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DECISION ANALYSIS
Lecture 2
Learning Objectives
Students should be able to:
To outline the key steps of decisionmaking under uncertainty and risk
To identify various decision-making
models and criteria in decision analysis,
To apply these models and criteria to
improve decision-making in organisations
Making Decisions
Decision-making is a critical managerial activity
that occurs virtually everyday.
A managers main role is to make decisions and
take action to direct and guide the operations of an
organisation towards its overall goals.
Decisions can be made under various conditions:
certainty (complete information available), risk and
uncertainty.
We will focus on decision-making under
uncertainty and under risk for this session.
Decision-analysis is a quantitative method that is
used to aid in managerial decision-making in
organisations, especially under conditions of
uncertainty and risk.
List alternatives
1.
2.
3.
Identify outcomes/
business conditions
List payoffs
Select a model
Favorable
Market ($)
Unfavorable
Market ($)
200,000
-180,000
100,000
-20,000
Maximax Approach
Maximax: Optimistic Approach
Find the alternative that maximizes the
maximum payoff for every alternative.
This approach evaluates each decision
alternative in terms of the best payoff that can
occur. The decision maker selects the decision
that has the largest gain.
Locate the maximum payoff for each
alternative, and then select the alternative with
the maximum number (compare rows).
Favorable
Market ($)
Unfavorable
Market ($)
200,000
-180,000
100,000
-20,000
Do nothing
Maximax
Favorable
Market ($)
Unfavorable
Market ($)
Construct a
large plant
200,000
-180,000
200,000
Construct a
small plant
100,000
-20,000
100,000
Do nothing
BEST DECISION
BUILD LARGE
PLANT
Maximin Approach
Maximin: Pessimistic Approach
Find the alternative that maximizes the
minimum payoff for every alternative.
This approach evaluates each decision
alternative in terms of the worst payoffs that can
occur. Then, the decision maker selects the
decision that has the best of the worst payoffs.
Locate the minimum payoffs for each
alternative, and then select the alternative with
the maximum number.
Favorable
Market ($)
Unfavorable
Market ($)
200,000
-180,000
100,000
-20,000
Maximin
Favorable
Market ($)
Unfavorable
Market ($)
Construct a
large plant
200,000
-180,000
-180,000
Construct a
small plant
100,000
-20,000
-20,000
Do nothing
BEST DECISION
DO NOTHING
Favorable
Market ($)
AVERAGE
PAYOFF
Unfavorable
Market ($)
Construct a
large plant
Construct a
small plant
Do nothing
200,000
100,000
10,000
-180,000
-20,000
40,000
0
BEST DECISION
BUILD SMALL PLANT
Minimax Regret
Favorable
Market ($)
Unfavorable
Market ($)
200,000
-180,000
100,000
-20,000
State of Nature
Alternative
Construct a
large plant
Construct a
small plant
Do nothing
Favorable
Market ($)
Unfavorable
Market ($)
200,000
-180,000
100,000
-20,000
State of Nature
Alternative
Construct a
large plant
Construct a
small plant
Favorable
Market ($)
200,000200,000
200,000100,000
Unfavorable
Market ($)
0- (-180,000)
Do nothing
200,000-0
0-0
0-(-20,000)
State of Nature
Alternative
Construct a
large plant
Construct a
small plant
Do nothing
Favorable
Market ($)
Unfavorable
Market ($)
180,000
100,000
20,000
200,000
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State of Nature
Alternative
Construct a
large plant
Construct a
small plant
Do nothing
Favorable
Market ($)
Unfavorable Worst
Market ($) Regret
180,000
180,000
100,000
20,000
100,000
200,000
200,000
State of Nature
Alternative
Construct a
large plant
Construct a
small plant
Do nothing
Favorable
Market ($)
Unfavorable Worst
Market ($) Regret
180,000
180,000
100,000
20,000
100,000
200,000
200,000
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State of Nature
Favorable Unfavorable
Market ($)
Market ($)
200,000
-180,000
100,000
-20,000
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SOO..
Suppose John was able to determine that the
probability of favourable market conditions is .60, and
the probability of unfavourable market conditions is .40
(hint: probabilities for both conditions must sum to 1).
Given the known probabilities, we can turn to EMV
approach as we are operating under risk.
To determine the best alternative, the EMV approach
works out like this: Payoff x probability
EMV (large plant) = ($200,000)(.6) + (-$180,000)(.4) =
EMV (small plant) = ($100,000)(.6) + (-$20,000)(.4) =
EMV (do nothing) = ($0)(.6) + ($0)(.4) =
You must choose the alternative that generates the
highest EMV.
EMV RESULTS
State of Nature
Alternative
Favorable
Market ($)
Unfavorable
Market ($)
Construct a
large plant
200,000
-180,000
Construct a
small plant
100,000
-20,000
Do nothing
0.60
0.40
Probabilities
EMV
200,000*0.6 +
(-180,000)*0.4 =
48,000
100,000*0.6 +
(-20,000)*0.4 =
52,000
0*0.6 + 0*0.4 =
0
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EMV RESULTS
The best decision is to construct a small plant as this generated
the highest EMV of $52,000
State of Nature
Alternative
Construct a
large plant
Construct a
small plant
Do nothing
Probabilities
Favorable
Market ($)
Unfavorable
Market ($)
EMV
200,000
-180,000
48,000
100,000
-20,000
52,000
0.60
0.40
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Alternatives
Construct a
large plant
Construct a
small plant
Do nothing
Probabilities
States of Nature
Favorable Unfavorable
Market ($)
Market ($)
200,000
-180,000
100,000
-20,000
.60
.40
State of Nature
Alternative
Construct a
large plant
Construct a
small plant
Do nothing
Probabilities
Favorable
Market ($)
Unfavorable
Market ($)
200,000
-180,000
100,000
-20,000
.60
.40
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State of Nature
Alternative
Construct a
large plant
Construct a
small plant
Favorable
Market ($)
200,000200,000
200,000100,000
0- (-180,000)
Do nothing
200,000-0
0-0
.60
.40
Probabilities
Unfavorable
Market ($)
0-(-20,000)
State of Nature
Alternative
Construct a
large plant
Construct a
small plant
Do nothing
Probabilities
Favorable
Market ($)
Unfavorable
Market ($)
180,000
100,000
20,000
200,000
.60
.40
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EMV RESULTS
State of Nature
Alternative
Favorable
Market ($)
Unfavorable
Market ($)
Construct a
large plant
180,000
Construct a
small plant
100,000
20,000
Do nothing
200,000
0.60
0.40
Probabilities
EOL
0*0.6 +
180,000*0.4 =
72,000
100,000*0.6 +
20,000*0.4 =
68,000
200,000*0.6 +
0*0.4 = 120,000
EOL
State of Nature
Alternative
Construct a
large plant
Construct a
small plant
Do nothing
Probabilities
Favorable
Market ($)
Unfavorable
Market ($)
EOL
180,000
72,000
100,000
20,000
68,000
200,000
120,000
0.60
0.40
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EVPI Calculation
EVPI = Expected Value with Perfect
Information minus Maximum Expected
Monetary Value (also called the Expected
Value without perfect information).
We have to work out the expected value with
perfect information first.
Lets use the last example on the Dr. Green payoff
table with probabilities.
Alternatives
Construct a
large plant
Construct a
small plant
Do nothing
Probabilities
States of Nature
Favorable Unfavorable
Market ($)
Market ($)
200,000
-180,000
100,000
-20,000
.60
.40
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States of Nature
Favorable Unfavorable
Market ($)
Market ($)
Alternatives
Construct a
large plant
Construct a
small plant
Do nothing
Probabilities
200,000
-180,000
100,000
-20,000
.60
.40
EVPI Calculation
EVPI = Expected Value with Perfect
Maximum
Information
(EVwPI)
minus
Expected Monetary Value (EMV) (also called
the Expected Value without perfect information).
EVwPI Max. EMV
So we have the first EV with perfect information
covered:
EVwPI = 120,000 minus Maximum EMV (from
last example).
Now remember when we worked out the EMV
by multiplying the payoffs for each alternative by
corresponding probabilities of states of nature.
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EMV RESULTS
State of Nature
Alternative
Favorable
Market ($)
Construct a
large plant
200,000
-180,000
Construct a
small plant
100,000
-20,000
Do nothing
0.60
0.40
Probabilities
EMV
Unfavorable
Market ($)
200,000*0.6 +
(-180,000)*0.4 =
48,000
100,000*0.6 +
(-20,000)*0.4 =
52,000
0*0.6 + 0*0.4 =
0
EMV RESULTS
The maximum EMV (without perfect information) was 52,000.
State of Nature
Alternative
Construct a
large plant
Construct a
small plant
Do nothing
Probabilities
Favorable
Market ($)
Unfavorable
Market ($)
EMV
200,000
-180,000
48,000
100,000
-20,000
52,000
0.60
0.40
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EVPI Calculation
EVPI = Expected Value with Perfect Information
minus Maximum Expected Monetary Value (EMV)
(also called the Expected Value without perfect
information).
So we subtract the two values: EVwPI Max. EMV
EVPI = 120,000 - 52,000 = $68,000
The EVPI is the maximum you will be willing to pay
for certain information and that is $68,000 dollars.
This is maximum worth of such information.
So if someone had asked you to pay $80,000 for
such information (i.e. To know exactly what will
happen in the future so you can make a certain
decision), you can decline. You will only pay for such
information if it costs less than $68,000.
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APPENDIX NOTES:
Expanded Summary of DecisionMaking Steps using Dr. Green
Decision Problem Example
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END OF LECTURE
Download
tutorial
assignment
for
analysing decision problems.
Read Chapter 3 (Decision Analysis) of
Render et al. text.
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