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DECISION ANALYSIS - The Decision Analysis Process - The 2 Classes of Decision Models - Expected value of perfect information
Decision analysis can be used to determine an optimal strategy when a decision maker is faced with several decision alternatives and an uncertain or risk-filled pattern of future events
E.g. A global manufacturer might be interested in determining the best location for a new plant. Faced with, several locations in different countries, with several alternative. Decision complicated by several factors world economy, demand in the region, govt. policies, etc.
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Even when a careful decision analysis has been conducted, the uncertain future events make the final consequence uncertain In some cases, the selected decision alternative may provide good or excellent results In other cases, a relatively unlikely future event may occur causing the selected decision alternative to provide only fair or poor results.
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A good decision analysis includes risk analysis. Through risk analysis, the decision maker is provided with probability information about the favorable, as well as the unfavorable consequences that may occur.
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DECISION ANALYSIS
-The
1. 2. 3.
Steps
4.
Case Study
The National Development Company (NDC) has purchased land that will be the site of a new luxury condominium complex. NDC plans to price individual condominium units between $300,000 and $1,400,000. NDC has preliminary drawings for 3 different-sized projects, one with 30 condos, one with 60 condos, and one with 90 condos. The financial success of the project depends upon the size of the condo complex and the chance event concerning the demand for the condos.
A verbal statement of the problem To select the size of the new luxury condo project that will lead to the largest profit given the uncertainty concerning the demand for the condos. I.e. The decision is to select the best size for the condo complex.
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Complex Size
profit Decision Alternatives Small Complex (d1) Medium Complex (d1) Large Complex (d1)
Weak (d2)
Consequence Profit
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Given
the 3 decision alternatives the 2 states of nature Which complex size should NDC choose?
Question:
To answer this, NDC will need to know the consequence associated with with each decision alternative and each state of nature. In Decision Analysis, the consequence resulting from a specific combination of a decision alternative and a state of nature as 13 PAYOFF.
8 14
7 5
20
-9
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Case Study :
Decision Tree
Small (d1)
Weak (s2)
Medium (d2) Strong (s1) 3 Weak (s2) Large (d3) 4 Weak (s2) Strong (s1)
7 14
5 20 -9
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Case Study :
Decision Tree -
Notation
Decision Nodes
Chance Nodes
The branches, from square to circle, correspond to the decision alternatives.
The branches, from chance node correspond to
states of nature
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Case Study :
Decision Tree
Small (d1)
Weak (s2
Medium (d2) Strong (s1) 3 Weak (s2 Large (d3) 4 Weak (s2 Strong (s1)
7 14
5 20
-9
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3 Approaches
1.
2.
3.
Optimistic Approach Maximum Pay-off - best if the best- maximax (20) Pessimistic Approach Best of the Worst maximin (7) Minimax Regret Approach Minimum of the Maximum Regret/Opportunity Loss (i.e. 6.)
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These approaches are appropriate in situations in which the decision maker has little confidence in his or her ability to assess probabilities, or in which a simple best-case and worst-case analysis is desirable. Because different appropriates sometimes lead to different decision
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Weak Demand
(s2)
14
5
-9
20
20
Weak Demand
(s2)
7
5
-9
21
14
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Given the Payoff Table for the NDC Condo Project State of Nature
(s1)
Weak Demand
(s2)
8 14
7 5
20
-9
22
Weak Demand
(s2)
Maximum Regret
12 6 0
0 2 16
12 6 16
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IN $M)
Decision Alternative
Small Complex (d1)
Strong Demand 8
State of Nature
(s1)
Weak Demand
(s2)
7 5 -9
Weak Demand
(s2)
14 20
Strong Demand (s1)
Decision Alternative
Small Complex (d1)
Maximum Regret
12 6
0 2
12 6
16
16
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Weak Demand
(s2)
Maximum Regret
12 6 0
0 2 16
12
6
16
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Vij
Weak Demand
(s2)
8 14
7 5
20
0.8
-9
0.2
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Probability
Using the Table inclusive of the Probabilities, the Expected Money Value for each of the 3 decision alternatives can be computed, viz.
EMV(d1) = 0.8(8) +0.2(7) = 7.8 EMV(d2) = 0.8(14) +0.2(5) = 12.2 EMV(d3) = 0.8(20) +0.2(-9) = 14.2
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Using the Expected Money Value Approach, we find that the large condo complex, with an expected money value of $14.2 million is the recommended decision.
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Class 1. Decision Making under Uncertainty the EMV Approach using Decision Trees
Small (d1) 2
EMV(d1)
Medium (d2)
EMV(d2)
Large (d3) 4
EVPI Although perfect information is almost never available in practice, determining its value can be very useful i.e.
2.
Expected value with perfect Information (EVwPI) and, Expected value of perfect information (EVPI)
EVwPI is the expected payoff if we have perfect information before a decision has to be taken.
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EVPI = EVwPI Maximum EMV Nb. EVwPI = (Best payoff of first outcome) X (Probability of first outcome) + (Best payoff of second outcome) X (Probability of second outcome) ++ (Best payoff of last outcome) X (Probability of last outcome)
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Strong Demand 8 14 20
Weak Demand
(s1) (s2)
7 5 -9
Probability
Recall: EVPI = EVwPI Maximum EMV
0.8
0.2
EVwPI = 20 x 0.8 + 7 x 0.2 = 16 + 1.4 = $17.4 million Recall Maximum EMV = EMV(d3) = 0.8(20) +0.2(-9) = $14.2 million