Topic 1: Decision Analysis

1. Six Steps in Decision Theory

a. Clearly define the problem at hand.
b. List the possible alternatives.
c. Identify the possible outcomes
d. List the payoff or profit of each combination of alternatives and outcomes.
e. Select one of the mathematical decision theory models.
f. Apply the model and make your decision
Example: Thompson Lumber Company Case
John Thompson is the founder and president of Thompson Lumber Company, a
profitable firm located in Portland. The problem that John Thompson identifies is
whether to expand his product line by manufacturing and marketing a new product,
backyard sheds.
Define problem
List alternatives

To manufacture or market backyard storage sheds

1. Construct a large new plant
2. Construct a small plant
3. No plant at all (Do nothing)
Identify outcomes The market could be favorable or unfavorable for storage sheds
(State of nature)
List payoffs
List the payoff for each state of nature/decision alternative
combination. (Construct the decision table)
Select a model
Decision tables/trees can be used to solve the problem
Apply model and Solutions can be obtained and a sensitivity analysis used to
make decision
make a decision
Alternative
Construct a large plant
Construct a small plant
Do nothing

State of nature
Favorable market ($)
Unfavorable market($)
200,000
-180,000
100,000
-20,000
0
0

2. Types of Decision-Making Environments

Type
a Decision making Decision maker knows with certainty the consequences of
under certainty
every alternative or decision choice.
b Decision making Decision maker does know the probabilities of the various
under risk
outcomes.
c Decision making Decision maker does not know the probabilities of the
under uncertainty various outcomes.
a. Decision making under Uncertainty
i. Optimistic (Maximax)
ii. Pessimistic (Maximin)
iii. Equally likely (Laplace Criterion)
iv. Criterion of realism (Hurwicz criterion)
v. Minimax (Opportunity loss of regret
i. Optimistic Approach
Maximax- Find the alternative that maximizes the maximum payoff.
Example:
Alternative
State of nature
Maximax
Favorable
Unfavorable
market ($)
market($)
Construct a large plant
200,000
-180,000
Construct a small plant
100,000
-20,000
Do nothing
0
0
Answer: Construct a large plant.
ii. Pessimistic Approach
Maximin- Choose the alternative with maximum minimum payoff.
Example:
Alternative
State of nature
Favorable
Unfavorable
market ($)
market($)
Construct a large plant
200,000
-180,000
Construct a small plant
100,000
-20,000
Do nothing
0
0
Answer: Do nothing.

Maximin

iii. Equally Likely approach

Assume all states of nature to be equally likely.
Finding the average payoff of each alternative and select the alternative with the
highest average payoff.
Example:
Alternative

State of nature
Favorable
Unfavorable
market ($)
market($)
200,000
-180,000

Construct a large
plant
Construct a small
100,000
plant
Do nothing
0
Answer: Construct a small plant.

Average

-20,000
0

iv. Criterion of Realism

Criterion of realism is a compromise between an optimistic and a pessimistic
decision.
To begin, a coefficient of realism, is selected and
.
When is 1, the decision maker is 100% optimistic about the future while
,
the decision maker is 100% pessimistic about the future.
(
Example:
Alternative

State of nature
Favorable Unfavorable
market ($)
market($)
200,000
-180,000

Construct a large
plant
Construct a
100,000
small plant
Do nothing
0
Answer: Construct a large plant

-20,000
0

)(

Weighted Average,

v.

Minimax Regret
Choose the alternative that minimizes the maximum opportunity loss.
Construct an opportunity loss table.
Opportunity loss for any state of nature or any column is calculated by
subtracting each payoff in the column from the best payoff in the same column.

Alternative

Construct a large
plant
Construct a
small plant
Do nothing
Alternative

State of nature
Favorable Unfavorable
market ($)
market($)
200,000
-180,000
100,000

-20,000

State of nature
Favorable Unfavorable
market ($)
market($)

Construct a large
plant
Construct a
small plant
Do nothing
Answer: Construct a small plant

Minimax Regret

b. Decision Making under risk

Expected Monetary value (EMV),

( )

Where
( )
(Alternative with the highest EMV is chosen)
Example:
Alternative
State of nature
Favorable Unfavorable
market ($)
market($)
0.5
0.5
Construct a large
200,000
-180,000
plant
Construct a
100,000
-20,000
small plant
Do nothing
0
0
Answer: Construct a small plant

EMV

Expected value with perfect information (EVwPI)

)(

Expected value of perfect Information (EVPI)

EVPL place an upper bound on what one would pay for additional
information. ( Maximum value that decision maker would be willing to pay
for perfect information)

Note: For minimization cases,

Example:
Alternative

Construct a large
plant
Construct a
small plant
Do nothing
Perfect
information

State of nature
Favorable Unfavorable
market ($)
market($)
0.5
0.5
200,000
-180,000

EMV

10,000

100,000

-20,000

40,000

0
EVwPI=

EVPI=
Conclusion: The most Thompson would be willing to pay for perfect information is
$60,000.
Expected Opportunity Loss (EOL)
An alternative approach to maximizing EMV is to minimize EOL.
EOL is the cost of not picking the best solution.

Where
( )
(Alternative with the lowest EOL is chosen)

( )

Example:
Alternative

State of nature
Favorable Unfavorable
market ($)
market($)
0.5
0.5
0
180,000

Construct a large
plant
Construct a
100,000
small plant
Do nothing
200,000
Answer: Construct a small plant

EOL

20,000
0

Note:
i. EOL will always result in the same decision as the maximum EMV
ii. EVPI will always equal the minimum EOL

Exercise 1:
1. George is considering the purchase of two types of industrial robots. The Rob1
(alternative 1) is a large robot capable of performing a variety of tasks, including
welding and painting. The Rob2 (alternative 2) is a smaller and slower robot, but
it has all the capabilities of Rob1. The robots will be used to perform a variety of
repair operations on large industrial equipment. Of course, George can always do
nothing and not buy any robots (alternative 3). The market for the repair
operation could be either favorable (event 1) or unfavorable (event 2). George
has constructed a payoff matrix showing the expected returns of each alternative
and the probability of a favorable or unfavorable market. The data are presented:
Event 1
Event 2
0.6
0.4
Probabilities
50,000
-40,000
Rob1
30,000
-20,000
Rob2
0
0
Do nothing
a. What type of decision is George facing?
b. What would you recommend to George?
c. Develop an opportunity loss table.
d. What is the minimum EOL?
e. Calculate the expected value of perfect information for this problem?

2. George is not confident about the probability of a favorable or unfavorable

market. The Hurwicz coefficient should be 0.7.He would like to determine:
a. the equally likely (Laplace),
b. Optimistic (maximax),
c. Pessimistic (maximin),
d. criterion of realism (Hurwicz), and
e. minimax regret decisions.