Decision Analysis with Payoff Tables

HSCI 615 Information Management and Quantitative Decision Making and Control Spring 2009 Dr. Brian Malec

Introduction of case problem

Problem 2.4 Option A: The home health agency would hire an independent contractor COST = The PT will be paid $60 per home visit

Option B: The home health agency would hire a staff physical therapist, provide the therapist with a car and cover medical supplies and gas. COST = Monthly PT salary of $4000 Monthly car lease payment of $400 Medical supplies and gas allowance of $7 per visit Option C: The home health agency would utilize an independent contractor to provide PT services, provide the contractor with a car and fringe benefits, and pay a medial supply and gas allowance. COST = PT services of $35 per visit Monthly lease of $400 Fringe benefits (including inc.) of $200 Med. supplies and gas allowance of $7 per visit

Under all three options, the average payment for a PT home visit is $75 per visit.

Questions to be answered:
1.

2.

3.

4.

With no knowledge of demand for PT services, which option should be chosen? For a given probability distribution of demand for PT services, which option provides maximum profit? How sensitive is the choice of best option to the probability distribution of demand? How much value should be placed on a system that can forecast future demand for PT services?

II.

An overview of the model

A. Single-stage Decision analysis Number of alternative decisions is finite (limited) and the choice is a discrete one. It becomes more complicated if there are an infinite number of choices and you must choose one. B. Once the alternative is chosen, the executive knows that NATURE will cause one of several alternative events to take place. No specific knowledge of what event Nature will choose, but the choices are discrete. The collection of possible events is referred to as the alternative states of Nature. Each decision alternative/state of Nature combination has an economic consequence or payoff. The payoff might be a profit or a loss or minimum costs or maximum production. Sometimes the payoff is valued in terms of some utility or welfare rather then dollars.

Decision-analysis strategies
C. Decision-analysis can be further characterized as either

Decision making under uncertainty (you have no idea) Decision making under risk (you know the probability)

D. Multistage Decision Analysis

Once Nature has chosen a particular state in response to he executives choice of a decision alternative, the executive is then called on to make at least one (1) more decision. Each additional decision could then be followed by more choices by Nature. {See Chapter 4}

General Form of Payoff Matrix

Decision
Alternative a1 a2 a3
. .

State of Nature
S1 c1,1 c2,1 c1,2 c2,2 S2 c1,3 c2,3 S3 c1.4 c2,4 S4

Am

cm,1

cm,2

cm.3

cm.4

Payoff Matrix
The approach calls for the use of a payoff matrix page 41 a. Rectangular array of numbers, Cij that represent the consequences or payoff resulting from decision makers choice of a particular alternative ai, and Nature adopts a particular state, sj, b. the number of column in the matrix depends on the number of possible values assumed for demand in the case problem. The number of rows represents the three possible way of providing PT services. c. ASSUME that marketing has determined that there are four possible values for monthly demand and that each has a known probability of occurring.

30, 90, 140 or 150 known monthly demand .1 , .4, .2 and .3 known probability

Payoff Table analysis

C.

Cell values or payoffs will denote the NET profit associated with each alternative method. 12 values for net profit exist (3 alternatives times 4 possible values of demand = d) Calculations for first alternative Net profit/month = (75 60) x d = 15 x d if d = 30 then net profit = $450 Second alternative Net profit/month = -(4000 + 400) + (75- 7) x d = -4400 + 68 x d if d = 30 the net profit = -$4,400 + 68x(30) = -$2360 Third alternative Net profit/month = -(400+200) + (75-35-7) x d = -600 + 30 x d if d = 30, the net profit = -600+33x(30) = $390

Table 3.2

Case Problem Payoff Matrix

State of Nature - Monthly demand PT

Decision

Alternative

30

90

140

150

$450

$1,350

$2,100

$2,250

($2,360)

$1,720

$5,120

$5,800

$390

$2,370

$4,020

$4,350

IV.
A.

Solving the case problem

Table 3.2 Case Problem Payoff Matrix with maximum or minimum Profit Values B. Maximax criterion represents a very optimistic approach to decision making. Under this criterion each decision alternative is evaluated to max profit under the most optimistic conditions. C. Alternative B would be the optimum choice because is returns a net profit of $5,800 D. Decision maker assumes that things will go his/her way If we substituted cost for net profit we would use the same analysis and choose the alternative with the lowest minimum or minimum criterion.

MAXIMIN
C. If you think the Nature deals with managers with a vengeance the appropriate criterion might be MAXIMIN. Or the largest of the lowest profits possible. 1. The optimum choice is the decision that has the largest minimum profit. Under this strategy, Alternative A would be best because it has the largest minimum profit ($450). 2. For problems formulated in terms of cost then criterion is known as the MINIMAX criterion. The procedure is to choose the largest possible cost for each alternative and choose the one with the smallest maximum cost.

Table 3.2

Case Problem Payoff Matrix

Decision Alternative D=

State of Nature Monthly demand PT 30 90 140 150

Max Profit

Min Profit

$450

$1,350

$2,100

$2,250

$2,250

$450

($2,360)

$1,720

$5,120

$5,800

$5,800

($2,360)

$390

$2,370

$4,020

$4,350

$4,350

$390

3.

Minimax Regret: a third approach

1. Regret represents the amount of profit lost by choosing a non-optimal alternative for a given state of Nature. That is, for each cell within a given column of a payoff matrix, values of regret (rij) are obtained from Rij = [largest profit in column j] cij 2. For example: If demand = 30 (state #1) then if you choose Alternative C the result would a profit of only $90 or $60 less then the maximum possible profit. Therefore rij = $60 3. The goal is to minimize regret. The common procedure is to assume the worst. So the decision maker calculates the maximum regret for each Alternative and chooses the alternative with the minimum value for maximum regret. 4. In Table 3.4 the smallest maximum regret value is $1450 or Alternative C.

Table 3.4

Case Problem- Table of Regret Values

Decision

State of Nature - Monthly demand PT services.

Alternative

30

90

140

150

Max Regret $3,550

$0

$1,020

$3,020

$3,550

$2,810

$650

$0

$0

$2,810

$60

$0

$1,100

$1,450

$1,450

Decisions under Risk

States of Nature and the Probability that they will occur

Taking Table 3.4 on page 45 Expected Profits

States of Nature are .1%, .4%, .2%, .3%

(450 x .1) + (1350 x .4) + (2100 x .2) + (2250 x .3) For alternative A that equals $1680 Same method for Alternative B $3216 Same method for Alternative C $3096

Decisions under risk (continued)

Expected Regrets versus Expected Profits

Using Table 3.4 calculate the expected regret for each alternative

($0 x .1) + ($1020 x .4) + ($3.20 x .2) + ($3550 x .3) Alternative A expected regret = $2077 Alternative B = $541 Alternative C = $661

Sensitivity analysis

The expected profit can be plotted against the probability fo the firs state of Naure for each decision alternative. With only two known states of Nature, the probability of the second state is just one minus the probability of the first. Confident of demand of 90 (40%) and 140 (20%) Not sure about demand of 30 and 150 If probability of demand for 90 and 140 total .6 then the sum of the probability of demand for 30 and 150 must equal .4

Probability of demand equal to 30 is 1 minus probability of 150

Probability of 150 = p150 Probability of 30 = .4 p150

Expected profit for Alternative A = ($450 x (.4 p150)) + (1350 x .4) + (2100 x .2) + (2250 x p150) By substituting values for p150 you can obtain various outcomes Figure 3.1 shows Expected Profit vs. Probability of Demand for 150 Alternative A is dominated by Alternatives B and C

Sensitivity Analysis (continued)

From Figure 3.1 we see that for value of p150 less then .27143 we choose Alternative C. For values of p150 greater then .27143 we prefer Alternative B So if the probability of demand = 150 were to drop slightly below .3 we would shift from Alternative B to C

Maximum expected profit and the importance of forecasting

What is Perfect Information

Knowing the upcoming state of Nature If you knew this then you would choose the alternative with hightest profit (r minimum regret)

If you knew for sure that for the next month the demand was going to be 30 you would choose Alternative A. If you knew for sure that demand was going to be 90 you would choose Alternative C Forecast information produces ($450 x .1) + (2370 x.4) + (5120 x .2) + (5800 x .3) or $3757 Without perfect information the agency would select Alternative B with a value of $3216 With perfect information your expected profit is $3757 or a difference of $541 $541 is the expected value of perfect information. Alternative had an expected regret value equal to $541. This is not coincidence. This will always be the case.

Remaining topics

Model variation Description of available computer software Analysis, interpretation and application of results to management decisions Case studies from the literature. Discussion questions and problems