 40
Oᵢ₃ = M₃ - Pᵢ₃
= 0 – (-50) = 50
= 0 – (30) = 30
=0–0 =0
= 80 – 0 = 80
Oᵢ₂ = M₂ - Pᵢ₂
= 20 – (-10) = 30
= 20 – 20 = 0
= 20 – 0 = 20
 c. Find the expected opportunity loss per row (EOLᵢ)
using the formula:
EOLᵢ = Ʃ Oᵢⱼ Pⱼ
EOL₁ = 0(0.60) + 30(0.25) + 50(0.40) = 27.5
EOL₂ = 40(0.60) + 0(0.25) + 30(0.40) = 36.0
EOL₃ = 80(0.60) + 20(0.25) + 0(0.40) = 53

d. Find the minimum EOL.

Minimum EOL = (27.5 36 53) = 27.5
This means that the amount of ₱27,500 is the
minimum expected opportunity loss.

Thus, the market analyst’s decision will be to

construct a plant.

To summarize the solution of the two approaches,

the figures are presented in the following tables for
comparative analysis.
 Table of Expected Monetary Value (EMV)
Expansion plan Type of Market
payoff Favorable Average Unfavorabl EVM
(in thousand pesos) e
Construct a plant 80 -10 -50
Open a distribution 40 20 -30
center
Do nothing 0 0 0
Maximum 80 20 0 25.5
Decision Construct a plant Total
Probability 60% = 0.60 25% = 0.25 40% = 0.40 1.00
EVw PI 53.00
EVPI 27.50
CPI 2.00
NGw PI 25.50
Buy perfect Yes
information?
 Table of Expected Opportunity Loss (EOL)

Expansion plan Type of Market

payoff EVM
Favorable Average Unfavorable
(in thousand pesos)
Construct a plant 80 -10 -50
Open a distribution 40 20 -30
center
Do nothing 0 0 0
Maximum 80 20 0 25.5
Probability 60% = 0.60 25% = 0.25 40% = 0.40 1.00
 Expansion plan Type of Market
payoff EVM
Favorable Average Unfavorable
(in thousand pesos)
Construct a plant 0 30 50 27.50
Open a distribution 40 0 30 36.00
center
Do nothing 80 20 0 53.00
Minimum 27.50
Decision Construct a plant
 Marginal analysis with discrete distribution is used when
more than a few, but not too many states of nature are
involved, because handling such kind of problem contains
a tremendous calculation.
If the additional unit is sold, an increase of conditional
profit, also called marginal profit (MP).
The amount of reduction is referred to as marginal loss
(ML).

To determine the stocking point of units, the following

equation is used:
p(MP) = (1- p) (ML) (Eq.1)

The probability for which the maximizing equation is true

is expressed as:
ML
p(S*) = (Eq.2)
MP+ML
 Table of Probability Distribution
Cost per unit (in pesos) 6.00
Selling price (SP) per copy, (in pesos) 15.00
Marginal Loss 6.00
Sold copies per month (in thousands) Probability
11 5% = 0.05
12 6% = 0.06
13 7% = 0.07
14 7% = 0.07
15 10% = 0.10
16 15% = 0.15
17 20% = 0.20
18 15% = 0.15
19 10% = 0.10
20 5% = 0.05
a. Find the marginal profit (MP) and marginal loss
(ML) based on the selling price (SP). The marginal
profit per unit is selling price (SP) per unit less
cost.

MP = SP/unit – cost/unit ML = SP – MP
= 15 – 6 = 15 – 9
=9 = 6
b. Find the probability of optimal stocking.

ML
p(s*) =
MP+ML
6
p(s*) =
9+6
= 0.40

c. Find the cumulative probability.

Let 1.00 be 100% sold units. Saying a 5% probability of
selling 11,000 copies implies that 95% will not be sold. A 6%
probability of selling 12,000 copies implies that 89% will not be
sold, etc. Using cumulative probabilities based on the table
results in:
1.00 – 0.00 = 1.00
1.00 – 0.05 = 0.95
0.95 – 0.06 = 0.8
 0.89 – 0.07 = 0.82
0.82 – 0.07 = 0.75
0.75 – 0.10 = 0.65
0.65 – 0.15 = 0.50
0.50 – 0.20 = 0.30
0.30 – 0.15 = 0.15
0.15 – 0.10 = 0.05

d. Find the minimum probability that the unit sold is greater

than equal to an optimal stock. Thus, if p(≥S) is the
minimum optimal stock, the p(≥S) ≥ p(S*). Since p(S*) =
0.40, then p(≥S) must be 0.50 which is equivalent to 20%
probability that 17,000 copies will be sold.

Thus, the number of copies that should be printed every

month is 17,000 copies.
a. The criterion of rationality. This decision-making
situation is applicable whenever there is no sufficient
past data available. This assumption was introduced by
Jacob Bernolli (1654-1706). Also known as the
principle of insufficient reason, it states that in the
absence of any strong information to the contrary, it
might as well be assumed that “all states of nature are
equally likely.”
b. The maximum likelihood criterion. To apply this
criterion, one just selects the state of nature that has the
highest probability of occurrence. It is assumed that
this states of nature will occur. The alternative decision
is the one that will yield the highest payoff .
 Table for Maximum Likelihood Criterion

Sold copies per month Probability Payoff (in thousands)

(in thousands)
11 5% = 0.05 0.55
12 6% = 0.06 0.72
13 7% = 0.07 0.91
14 7% = 0.07 0.98
15 10% = 0.10 1.5
16 15% = 0.15 2.4
17 20% = 0.20 3.4
18 15% = 0.15 2.7
19 10% = 0.10 1.9
20 5% = 0.05 1.0
The highest probability of occurrence is 20% with
a maximum payoff of ₱3,400.

Decision:
The number of copies to be printed for
circulation is 17,000
 This model is used when there are
infinitely many alternatives and states of
nature. To use this decision- making method,
the following conditions must first be
satisfied: the selling price and marginal loss
per unit are known; the mean value and the
standard deviation are identified; and the
probability distribution is normal.
 The store manager of 3N Siopao Center is
asked to determine the number of siopao to be
steamed per day to maximize the profit. The past
records of average sales per day were retrieved and
the standard deviation was computed. A dozen of
siopao cost ₱36.00 and can be sold at ₱96.00.
Pieces of siopao not sold within the day are
donated to the Gift of Love Center to feed the
homeless. The average sale per day is 200 dozens
and the standard deviation is 15. How many
dozens of siopao should be steamed per day?
The data are summarized below:

Marginal cost per dozen ₱36.00

Selling price per dozen ₱96.00
Average sale (dozen) per day (μ) 200.00 dozens
Standard deviation of sales (𝜋) 15.00

a. Fine the MP and ML based on the selling price and cost.

MP = SP/doz. – cost/doz.
= 96 – 36
= 60
ML = SP – ML
= 96 – 36
= 36
b. Find the optimal stock P(S*).

ML
P(S*) =
MP+ML
36
=
60+36
= 0.38

c. Find the area under normal curve.

Area = 1 – p(S*)
= 1 – 0.38
= 0.62
d. Find the Z value using the table on areas under
normal curve in the Appendix.

MP ≥ ML at Z is 0.62 = 0.31

e. Find the optimal stock S* based on average sales (μ =

200) and standard deviation (σ = 20).

S* = μ + Zσ
= 200 + 0.3I(20)
S* = 206

This means that the company should stream 206 dozens

of siopao per day to maximize the profit.
The shift manager of 3N Siopao Center is asked to
determine the number of toasted siopao to be made
per day to maximize the profit. The past records of
average sales per day were found and the standard
deviation was computed. A dozen of siopao costs
₱60.00 per dozen and can be sold at ₱96.00. Pieces
of siopao not sold within the day are donated to the
Gift of Love Center to feed the homeless. The
average sale per day is 200 dozens and the
standard deviation is 15. how many dozen of
roasted siopao should be made per day?
The data are summarized below.

Data of Toasted Siopao Sales

Marginal cost per dozen ₱60.00

Selling price per dozen ₱96.00
Average sale(dozen) per day (μ) 200.00
dozens
Standard deviation of sales (𝜋) 15.00
a. Find the MP and ML based on the selling price and
cost.
MP = SP/doz. – cost/doz.
= 96 – 60
= 36
ML = SP – ML
= 96 – 36
= 60
b. Find the optimal stock P(S*)
ML
P(S*) =
MP+ML
60
=
36+60
= 0.63
c. Find the area under normal curve.

Area = 1 – p(S*)
= 1 – 0.63
= 0.37

d. Find the Z value using the table on areas under

normal curve in the Appendix.

MP ≤ ML at Z is 0.37 = -0.33
e. Find the optimal stock S* based on average
sales (μ = 200) and standard deviation (σ = 20).

S* = μ + Zσ = 200 + (-0.33)(20)
= 200 – 7 = 193

The shift manager should order the making of 193

dozens of roasted siopao per day to maximize the
profit.
Solve the following problems using decision-making
techniques.

1. The market analysis of B-MEG Feeds is asked to present

an expansion plan of the company to the senior managers.
The options are to construct a large plant, build a small
plant, or do nothing. The expected payoff is determined
depending on the decision the market which may
favorable, average, or unfavorable to the business. If the
decision is to construct a large plant, the company will
gain ₱20,000 if the market turns out favorable, gain
₱12,000 if the market turns out to be average, and lose
₱18,000 if the market turns out to be unfavorable. In
constructing a small plant, the company will gain ₱15,000
if the market is favorable, and ₱12,000 if the market is
average, and lose ₱10,000 if the market is unfavorable. If
the decision is to do nothing, the company will gain
nothing regardless of the market turnout.
The market analyst noted that the decision of each
manager is affected by his/her personality. Each
manager is describe as follows:

a. Sean is optimistic
b. Sally is very pessimistic
c. Winnie thinks that there is a 60% chance the
market is favorable.
d. Arnel thinks that each type of market has an
equal chance of occurring.
e. Minnie does not want to regret making a wrong
decision.
 Table of Payoff Summary

Expansion plan payoff Type of Market

(in thousand pesos) Favorable Average Unfavorable
Construct a plant 20 12 -18
Open a distribution 40 20 -30
center
Do nothing 0 0 0
Criterion of realism α 60% = 0.60

2. The sales manager of Bicol Mail Magazine was asked

to determine the number of copies to be printed every
month to maximize profit. The probabilities of the
number of copies that would be sold per month are
identified and listed below. Each copy costs ₱45,000 to
print and can be sold at ₱85,000. Copies not sold within
the month are brought to recyclng section.
 How many copies should be printed in month?
Probability Distribution Table

Cost per copy in ₱ 45

Selling price per copy ₱ 85
Number of copies sold per month (in thousands) Probability
22 1% = 0.01
24 5% = 0.05
26 7% = 0.07
28 8% = 0.08
30 20% = 0.20
32 20% = 0.20
34 15% = 0.15
36 10% = 0.10
38 9% = 0.9
40 5% = 0.05
3. Ana is a chef of Bigg’s. she wants to determine the
number of pastries to be cooked per day to maximize
profit. The average sales per day is 180 pieces, with a
standard deviation of 27 pieces. The cost of a piece of
pastry cooked per day is ₱13.00. it is sold at ₱20.00.
Pastries not sold within the day are donated to a
feeding facility. How many pieces of pastries should
be cook per day?

4. The Yakult Hut Company sells natural Yakult in

Partido College. Margie, is filling out the order for
the next week’s supply of Yakult. She is uncertain
what the sales will be. Margie obtained the table
below as a historical representation of profits given
certain sales and buying level combinations.
 Stock
Stock Action
Sales
Weekly sales in $ Buy 200 Buy 300 Buy 400
200 50 25 0
300 50 75 50
400 50 75 100

5. The New Era Toy Co. manufacturers children’s

wooden toy. The company believes that the current
trend towards towards sturdier and simpler toys
will continue. Thus, New Era must decide on what
action to take from among the three alternative
methods of providing for the anticipated higher
demand for each product. The options include
completely overhauling the existing plant and
installing computerized woodworking machinery, expanding
the current plant and adding more machinery, or buying a
competitor’s available plant. A fourth alternative is to limit
production to the current plant (do nothing).

New Era’s payoff is as follows:

State of
Alternatives
Nature
Do
Demand ($) Overhaul Expand Buy
nothing
High 30,000 60,000 50,000 3,000
Moderate 10,000 20,000 15,000 2,000
Low -5,000 -10,000 -20,000 -1,000
Failure -50,000 -70,000 -60,000 -5,000
 The decision process is simply the selection of a
single choice among all available alternatives. One of the
most helpful ways in making a decision is by using
decision trees, derived from the idea of a probability tree.
Decision trees are usually drawn with the standard
symbols. The square node symbolizes a decision point
or a place where a choice must be made. Each branch is
followed by a circular node representing the chance
event or expected value. It is a point where the possible
outcomes are beyond the control of the decision-maker.
Probabilities are involved in a chance of events.
Mario is a forth-year commerce student. A certain
company offers him a job for urgent hiring. He has
to decide whether to stop his studies and work for a
job that will pay him ₱15,000 monthly or continue
his studies, after which a job which pays ₱25,000
per month awaits him, provided he passes his
remaining subjects. He feels that the probability
that he can pass his remaining subjects is 40%.
Which choice is better for Mario? Should he
continue or stop studying?
Step 1. Construct a tree to view the total process.

The tree starts with a square. At this point, Mario

can choose whether to continue or to stop his
studies. If he stops, it is the end of the branch. If
he continues studying, there are two outcomes, he
may pass or fail. This outcome is beyond the
control of Mario; a circle is drawn.
 Pass
Continue
A B Fail
Stop

Step 2. Put the financial values and probabilities.

Pass
25,000
P=0.40
Continue
A B Fail
0
Stop
15,000 P=0.60
If Mario stops, he will have ₱15,000 monthly. This
amount is indicated at the end of the arrow or
branch. If he continues and passes his subjects, he
will have ₱25,000 at the end of the branch of the
circle. If he fails, he will not have any income,
thus, zero is placed at the end of the other branch
of the circle. Probabilities are indicated at each
branch.

Step 3. Compute for the expected value of

position B. The process is called rollback or fall
back.
EV = 0.40(25,000) + 0.60(0)
= 10,000
This value is place on the circle node which corresponds to
a state of nature . To complete the data in the tree, add the
amount of EV
Pass
25,000
P=0.40
Continue
A 10,000
Fail
0
Stop P=0.60
15,000

The final alternative are ₱10,000 and ₱15,000.

Continue
A 10,000
Stop
15,000
Step 4. Decision-making: It is best for Mario to
stop and work. His earnings will be more
advantageous if he takes this course of action.

A construction manager has to decide whether to

prepare a bid or not. It costs ₱10,000 to prepare a
bid. If the bid is submitted, the probability of
contract awarding is 50%. If the company is
awarded the contract, it may earn an income of
₱200,000 if its succeed or pay a fine of ₱18,000 if
it fails. The probability of success is 80%. Should
the engineer prepare the bid?
Solution The immediate problem is whether to prepare
a bid or not.

Prepare
A
Not prepare

The Starting position is a square because the manager has

to choose between preparing a bid or not. If his decision is
to prepare the bid, the contract maybe awarded or not. The
tree diagram is shown below. Contract
awarded

A Prepare
B Contract not
awarded
Not prepare
Position B is a circle since the outcomes are beyond his control.
If the contract is not awarded, it is the end of the branch. If it is
awarded, the company may succeed or fail. Again, the tree
diagram becomes as follows:

Contract
Success 200,000
A Prepare
B awarded
p= 0.50 C p= 0.80 -10,000
Not prepare Contract not Failure -18,000
0
awarded -10,000 p= 0.20 -10,000
p= 0.50

At the end of the success branch, ₱200,000 can be gained.

However, the cost in preparing the bid amounts to ₱10,000. It
should thus be subtracted from the gain. Since a fine of ₱18,000
is imposed in case of failure and there is also a cost in bid
preparation, -18,000 and -10,000 are indicated at the end of
failure branch. The amount of -10,000 should also be indicated at
The lower branch of position B, because even if the
contract is not awarded, there is a cost of ₱10,000 for bid
preparation. This time, EV can be computed using the
backward method. In the tree diagram, there are states of
nature at positions B and C.
Contract
Success
A Prepare
68,200
awarded
p= 0.50
146,400
p= 0.80
190,000

Not prepare Contract not Failure

0 -28,000
awarded
-10,000 p= 0.20
p= 0.50

Position C:
EV=0.80(190,000)+0.20(-28,000)=52,000–5,600= 146,000

Position B:
EV=0.50(146,000)+0.50(-10,000)=73,000–5,000 = 68,200
The final alternatives for the manager are 68,200 and 0.

Prepare
A 68,200
Not prepare
0

The manager should decide to prepare the bid.

The production analyst of Unilever is faced with
deciding whether to purchase a patent to develop a new
product or not. If the company purchases the patent, it
should develop the product. The selling price of the
patent is ₱75,000. There are two ways of developing the
product: the electronic system and the manual system. It
costs ₱60,000 to use the electronic system, and ₱40,000
to use the manual system. The probability of success in
the electronic system is 65% and that in the manual
system is 75%. If the product is successfully developed,
it will give an income of ₱800,000. Should the company
purchase the patent? If so, what system of development
is the best to use?