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Decision Analysis: Theory and Methodology:

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.

Decision Analysis Includes:

1. How to model a decision problem?


2. How to model the uncertainty with probability?
3. How to model the preference with utility?
4. Decision making with uncertainty.
5. Decision making with risk.
6. Bayesian Analysis.
7. Multiple criteria decision making

1.1 Decision Problem & Decision Making

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.

a. Alternatives/Options/Actions: Do I take my umbrella or not?


b. States/Uncertainty: Whether or not rain?
c. Outcomes/Payoff:
Outcome1: If I take and it is sunny, but its inconvenient.
Outcome2: If I take and it rains, it is good.
Outcome3: If I dont take and it is sunny, that is best.
Outcome4: If I dont take and it rains, I ruin my suit.

Alternatives States Outcomes

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.

Options States of Nature Objectives/Goals


Manufacture itself Payoff ?

Buy Domestic Sale level is low for sure Payoff ??

Buy Abroad Payoff ???

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

Step 6 Apply the model to the data


Solution and analysis used to help the decision making
Table 1 Decision Matrix (Payoff table)

STATE OF NATURE

FAVORABLE MARKET
ALTERNATIVE ($) UNFAVORABLE MARKET ($)

Construct a large plant 180,000


200,000

Construct a small plant 100,000 20,000

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

(2) Maximin (pessimistic)


Used to find the alte rnative that maximizes the minimum payoff.Locate the
minimum payoff for each alternative.Select the alternative with the maximum
number

(3) Criterion of realism (Hurwicz)


(4) Equally likely (Laplace)
Considers all the payoffs for each alternative.Find the average payoff for each
alternative.Select the alternative with the highest average

(5) Minimax regret (Savage)


Based on opportunity loss or regret, the difference between the optimal profit and
actual payoff for a decision.Create an opportunity loss table by determining the
opportunity loss for not choosing the best alternative.Opportunity loss is calculated
by subtracting each payoff in the column from the best payoff in the column.Find
the maximum opportunity loss for each alternative and pick the alternative with the
minimum number
Opportunity Loss Tables
STATE OF NATURE STATE OF NATURE
FAVORABL UNFAVORAB MAXIMUM
FAVORABLE UNFAVORABLE E MARKET LE MARKET IN A ROW
ALTERNATIVE MARKET ($) MARKET ($) ALTERNATIVE ($) ($) ($)
Construct a large
0 180,000 180,000
Construct a large plant 0 180,000 plant
Construct a
Construct a small plant 100,000 20,000 small plant
100,000 20,000 100,000

Do nothing 200,000 0 Do nothing 200,000 0 200,000

Decision Making under Risk


Risk refers to the situation in which the outcome of each action is not certain, but
where the probabilities of the different states of nature (and hence of the
alternative outcomes) can be determined. Decision making when there are several
possible states of nature and we know the probabilities associated with each possible
state. The decision maker knows the probabilities of the various outcomes
Most popular method is to choose the alternative with the highest expected
monetary value (EMV)
Probability: Objective / Subjective
Decision criterion: EMV / EU

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)

EMV (large plant) = (0.50)($200,000) + (0.50)($180,000)


Each market has a probability of 0.50 = $10,000
EMV (small plant) = (0.50)($100,000) + (0.50)($20,000)
Which alternative would give the highest EMV?
= $40,000
The calculations are:
EMV (do nothing) = (0.50)($0) + (0.50)($0)
= $0
STATE OF NATURE
EMV for Thompson Lumber FAVORABLE UNFAVORABL
ALTERNATIVE MARKET ($) E MARKET ($) EMV ($)
Construct a large
200,000 180,000 10,000
plant
Each market has a probability of 0.50 Construct a small
100,000 20,000 40,000
plant
Which alternative would give the highest EMV?
Do nothing 0 0 0
Probabilities 0.50 0.50

Expected Value of Perfect Information (EVPI)


Scientific Marketing, Inc. offers analysis that will provide certainty about market
conditions (favorable)
Additional information will cost $65,000
Is it worth purchasing the information?

State of Nature Compute EVwPI


Alternative Favorable Market Unfavorable Market EMV
The best alternative with a favorable market is to build a large plant with
(p=0.5) (p=0.5)
a payoff of $200,000. In an unfavorable market the choice is to do nothing
Construct a large plant 200,000 -180,000 10,000
with a payoff of $0
Construct a small plant 100,000 -20,000 40,000
Do nothing 0 0 0
EVwPI = ($200,000)*.5 + ($0)(.5) = $100,000
Perfect Information 200,000 0
EVwPI =
100,000
Compute EVPI = EVwPI max EMV = $100,000 - $40,000 = $60,000
The most we should pay for any information is $60,000
1. Best alternative for favorable state of nature is build a
large plant with a payoff of $200,000
Best alternative for unfavorable state of nature is to do
nothing with a payoff of $0
EVwPI = ($200,000)(0.50) + ($0)(0.50) = $100,000
2. The maximum EMV without additional information is
$40,000
EVPI = EVwPI Maximum EMV
= $100,000 - $40,000
= $60,000

Expected Opportunity Loss:


Expected opportunity loss (EOL) is the cost of not picking the best solution
First construct an opportunity loss table
For each alternative, multiply the opportunity loss by the probability of that
loss for each possible outcome and add these together
Minimum EOL will always result in the same decision as maximum EMV
Minimum EOL will always equal EVPI

Thompson Lumber: Payoff Table The Opportunity Loss Table

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

The EVPI will always equal the minimum EOL

EVPI = minimum EOL

(3) Sensitivity Analysis


Sensitivity analysis examines how our decision might change with different input data
For the Thompson Lumber example
P = probability of a favorable market
(1 P) = probability of an unfavorable market

EMV(Large Plant) = $200,000P $180,000)(1 P)


= $200,000P $180,000 + $180,000P
= $380,000P $180,000
EMV(Small Plant) = $100,000P $20,000)(1 P)
= $100,000P $20,000 + $20,000P
= $120,000P $20,000
EMV(Do Nothing) = $0P + 0(1 P)
= $0
Point 1:

EMV(do nothing) = EMV(small plant)

Point 2:

EMV(small plant) = EMV(large plant)


The end

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