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Quantitative
Decision Making
Decision Analysis
This document will tell you the decision analysis. That how and in
which situations we can make decisions and what are the
methods by which we can take decision based on.
Document Outline:
Introduction
Six Steps in Decision Making
Types Of Decision Making Environments
Decision Making Under Uncertainty
Decision Making Under Risk
Sensitivity Analysis
Khawaja Naveed
Haider
University Of Management and Technology, Lahore Pakistan
Sunday, February 07, 2010
QUANTITATIVE DECISION
MAKING
Example Question:
Ali wants to establish the factory in Pakistan. He has two outcomes or states
of nature which are favorable market and unfavorable market. He can either
establish last factory, small factory or he won’t go for the factory that means
do nothing. If he establishes a large factory, he could earn profit of PKR
200,000 or loose PKR 180,000 in unfavorable market. If he establishes the
small factory, he could earn PKR 100,000 in favorable market. He could lose
PKR 20,000 in unfavorable market. Now the purpose of establishing the
factory is to earn maximum profit.
STATES OF NATURE
DO NOTHING 0 0
1. Maximax
2. Maximin
3. Criterion of Realism
4. Equally Likely
5. Minimax Regret
Maximax:
We usually use the optimistic or positive thinking approach here. We will
choose which will give us maximum payoff.
Let’s have a look to the table that we have constructed before discussing the
environments.
States Of Nature
Alternatives Favorable Unfavorable Maximum in a
Market Market Row
Establish Large 200,000 -180,000 200,000
Factory
Establish Small 100,000 -20,000 100,000
Factory
Do Nothing 0 0 0
Maximin:
Maximin is the totally opposite to the Maximax. In this environment, we take
the pessimistic approach. In this scenario, we will take the lowest payoff
which will be like decreasing the risk factor. We will see the value which will
be minimum in a row. Now take the above table.
States Of Nature
Alternatives Favorable Unfavorable Minimum in a
Market Market Row
Establish Large 200,000 -180,000 200,000
Factory
Establish Small 100,000 -20,000 100,000
Factory
Do Nothing 0 0 0
If we look at the above table, we will come to know that we will not establish
the factory or you can say do nothing. The lowest value in a row is 0 that is
kind of minimum risk.
Criterion Of Realism:
In this situation, we are given the percentage of either pessimistic or
optimistic. Like a question may contain that the person is 80% optimistic. So
the probability will be 0.80 and 0.20. 0.80 of optimistic and 0.20 of
pessimistic. We have to complete the 1 or 100% like 0.80+0.20=1
States Of Nature
Alternatives Favorable Unfavorable Criterion Of
Market Market Realism
Establish Large 200,000 -180,000 124,000
Factory
Establish Small 100,000 -20,000 76,000
Factory
Do Nothing 0 0 0
We can also call criterion of realism as Weighted Average. The formula of
calculating weighted average is given below.
= 124,000
In this pattern, we will take the higher realism value among all the
alternatives. In this table we will take 124,000. That means we will establish
the large factory.
States Of Nature
Alternatives Favorable Unfavorable Criterion Of
Market Market Realism
Establish Large 200,000 -180,000 10,000
Factory
Establish Small 100,000 -20,000 40,000
Factory
Do Nothing 0 0 0
In the above table, we will take the average of each alternative like for large
factory, we will add 200,000 and -180,000 and divide it on 2, we will get
10,000. Same is for small factory. After getting all the values, we will see that
the highest average is of establishing a small factory which has the value
rupees 40,000. So our decision will be establishing a small factory.
Minimax Regret:
This criterion is based on opportunity loss. We will discuss and draw the
opportunity loss table. Opportunity loss refers to the difference between the
optimal profit or payoff for a given state of nature and the actual payoff
received for a particular decision. In other words, it is the amount lost by not
picking the best alternative in a given outcome.
States Of Nature
Favorable Unfavorable
Market Market
200,000 -
200,000 0 - (-180,000)
200,000 -
100,000 0 - (-20,000)
200,000 - 0 0-0
States Of Nature
Favorable Unfavorable Maximum in a
Alternatives Market Market Row
Establish Large
Factory 0 180,000 180,000
Establish Small
Factory 100,000 20,000 100,000
Do Nothing 200,000 0 200,000
Now we have completed the entire decision making criterion for decision
making under uncertainty.
Now let’s calculate the EMV of every alternative. The probability is given that
is 0.5
States Of Nature
Alternatives Favorable Unfavorable EMV
Market Market
Establish Large 200,000 -180,000 10,000
Factory
Establish Small 100,000 -20,000 40,000
Factory
Do Nothing 0 0 0
naveedtaji@gmail.com Page Number: 8
Probabilities 0.5 0.5
The largest value of EMV is of small factory. So Ali needs to go and establish
a small factory. The long run average of small factory is high.
Now here comes another question that what the hell Expected Value With
Perfect Information is? So here is the formula for EVwPI.
EVwPI = (best payoff for first state of nature) X (probability of first state of
nature) + (best payoff for second state of nature) X (probability of second
state of nature) ……. (best payoff for i state of nature) X (probability of i state
of nature)
States Of Nature
Alternatives Favorable Unfavorable EMV
Market Market
Establish Large 200,000 -180,000 10,000
Factory
Establish Small 100,000 -20,000 40,000
Factory
Do Nothing 0 0 0
Probabilities 0.5 0.5
Look at the table given above. We have two states of nature. One is favorable
market and the other one is unfavorable market. The best alternative for
favorable market is Establishing a large factory with the payoff of 200,000.
The best alternative for unfavorable market is Do Nothing with the payoff of 0
only. By using this information, we can put the values in our EVwPI formula.
naveedtaji@gmail.com Page Number: 9
EVwPI = (200000)(0.5) + (0)(0.5) = 100,000
We have the EVwPI 100,000 rupees. Now we have also the formula of EVPI
where the value of EVwPI is used.
= 100000 – 40000
= 60,000
Thus, Ali would be willing to pay for perfect information is 60,000 rupees and
the firm is charging 65,000 rupees. So Ali won’t go for the scientific
marketing firm because the value of information is not 65,000.
States Of Nature
Alternatives Favorable Market Unfavorable Market
Establish Large Factory 0 180,000
Establish Small Factory 100,000 20,000
Do Nothing 200,000 0
Probabilities 0.5 0.5
The above table is describing the Opportunity Loss Table. Now we will
calculate the Expected Opportunity Loss for every alternative.
States Of Nature
Alternatives Favorable Unfavorable EOL
Market Market
Establish Large 0 180,000 90,000
Factory
Establish Small 100,000 20,000 60,000
Factory
Do Nothing 200,000 0 100,000
Here we have the results in a tabular form. I have already told you that our
decision will be based on the minimum EOL. So the choice that Ali will select
is to establish a small factory as the Expected Opportunity Loss is less than
the EOL of Large factory and if he don’t construct a factory. One thing to
remember is that minimum EOL will always result in the same decision as
maximum EMV and that the EVPI will always equal to minim EOL. You can
compare the EOL of small factory with the EVPI that we have calculated. The
values of both the things are 60,000 rupees.
= 380000P – 180000
= 120000P – 20000
=0
Now we will define two points. Point 1 will be EMV do nothing = EMV small
factory, Point 2 will be EMV small plant = EMV large plant.
P = 20000/120000 = 0.167
Now the next work is to put all the data in a tabular form.
naveedtaji@gmail.com Page Number: 12
Best Range Of P
Alternative Value
Do Nothing Less than 0.167
Small Factory 0.167 - 0.615
Greater than
Large Factory 0.615
Here we have the tabular form of our analysis. If the value of P is less than
0.167 we will go for the option of Do Nothing.
As you can see in the graph, the best decision is to do nothing as los as P is
between 0 and the probability associated with point 1, where the EMV for
doing nothing is equal to the EMV for the small factory. When P is between
the probabilities for point 1 and 2, the best decision is to establish small
factory. Point 2 where EMV of small factory is equal to EMV of large factory.
When P is greater than probability of point 2, the decision will be establishing
a large factory.