Decision Making Under Risk

Lesson 2.2

Decision Making Under Risk

Decision making when there are several possible states of nature and we know the probabilities associated with each possible state Most popular method is to choose the alternative with the highest expected monetary value (EMV)
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)

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Example Thompson Lumber Company

STATE OF NATURE ALTERNATIVE Construct a large plant Construct a small plant Do nothing FAVORABLE MARKET ($) 200,000 100,000 0 UNFAVORABLE MARKET ($) 180,000 20,000 0

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Expected Monetary Value ( EMV )

Assume each market has a probability of 0.50 Which alternative would give the highest EMV? The calculations are
EMV (large plant) = (0.50)($200,000) + (0.50)($180,000) = $10,000 EMV (small plant) = (0.50)($100,000) + (0.50)($20,000) = $40,000 EMV (do nothing) = (0.50)($0) + (0.50)($0) = $0

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Operations Research - Asia Pacific College

Expected Monetary Value ( EMV )

STATE OF NATURE
ALTERNATIVE Construct a large plant Construct a small plant Do nothing Probabilities FAVORABLE MARKET ($) 200,000 100,000 0 0.50 UNFAVORABLE MARKET ($) 180,000 20,000 0 0.50 EMV ($) 10,000 40,000 0

Largest EMV

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Expected Opportunity Loss (EOL)

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
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25 September 2010

Expected Opportunity Loss (EOL)

STATE OF NATURE
ALTERNATIVE Construct a large plant Construct a small plant Do nothing FAVORABLE MARKET ($) 0 100,000 200,000 UNFAVORABLE MARKET ($) 180,000 20,000 0 EOL 90,000 60,000 100,000

Probabilities

0.50

0.50

EOL (large plant) = (0.50)($0) + (0.50)($180,000) Minimum EOL = $90,000 EOL (small plant) = (0.50)($100,000) + (0.50)($20,000) = $60,000 EOL (do nothing) = (0.50)($200,000) + (0.50)($0) = $100,000
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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

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Sensitivity Analysis
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

= $0P + 0(1 P) = $0

EMV(Do Nothing)

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Sensitivity Analysis
EMV Values
$300,000 $200,000 $100,000 0

Point 2 Point 1

EMV (large plant) EMV (small plant) EMV (do nothing)

.167 $100,000
$200,000

.615
Values of P

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Sensitivity Analysis
Point 1: EMV(do nothing) = EMV(small plant)
0 $120,000 P $20,000

20,000 P 0.167 120,000

Point 2: EMV(small plant) = EMV(large plant)

$120,000 P $20,000 $380,000 P $180,000

160,000 P 0.615 260,000

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Sensitivity Analysis
BEST ALTERNATIVE
EMV Values $300,000 $200,000 $100,000 0 .167 $100,000 $200,000 .615 Values of P 1

RANGE OF P VALUES
Less than 0.167 0.167 0.615 Greater than 0.615
EMV (large plant) EMV (small plant) EMV (do nothing)

Do nothing Construct a small plant Construct a large plant

Point 2 Point 1

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Example 2.2 Nestle II

Mary, the Marketing Analyst of Nestle in Example 2.1, was able to determine further the probability of occurrence of each type of market. The probability of occurrence is 50% that the market is favorable, 20% that the market is average, and 30% that the market is unfavorable. The figures are summarized in the following table.

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Example 2.2 Nestle II

Expansion Plan Payoff ($000)
Construct Open Do

Type of Market
Favorable 8 Average -1 Unfavorable -5

a Plant

a Distribution Center

4
0 0.50

2
0 0.20

-3
0 0.30

Nothing

Probability

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Example 2.2 Nestle II

What will be Marys decision? How much gain or loss will she expect for the company? What will be her decision to minimize opportunity losses?

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