Chapter 1 Derivatives

Definition: Let f be a function, and let a be in the domain of f. If exists, we say that the graph of f has a tangent line at . In that case the line tangent to the graph of f at defined to be the line through with this limit as rtt slope. Note: There is at most one line tangent to a graph at a given point on the graph. Let then a point slope equation of the line tangent to the graph of f at is given by
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Examples
1. Find an equation of the line tangent to the sine function at the indicated point a. f ( x) x 3 1 at (1,0) b. at (0,0) Definition: Let f be continuous at a point a. If then we say that the graph of f has a vertical tangent line at (a,f(a)). In that case the vertical line is called the line tangent to the graph of f at a.

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Derivatives of function
Definition: Let f be a function and a be in the domain of f. The function is said to be differentiable at a if exists. we call this limit the derivative of f at and we write If this limit exists, we say that f has a derivative at a, or that f is differentiable at a, or that f(a) exists. If , then and as x tends to a, h tends to zero

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Example:
Find the derivative of 2. Let using definition 3. Let using definition Remark: is the function whose domain is the collection of numbers at which f is differentiable and whose value at any such x is given by:
1.

If we let

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Differentiable Functions

Definition: A function f is said to be differentiable if it is differentiable at each numbers in its domain. A function is differentiable on an open interval (a, b) if it is differentiable at every number in the interval. The process of finding a derivative is called differentiation. You can think of differentiation as an operation on functions that associates a function f with a function f . When the independent variable is x, the differentiation operation is also commonly denoted by

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 In

the case where there is a dependent variable y = f(x) , the derivative is also commonly denoted by

With

the above notations, the value of the derivatives at a point a can be expressed as

Example:

show that a constant function is differentiable.

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ONE SIDED DERIVATIVES

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Influence Diagrams

An influence diagram is a graphical device showing the relationships among the decisions, the chance events, and the consequences. Squares or rectangles depict decision nodes. Circles or ovals depict chance nodes. Diamonds depict consequence nodes. Lines or arcs connecting the nodes show the direction of influence.

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Payoff Tables

The consequence resulting from a specific combination of a decision alternative and a state of nature is a payoff. The payoff is a quantitative measure of the value to the decision maker of the consequences of the outcome. A table showing payoffs for all combinations of decision alternatives and states of nature is a payoff table. Payoffs can be expressed in terms of profit, cost, time, distance or any other appropriate measure.
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Decision Trees

A decision tree is a chronological representation of the decision problem. Each decision tree has two types of nodes; round nodes correspond to the states of nature while square nodes correspond to the decision alternatives. The branches leaving each round node represent the different states of nature while the branches leaving each square node represent the different decision alternatives. At the end of each limb of a tree are the payoffs attained from the series of branches making up that limb.
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Example: CAL Condominium Complex

A developer must decide how large a luxury condominium complex to build small, medium, or large. The profitability of this complex depends upon the future level of demand for the complexs condominiums.

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CAL Condos: Elements of Decision Theory

States of nature: The states of nature could be defined as low demand and high demand. Alternatives: CAL could decide to build a small, medium, or large condominium complex. Payoffs: The profit for each alternative under each potential state of nature is going to be determined.

We develop different models for this problem on the following slides.

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CAL Condos: Payoff Table

THIS IS A PROFIT PAYOFF TABLE

States of Nature Alternatives Low High Small 8 8 Medium 5 15 Large -11 22 (payoffs in millions of dollars)

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CAL Condos: Decision Tree

8

8 5

Medium Complex

15

11 22
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Decision Making without Probabilities

Three commonly used criteria for decision making when probability information regarding the likelihood of the states of nature is unavailable are:

the optimistic approach the conservative approach the minimax regret approach. Equally likely (Laplace criterion) Criterion of realism with (Hurwicz criterion)

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Optimistic Approach

The optimistic approach would be used by an optimistic decision maker. The decision with the best possible payoff is chosen. If the payoff table was in terms of costs, the decision with the lowest cost would be chosen. If the payoff table was in terms of profits, the decision with the highest profit would be chosen.

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Conservative Approach

The conservative approach would be used by a conservative decision maker. For each decision the worst payoff is listed and then the decision corresponding to the best of these worst payoffs is selected. (Hence, the worst possible payoff is maximized.) If the payoff was in terms of costs, the maximum costs would be determined for each decision and then the decision corresponding to the minimum of these maximum costs is selected. (Hence, the maximum possible cost is minimized.) If the payoff was in terms of profits, the minimum profits would be determined for each decision and then the decision corresponding to the maximum of these minimum profits is selected. (Hence, the minimum possible profit is maximized.)

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Minimax Regret Approach

1. The minimax regret approach requires the construction of a regret table or an opportunity loss table. This is done by calculating for each state of nature the difference between each payoff and the best payoff for that state of nature. 2. Then, using this regret table, the maximum regret for each possible decision is listed. 3. The decision chosen is the one corresponding to the minimum of the maximum regrets.

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Example: Marketing Strategy

Consider the following problem with two decision alternatives (d1 & d2) and two states of nature S1 (Market Receptive) and S2 (Market Unfavorable) with the following payoff table representing profits ( $1000):

States of Nature s1 s3 d1
Decisions d2
19

20
25

6
3
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Example: Optimistic Approach

An optimistic decision maker would use the optimistic approach. All we really need to do is to choose the decision that has the largest single value in the payoff table. This largest value is 25, and hence the optimal decision is d2. Maximum Decision Payoff d1 20 choose d2 d2 25 maximum

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Example: Conservative Approach

A conservative decision maker would use the conservative approach. List the minimum payoff for each decision. Choose the decision with the maximum of these minimum payoffs. Minimum Decision Payoff choose d1 maximum d2
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d1 3

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Example: Minimax Regret Approach

For the minimax regret approach, first compute a regret table by subtracting each payoff in a column from the largest payoff in that column. The

resulting regret table is:

s1 s2
Maximum

d1 d2

5 0

0 3

5 3

minimum

Then, select the decision with minimum regret.

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Example: Equally Likely (Laplace) Criterion

Equally likely, also called Laplace, criterion finds decision alternative with highest average payoff. First calculate average payoff for every alternative. Then pick alternative with maximum average payoff. Average for d1 = (20 + 6)/2 = 13 Average for d2 = (25 + 3)/2 = 14 Thus, d2 is selected

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Example: Criterion of Realism (Hurwicz)

Often called weighted average, the criterion of realism (or Hurwicz) decision criterion is a compromise between optimistic and a pessimistic decision.

First, select coefficient of realism, , with a value between 0 and 1. When is close to 1, decision maker is optimistic about future, and when is close to 0, decision maker is pessimistic about future.
Payoff = x (maximum payoff) + (1-) x (minimum payoff)

In our example let = 0.8 Payoff for d1 = 0.8*20+0.2*6=17.2 Payoff for d2 = 0.8*25+0.2*3=20.6 Thus, select d2
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Solving CAL Condominiums Problem

Suppose that information regarding the probability (or likelihood) that there will be a high or low demand is unavailable. A conservative or pessimistic decision maker would select the decision alternative determined by the conservative approach. An optimistic decision maker would select the decision alternative rendered by the optimistic approach. The minimax regret approach is generally selected by a decision maker who reflects on decisions after the fact, and complains about or regrets their decisions based upon the profits that they could have made (or cheaper costs that they could have spent) had a different decision been selected.

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CAL Condos: Optimistic Decision

If the optimistic approach is selected: STATES OF NATURE Alternatives Low High Small 8 8 Medium 5 15 Large -11 22

BEST PROFIT 8 15 Maximax payoff 22

Maximax decision

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CAL Condos: Conservative Decision

Maximi n decision

If the conservative approach is selected: STATES OF NATUR WORST Alternatives Low High PROFIT Maximin payoff Small 8 8 8 Medium 5 15 5 Large -11 22 -11

The decision with the best profit from the column of worst profits is selected.

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CAL Condos: Minimax Regret Decision

If the minimax regret approach is selected:

Step 1: Determine the best payoff for each state of nature and create a regret table.

STATES OF NATURE Alternatives Low High Small 8 8 Medium 5 15 Large -11 22

Best Profit for Low 8 Best Profit for High 22

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CAL Condos: Minimax Regret Decision

If the minimax regret approach is selected:

Step 1: Create a regret table (continued).

STATES OF NATURE Alternatives Low High Small 0 14 Medium 3 7 Large 19 0

For a profit payoff table, entries in the regret table represent profits that could have been earned.

If they knew in advanced that the demand would be low, they would have built a small complex. Without this psychic insight, if they decided to build a medium facility and the demand turned out to be low, they would regret building a medium complex because they only made 5 million dollars instead of 8 million had they built a small facility instead. They regret their decision by 3 million dollars.
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CAL Condos: Minimax Regret Decision

If the minimax regret approach is selected:

Step 2: Create a regret table (continued).

Step 3: Determine the maximum regret for each decision.

STATES OF NATURE Max Alternatives Low High Regret Small 0 14 14 Medium 3 7 7 Large 19 0 19
Regret not getting a profit of 19 more than not making a profit of 0.
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CAL Condos: Minimax Regret Decision

If the minimax regret approach is selected:

Step 4: Select the decision with the minimum value from the column of max regrets.

Minimax Regret decision

STATES OF NATURE Alternatives Low High Small 0 14 Medium 3 7 Large 19 0

Max Regret 14 Minimax Regret 7 payoff 19

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Generic Example
Consider the following problem with three decision alternatives and three states of nature with the following payoff table representing costs: States of Nature s1 s2 s3 COST PAYOFF TABLE d1 Decisions d2 d3 4.5 0.5 1 3 4 5 2 1 3

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Generic Example : Optimistic Decision

Optimistic Approach An optimistic decision maker would use the optimistic (maximax) approach. We choose the decision that has the best single value in the payoff table.
Maximax decision

Decision d1 d2 d3

Best Cost 2 0.5 1

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Maximax payoff

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Generic Example: Conservative Approach

Conservative Approach A conservative decision maker would use the conservative (maximin) approach. List the worst payoff for each decision. Choose the decision with the best of these worst payoffs. Decision Maximin d1 decision d2 d3 Worst Payoff 4.5 4 5
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Maximin payoff

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Generic Example: Minimax Regret Decision

Minimax Regret Approach States of Nature s1 s2 s3

For a cost payoff table, entries in the regret table represent overpayments (i.e. higher costs incurred).

Decisions

d1 d2 d3

4.5 0.5 1

3 4 5

2 1 3

Best cost for each state of nature.

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Example

Minimax Regret Approach (continued) For each decision list the maximum regret. Choose the decision with the minimum of these values. States of Nature Max s1 s2 s3 Regret 4 0 0.5 0 1 2 1 0 2 4 1 2

d1 Decisions d2 d3 Minimax
decision
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Minimax regret

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Decision Making with Probabilities

Expected Value Approach

If probabilistic information regarding the states of nature is available, one may use the expected value (EV) approach. Here the expected return for each decision is calculated by summing the products of the payoff under each state of nature and the probability of the respective state of nature occurring. The decision yielding the best expected return is chosen.

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Expected Value of a Decision Alternative

The expected value of a decision alternative is the sum of weighted payoffs for the decision alternative. N The expected value (EV) of decision alternative di EV( d i ) P( s j )Vij is defined as: j 1

where:

N = the number of states of nature P(sj ) = the probability of state of nature sj Vij = the payoff corresponding to decision alternative di and state of nature sj
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Example: Burger Prince

Burger Prince Restaurant is contemplating opening a new restaurant on Main Street. It has three different models, each with a different seating capacity. Burger Prince estimates that the average number of customers per hour will be 80, 100, or 120. The payoff table (profits) for the three models is on the next slide.

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Example: Burger Prince

Payoff Table Average Number of Customers Per Hour s1 = 80 s2 = 100 s3 = 120 Model A Model B Model C $10,000 $ 8,000 $ 6,000 $15,000 $18,000 $16,000 $14,000 $12,000 $21,000

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Example: Burger Prince

Expected Value Approach Calculate the expected value for each decision. The decision tree on the next slide can assist in this calculation. Here d1, d2, d3 represent the decision alternatives of models A, B, C, and s1, s2, s3 represent the states of nature of 80, 100, and 120.

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Example: Burger Prince

Decision Tree
2
s1 s2 s3 s1

Payoffs
.4 .2 .4 .4 .2 .4 .4

10,000 15,000

d1 1 d2 d3

s2 s3 s1 s2 s3

14,000 8,000
18,000

12,000
6,000

.2
.4

16,000
21,000

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Example: Burger Prince

Expected Value For Each Decision d1 2
EMV = .4(10,000) + .2(15,000) + .4(14,000) = $12,600

Model A

Model B d2

EMV = .4(8,000) + .2(18,000) + .4(12,000) = $11,600

Model C

d3

EMV = .4(6,000) + .2(16,000) + .4(21,000) = $14,000

Choose the model with largest EV, Model C.

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CAL Condos Revisited

Suppose market research was conducted in the community where the complex will be built. This research allowed the company to estimate that the probability of low demand will be 0.35, and the probability of high demand will be 0.65. Which decision alternative should they select.

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CAL Condos Revisited

STATES OF NATURE Alternatives Low (0.35) High (0.65) Small 8 8 Medium 5 15 Large -11 22

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CAL Condos Revisited

STATES OF NATURE Alternatives Low High (0.35) (0.65) Expected value (EV) Small 8 8 8(0.35) + 8(0.65) = 8 Medium 5 15 5(0.35) + 15(0.65) = 11.5 Large -11 22 -11(0.35) + 22(0.65) = Recall that this is a profit payoff table. Thus since the decision to build a medium 10.45 complex has the highest expected profit, this is our best decision.
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Expected Value of Perfect Information

Frequently information is available which can improve the probability estimates for the states of nature. The expected value of perfect information (EVPI) is the increase in the expected profit that would result if one knew with certainty which state of nature would occur. The EVPI provides an upper bound on the expected value of any sample or survey information.

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Expected Value of Perfect Information

EVPI Calculation

Step 1: Determine the optimal return corresponding to each state of nature. Step 2: Compute the expected value of these optimal returns. Step 3: Subtract the EV of the optimal decision from the amount determined in step (2).

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Example: Burger Prince

Expected Value of Perfect Information Calculate the expected value for the optimum payoff for each state of nature and subtract the EV of the optimal decision.

EVPI= .4(10,000) + .2(18,000) + .4(21,000) - 14,000 = $2,000

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Exercises:

1. The following matrix gives the payoff of different strategies (alternatives) A, B, and C against conditions (events) W, X, Y and Z. Identify the decision taken under the following approaches: (i) Pessimistic, (ii) Optimistic, (iii) Equal probability, (iv) Regret, (v) Hurwicz criterion. The decision makers degree of optimism () being 0.7
W X Y Z

A B C
50

4000 20000 20000

-100 5000 15000

6000 400 -2000

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180000 0 10000

2. In a game of head and tail of coins the player A will get Rs. 4/- when a coin is tossed and head appears; and will lose Rs. 5/- each time when tail appears. Find the optimal strategy of the player. 3. A business manager wants to decide whether to replace certain equipment in the first year or in the second year or not replace at all. The payoffs are shown below. Draw a decision tree to decide the strategy.
Strategy A Replace now First year 4000 2 nd Year 6000 4000 3000 Total 10000 9000 8000
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B Replace after 5000 one year C Do not 51 replace 5000

Exercises:

4. A newspaper boy has the following probabilities of selling a magazine. Cost of the copy is Rs. 0.30 and sale price is Rs. 50. He cannot return unsold copies. How many copies can he order?
No. of copies sold
10 11 12 13 15 Total
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Probability
0.10 0.15 0.20 0.25 0.30 1.00
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