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MGMT 2012: Introduction to Quantitative Methods

DECISION ANALYSIS
Lecture 2

Lecturer : Dr. Dwayne Devonish

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.

SIX STEPS TO DECISION


MAKING
1. Clearly define the problem at hand.
2. List the possible decision alternatives.
3. Identify the
possible
outcomes
or
conditions facing the business/industry (i.e.
states of nature) circumstances under
which a decision is made.
4. List the payoffs (e.g. profits/losses) of each
combination of alternatives and outcomes.
5. Select one of the mathematical decision
theory models.
6. Apply the model and make your decision.

DR. GREENS DECISION PROBLEM


(SEE APPENDIX FOR EXPANDED SUMMARY)
Define problem

To manufacture mahogany work desks.

List alternatives

1.
2.
3.

Identify outcomes/
business conditions

The market could be favorable (i.e. high


demand) or unfavorable (i.e low demand) for
mahogany work desks

List payoffs

List the payoff for each state of


nature/decision alternative combination
create a payoff table (see next slide)

Select a model

Decision tables and/or trees can be used to


solve the problem

Apply model and make


decision

Solutions can be obtained and a sensitivity


analysis used to make a decision

Construct a large new plant


A small plant
No plant at all

Payoff Table of Dr Green Decision


Problem
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

Decision-Making Under Uncertainty


Selecting a decision model (step 5) depends on
the amount of risk and uncertainty involved.
Under uncertainty, a manager cannot ascertain
the probability of several outcomes occurring for a
given problem. Consequently, the managers
attitude towards uncertainty becomes relevant.
Several criteria for decision-making have been
developed. The most popular ones are:
 Maximax (i.e. optimistic manager)
 Maximin (i.e. pessimistic manager)
 Equally likelihood criterion (or LaPlace criterion)
 Minimax regret
 Lets look at these decision criteria:

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).

Payoff Table of Dr Green Decision


Problem
State of Nature
Alternative
Construct a
large plant
Construct a
small plant

Favorable
Market ($)

Unfavorable
Market ($)

200,000

-180,000

100,000

-20,000

Do nothing

Decision-Making under Maximax


State of Nature
Alternative

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

The maximum payoffs for each


alternative are circled in black.

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.

Payoff Table of Dr Green Decision


Problem
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

Decision-Making under Maximin


State of Nature
Alternative

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

The minimum payoffs for each


alternative are circled in black.

BEST DECISION
DO NOTHING

Equally Likelihood or LaPlace


Approach
Equally likely: LaPlace Approach
Find the alternative with the highest average
payoff.
This approach evaluates each decision
alternative in terms of its average payoff. Then,
the decision maker selects the alternative that
has the highest average payoff.
Find the average payoff for each alternative,
and then select the alternative with the highest
average.

Decision-Making under LaPlace


State of Nature
Alternative

Favorable
Market ($)

AVERAGE
PAYOFF

Unfavorable
Market ($)

Construct a
large plant

Average pay off = 200,000+-180,000/2

Construct a
small plant

Average pay off = 100,000+-20,000/2

Do nothing

200,000
100,000

10,000

-180,000
-20,000

40,000

Average pay off = 0 +0/2

0
BEST DECISION
BUILD SMALL PLANT

Minimax Regret

Minimax Regret (or Opportunity Loss)


Approach
Opportunity loss or regret refers to the
difference between the optimal (best) profit or
payoff for a given state of nature and the actual
payoff received for a specific decision
alternative i.e. the amount lost by not picking
the best alternative in a given state of nature.
The decision-maker chooses the alternative
that minimizes the amount of regret/loss.
Step 1: Create an opportunity loss/regret table
by calculating the opportunity loss/regret for not
selecting the best decision alternative this is
done by subtracting each payoff in a column
(i.e. state of nature) from the best payoff in that
same column. Hence, you first need to find
the best alternative for each state of nature
(in the columns).

Payoff Table of Dr Green Decision


Problem
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

Regret is the difference between the actual


choice and the best choice for a given state of
nature.

LETS FIRST DETERMINE THE BEST PAY-OFF FOR


EACH STATE OF NATURE: SEE RED CIRCLES
Hence, for a favourable market, the best payoff is $200,000,
whereas
for unfavourable market the best payoff is $0

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

THEN, WE MUST SUBTRACT EACH ACTUAL PAYOFF FOR


A GIVEN STATE OF NATURE FROM BEST PAYOFF IN THE SAME
STATE OF NATURE TO CREATE AN OPPORTUNITY LOSS TABLE
SO BEST PAYOFF ACTUAL PAYOFF

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)

HERE IS OUR OPPORTUNITY LOSS TABLE.


STEP 2 = USING THE MINIMAX REGRET CRITERION, WE MUST
LOCATE MAXIMUM (WORST) OPPORTUNITY LOSS FOR EACH
ALTERNATIVE.

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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THE MAXIMUM (WORST) OPPORTUNITY LOSS FOR EACH


ALTERNATIVE IS CIRCLED IN RED. THESE ARE ALSO NOTED IN
THE WORST REGRET COLUMN.

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

STEP 3: SELECT THE ALTERNATIVE WITH MINIMUM (BEST)


WORST REGRET. IN THIS CASE, IT IS CONSTRUCTING THE SMALL
PLANT ($100,000). $100,000 is the smallest loss/ lowest regret
among all losses

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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DECISION-MAKING UNDER RISK


We have considered decision criteria to be utilised
when there is no information about how likely a
particular state of nature will occur.
Decision-making under risk is a decision situation in
which several possible states of nature may occur,
and the probabilities of these states of nature are
known (Render et al., 2009, p.77).
Two popular methods of decision-making under risk is:
the Expected Monetary Value (EMV) and Expected
Opportunity Loss (EOL).
The EMV (or the mean value for an alternative) is
calculated by multiplying the probability of occurrence
for each state of nature by the corresponding payoff
and summing them. Lets look at this approach first.

Lets look at last exercise


Alternative
Construct a
large plant
Construct a
small plant
Do nothing

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

Expected Opportunity Loss or


Regret (EOL)
The EOL approach, like EMV, is used for decisionmaking under risk conditions based on
probabilities to arrive best decision .
The main difference is that for the EOL, the
probabilities of each state of nature are multiplied
by the corresponding regret values for each
decision alternative.
It is also similar to the Minimax regret criterion
such that the payoff table must first be converted
from payoff values to regret values using the
formula: Regret = Best Payoff Actual Payoff
(for a given state of nature). This is the first step.

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Lets look at last exercise

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

LETS FIRST DETERMINE THE BEST PAYOFF FOR


EACH STATE OF NATURE: SEE RED CIRCLES
Hence, for a favourable market, the best payoff is $200,000,
whereas
for unfavourable market the best payoff is $0

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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THEN, WE MUST SUBTRACT EACH ACTUAL PAYOFF FOR


A GIVEN STATE OF NATURE FROM BEST PAYOFF IN THE SAME
STATE OF NATURE TO CREATE AN OPPORTUNITY LOSS TABLE
SO BEST PAYOFF ACTUAL PAYOFF

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)

HERE IS OUR OPPORTUNITY LOSS OR REGRET TABLE.

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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STEP 2: FOR EOL CRITERION, WE MUST (LIKE EMV) MULTIPLY


REGRET VALUES FOR EACH ALTERNATIVE BY CORRESPONDING
PROBABILITY OF EACH STATE OF NATURE
EOL = Regret x Probability

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

Now you have expected opportunity loss or regret for


each alternative, the best decision is the alternative with least
expected opportunity loss or regret which is to construct
small plant (given 68,000 is minimum expected regret or loss)

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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Expected Value of Perfect


Information (EVPI)

In some situations, it is possible to determine which


states of nature will actually occur in the future.
In these cases, you would have obtained certain (or
perfect) information about those states of nature
either through political means or research analysis
(e.g. market or forecast analysis, etc).
If we have that information, we would be able to
make the best decision for a given state of nature
(i.e. decision-making under certainty).
Suppose we had to value this perfect information in
terms of what we would be willing to pay for it, this
value is known as expected value of perfect
information or EVPI.

Expected Value of Perfect


Information (EVPI)

EVPI = Expected Value with Perfect Information


minus Maximum Expected Monetary Value (also
called the Expected Value without perfect information).
Expected value with perfect information (EVwPI) is
the maximum expected payoff we can obtain if we had
perfect information or certainty before making a
decision.
EMV or (expected value without perfect information) is
the value we had computed earlier: the maximum EMV
is the maximum expected payoff we obtain if we did
not have complete or perfect information.
When we subtract the two values, we get the EVPI i.e.
the maximum you would pay for the perfect
information.

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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.

To calculate the EVwPI, Step 1:


we must choose the best payoff under
each state nature. You see those values in circles.

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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Step 2: Multiply the best value in each state by corresponding


probability of that state of nature and then sum values.
Favourable Market: 200,000 x .60 +
Unfavourable Market: 0 x .40 = 120,000
120,000 is EVwPI

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.

DECISION ANALYSIS: FINAL


NOTE
$68,000 also indicates the additional expected
value that can be obtained if perfect information
were available about the states of nature.
Recall too that $68,000 was the value of EOL; the
EOL normally equals the EVPI.
Decision analysis can be conducted manually but
advanced QM software can help decision-makers
solve more complex decision problems.
We will apply manual calculations in tutorials but
you can download the QM software from the core
text (Render et al.) and practise on your own.

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APPENDIX NOTES:
Expanded Summary of DecisionMaking Steps using Dr. Green
Decision Problem Example

Six Steps to Decision-Making


1. Clearly define the problem at hand Lets say
Dr. Green wants to determine whether it is more
profitable to expand his current product line by
manufacturing a new product mahogany work
desks.
2. List the possible decision alternatives (courses
of action that a decision-maker can choose from)
- Green has a number of choices: (1) construct
a large plant to develop the new products, (2)
construct a small plant to develop the new
products, (3) do nothing (do not worry about
expanding the product line)

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Six Steps to Decision-Making 2


3. Identify the possible states of nature (outcomes)
A state of nature or outcome is a condition or
event that may occur in the future. A decisionmaker under uncertainty cannot determine and
has no or little control over which states of
nature will occur. Dr. Green recognises that
there are two possible outcomes:
The market could be favourable (i.e. high
demand for the product), or
The market could be unfavourable (i.e. low
demand for the product).

Six Steps to Decision-Making 3


4. List the payoff or profit of each combination of
alternatives and outcomes Most decision
problems use profits or losses as a method of
evaluating the consequences of each decision
alternative. These values are presented in payoff
table (as shown in earlier slides). Negative values
are treated as losses, whereas positive values are
treated as profits.
5. Select one of the mathematic decision models
There are many criteria that can be used to aid
decision-making. However, the choice of these
criteria relies on the nature of business/market,
decision-maker, and level of risk or uncertainty that
is tolerated.

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Six Steps to Decision-Making 4


6. Apply model and make your decision
Once the decision model is applied, the
results are analysed, and the most
plausible decision is selected based on
the models requirements. However, it is
common for more than one decision
criterion to be used, and the alternative
which is supported by most of the criteria
is usually considered to be the best one.

END OF LECTURE
Download
tutorial
assignment
for
analysing decision problems.
Read Chapter 3 (Decision Analysis) of
Render et al. text.

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