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Decision analysis has a major role to play in helping decision makers to gain a greater
understanding of the problems they face, and provides tools for quantitatively
analyzing decision with uncertainty and/or multiple conflicting objectives.
We make decisions all the time. For example: Shall I bring the umbrella today? The
decision depends on something which I do not know, namely whether it will rain or
not.
Out1
Out2
Out3
Out4
1.2 Conditions for Decision Making:A decision problem is characterized by decision
alternatives, states of nature, and resulting payoffs.
Condition 1: Decision Making under Certainty
Condition 2: Decision Making under Uncertainty
Condition 3: Decision Making under Risk
Decision Making under Certainty:
The decision maker knows all possible alternatives, and can exactly say at what
probability each occurs. Decision maker knows with certainty the consequences of
every alternative or decision choice
The decision maker chooses the action that will result in the most desirable outcome.
A company has decided that it faces three alternatives:
It can manufacture/assemble the keyboard itself.
It can buy the keyboards from a domestic manufacturer.
It can buy the keyboards from a manufacturer in the Far East.
The objective of the decision: profit.
In this case there is a single, known state of nature. Although this case appears
simpler than those of non-certainty, the problem of calculating the payoff for each
alternative action, or at least of identifying an action that would result in an outcome
which was satisfactory, may not be trivial. Methods of Operational Research, such
as Linear Programming and Dynamic Programming, may be needed.
Break-Even Analysis
Total Revenue
80 Break-even point
Revenues/Costs ($000)
70 Profit area
60 Break-Even Point
50 Variable Costs
40 Loss Area
30
Fixed Costs
BE TFC
P-VC
20
10
10 20 30 40 50 60 70
Output (000)
Decision Making under Uncertainty:
There are several outcomes for each action, depending on the state of nature. The
outcome corresponding to the chosen action are uncertain, but the probabilities
associated with each outcome is known. The decision maker does not know the
probabilities of the various outcomes
There are several criteria for making decisions under uncertainty.
(1) Maximax (optimistic)
(2) Maximin (pessimistic)
(3) Criterion of realism (Hurwicz)
(4) Equally likely (Laplace)
(5) Minimax regret (Savage)
Example: Thompson Lumber Company
Step 1 Define the problem
Expand by manufacturing and marketing a new product, backyard storage sheds
Step 2 List alternatives
Construct a large new plant
A small plant
No plant at all
Step 3 Identify possible outcomes
The market could be favorable or unfavorable
Step 4 List the payoffs
Identify conditional values for the profits for large, small, and no plants for the two
possible market conditions
Step 5 Select the decision model
Depends on the environment and amount of risk and uncertainty
STATE OF NATURE
FAVORABLE MARKET
ALTERNATIVE ($) UNFAVORABLE MARKET ($)
Do nothing 0 0
(1) Maximax (optimistic)
Used to find the alternative that maximizes the maximum payoff.Locate the
maximum payoff for each alternative.Select the alternative with the maximum
number
EMV (alternative i ) =
(Payoff of first state of nature) x (probability of first state of nature) + (payoff of
second state of nature) x (probability of second state of nature) + + (payoff of
last state of nature) x (probability of last state of nature)
STATE OF NATURE
FAVORABLE UNFAVORABL
ALTERNATIVE MARKET ($) E MARKET ($) EOL
Construct a large 200,000 -
0-(-180,000) 90,000
plant 200,000
Construct a small 200,000 -
0-(-20,000) 60,000
plant 100,000
Do nothing 200,000 - 0 0-0 100,000
Probabilities 0.50 0.50
Expected Opportunity Loss
STATE OF NATURE
FAVORABLE UNFAVORABLE
ALTERNATIVE MARKET ($) MARKET ($) EOL EOL (large plant)= (0.50)($0) + (0.50)($180,000) = $90,000
Construct a large plant 0 180,000 90,000
EOL (small plant)=(0.50)($100,000) + (0.50)($20,000) = $60,000
Construct a small plant 100,000 20,000 60,000
Do nothing 200,000 0 100,000 EOL (do nothing)= (0.50)($200,000) + (0.50)($0) = $100,000
Probabilities 0.50 0.50
The minimum EOL will always result in the same decision (NOT value) as the
maximum EMV
Point 2: