Decision Analysis
Learning Objectives
After completing this chapter, students will be able to:
1. List the steps of the decision-making
process
2. Describe the types of decision-making
environments
3. Make decisions under uncertainty
4. Use probability values to make decisions
under risk
Introduction
What is involved in making a good
decision?
Decision theory is an analytic and
systematic approach to the study of
decision making
A good decision is one that is based
on logic, considers all available data
and possible alternatives, and the
quantitative approach described here
The Six Steps in Decision Making
1. Clearly define the problem at hand
2. List the possible alternatives
3. Identify the possible outcomes or states
of nature
4. List the payoff or profit of each
combination of alternatives and
outcomes
5. Select one of the mathematical decision
theory models
6. Apply the model and make your decision
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
Thompson Lumber Company
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
Thompson Lumber Company
STATE OF NATURE
FAVORABLE UNFAVORABLE
ALTERNATIVE MARKET ($) MARKET ($)
Construct a large plant 200,000 –180,000
Construct a small plant 100,000 –20,000
Do nothing 0 0
Table 3.1
Types of Decision-Making
Environments
Type 1: Decision making under certainty
Decision maker knows with certainty the
consequences of every alternative or
decision choice
Type 2: Decision making under uncertainty
The decision maker does not know the
probabilities of the various outcomes
Type 3: Decision making under risk
The decision maker knows the
probabilities of the various outcomes
Decision Making Under
Uncertainty
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
Maximax
Used to find the alternative that maximizes
the maximum payoff
Locate the maximum payoff for each alternative
Select the alternative with the maximum
number
STATE OF NATURE
FAVORABLE UNFAVORABLE MAXIMUM IN
ALTERNATIVE MARKET ($) MARKET ($) A ROW ($)
Construct a large
200,000 –180,000 200,000
plant
Maximax
Construct a small
100,000 –20,000 100,000
plant
Do nothing 0 0 0
Table 3.2
Maximin
Used to find the alternative that maximizes
the minimum payoff
Locate the minimum payoff for each alternative
Select the alternative with the maximum
number
STATE OF NATURE
FAVORABLE UNFAVORABLE MINIMUM IN
ALTERNATIVE MARKET ($) MARKET ($) A ROW ($)
Construct a large
200,000 –180,000 –180,000
plant
Construct a small
100,000 –20,000 –20,000
plant
Do nothing 0 0 0
Table 3.3
Maximin
Criterion of Realism (Hurwicz)
A weighted average compromise between
optimistic and pessimistic
Select a coefficient of realism
Coefficient is between 0 and 1
A value of 1 is 100% optimistic
Compute the weighted averages for each
alternative
Select the alternative with the highest value
Weighted average = (maximum in row)
+ (1 – )(minimum in row)
Criterion of Realism (Hurwicz)
For the large plant alternative using = 0.8
(0.8)(200,000) + (1 – 0.8)(–180,000) = 124,000
For the small plant alternative using = 0.8
(0.8)(100,000) + (1 – 0.8)(–20,000) = 76,000
STATE OF NATURE
CRITERION
FAVORABLE UNFAVORABLE OF REALISM
ALTERNATIVE MARKET ($) MARKET ($) ( = 0.8)$
Construct a large
200,000 –180,000 124,000
plant
Realism
Construct a small
100,000 –20,000 76,000
plant
Do nothing 0 0 0
Table 3.4
Equally Likely (Laplace)
Considers all the payoffs for each alternative
Find the average payoff for each alternative
Select the alternative with the highest average
STATE OF NATURE
FAVORABLE UNFAVORABLE ROW
ALTERNATIVE MARKET ($) MARKET ($) AVERAGE ($)
Construct a large
200,000 –180,000 10,000
plant
Construct a small
100,000 –20,000 40,000
plant
Equally likely
Do nothing 0 0 0
Table 3.5
Minimax Regret
Based on opportunity loss or regret,
regret the
difference between the optimal profit and
actual payoff for a decision
Create an opportunity loss table by determining
the opportunity loss for not choosing the best
alternative
Opportunity loss is calculated by subtracting
each payoff in the column from the best payoff
in the column
Find the maximum opportunity loss for each
alternative and pick the alternative with the
minimum number
Minimax Regret
STATE OF NATURE
FAVORABLE UNFAVORABLE
Opportunity MARKET ($) MARKET ($)
Loss Tables 200,000 – 200,000 0 – (–180,000)
200,000 – 100,000 0 – (–20,000)
200,000 – 0 0–0
Table 3.6
STATE OF NATURE
FAVORABLE UNFAVORABLE
ALTERNATIVE MARKET ($) MARKET ($)
Construct a large plant 0 180,000
Construct a small plant 100,000 20,000
Do nothing 200,000 0
Table 3.7
Minimax Regret
STATE OF NATURE
FAVORABLE UNFAVORABLE MAXIMUM IN
ALTERNATIVE MARKET ($) MARKET ($) A ROW ($)
Construct a large
0 180,000 180,000
plant
Construct a small
100,000 20,000 100,000
plant
Minimax
Do nothing 200,000 0 200,000
Table 3.8
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 Value (EV)
ative 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)
EV for Thompson Lumber
Each market has a probability of 0.50
Which alternative would give the highest EV?
The calculations are
e plant) = (0.50)($200,000) + (0.50)(–$180,000)
= $10,000
all plant) = (0.50)($100,000) + (0.50)(–$20,000)
= $40,000
nothing) = (0.50)($0) + (0.50)($0)
= $0
EV for Thompson Lumber
STATE OF NATURE
FAVORABLE UNFAVORABLE
ALTERNATIVE MARKET ($) MARKET ($) EV ($)
Construct a large
200,000 –180,000 10,000
plant
Construct a small
100,000 –20,000 40,000
plant
Do nothing 0 0 0
Probabilities 0.50 0.50
Table 3.9 Largest EV
Decision Trees
Any problem that can be presented in a
decision table can also be graphically
represented in a decision tree
Decision trees are most beneficial when a
sequence of decisions must be made
All decision trees contain decision points
or nodes and state-of-nature points or
nodes
A decision node from which one of several
alternatives may be chosen
A state-of-nature node out of which one state
of nature will occur
Five Steps to
Decision Tree Analysis
1. Define the problem
2. Structure or draw the decision tree
3. Assign probabilities to the states of
nature
4. Estimate payoffs for each possible
combination of alternatives and states of
nature
5. Solve the problem by computing
Expected Values (EVs) for each state of
nature node
Structure of Decision Trees
Trees start from left to right
Represent decisions and outcomes in
sequential order
Squares represent decision nodes
Circles represent states of nature nodes
Lines or branches connect the decisions
nodes and the states of nature
Decision Tree
A State-of-Nature Node
Favorable Market
A Decision Node
1
Unfavorable Market
uct nt
r
n st P l a
e
Co arg
L Favorable Market
Construct
2
Small Plant Unfavorable Market
Do
No
th
in
g
Figure 3.2
Decision Tree
EV for Node 1 = (0.5)($200,000) + (0.5)(–$180,000)
= $10,000
Payoffs
Favorable Market (0.5)
$200,000
Alternative with best
EV is selected 1
Unfavorable Market (0.5)
ct nt –$180,000
r u
n st P l a
e
Co arg
L Favorable Market (0.5)
$100,000
Construct
2
Small Plant Unfavorable Market (0.5)
–$20,000
Do
No
th EV for Node 2 = (0.5)($100,000)
in
g = $40,000 + (0.5)(–$20,000)
Figure 3.3
$0
Thank you
