A. Problem Formulation
The main purpose of decision analysis is to help the decision maker with the structuring and systematic description of possible
decision alternatives and an uncertain or risk-filled pattern of future events. Important segment of the decision analysis is the risk
analysis which is aimed to provide the decision maker with probability information about favorable a well as unfavorable
consequences that may occur.
To understand the complexity of decision analysis we will use the following step-by-step approach:
1. We will first describe the problem on hand and will call this step problem formulation
2. Next, we will identify the decision alternatives
3. Next, we will identify the uncertain future events, referred to as chance events, and
4. Finally, we will identify the consequences associated with each decision alternative and each chance event outcome.
EXAMPLE PROBLEM:
The PDC Project (starting conditions):
State of Nature: one and only one of all possible states that will occur
Influence Diagram: graphical device that shows the relationships among the decisions, the chance events, and the
consequences for a decision problem
Payoff: the consequence resulting from a specific combination of a decision alternative and a state of nature
Payoff Table: a table showing payoffs for all combinations of decision alternatives and states of nature
Decision Tree: a graphical representation of the decision-making process which is based on the natural or logical
progression that will occur over time
Influence Diagrams
An influence diagram is a graphical device that shows the relationships
among the decisions, the chance events, and the consequences for a
decision problem. The nodes in an influence diagram are used to represent
the decisions, chance events, and consequences. Rectangles or squares are
used to depict decision nodes, circles or ovals are used to depict chance
nodes, and diamonds are used to depict consequence nodes. The lines
connecting the nodes, referred to as arcs, show the direction of influence
that the nodes have on one another.
Figure 4.1 shows the influence diagram for the PDC problem. The complex
size is the decision node, demand is the chance node, and profit is the
consequence node. The arcs connecting the nodes show that both the
complex size and the demand influence PDCs profit.
The table below shows the payoff table for the PDC project, where:
If a small complex is build and demand turns out to be strong, a profit of V11 = $8M will be realized;
If a small complex is build and demand turns out to be weak, a profit of V 12 = $7M will be realized;
If a medium complex is build and demand turns out to be strong, a profit of V21 = $14M will be realized;
If a medium complex is build and demand turns out to be weak, a profit of V22 = $5M will be realized;
If a large complex is build and demand turns out to be strong, a profit of V31 = $20M will be realized;
If a large complex is build and demand turns out to be weak, a loss of V32 = -$9M has to be expected.
Decision Trees
A decision tree provides a graphical
representation of the decision-making
process. Figure 4.2 presents a decision
tree for the PDC problem. Note that the
decision tree shows the natural or logical
progression that will occur over time. First,
PDC must make a decision regarding the
size of the condominium complex (d 1, d2,
or d3). Then, after the decision is
implemented, either state of nature s1 or s2
will occur. The number at each end point
of the tree indicates the payoff associated
with a particular sequence. For example
the topmost pay-off of 8 indicates that an
$8 million profit is anticipated if PDC
constructs a small condominium complex
(d1) and demand turns out to be strong (s1). The next payoff of 7 indicates an anticipated profit of $7
million if PDC constructs a small condominium complex (d 1) and demand turns out to be weak (s2). Thus,
the decision tree shows graphically the sequences of decision alternatives and states of nature that
provide the six possible payoffs for PDC.
The decision tree in Figure 4.2 has four nodes, numbered 1-4. Squares are used to depict decision nodes
and circles are used to depict chance nodes. Thus, node 1 is a decision node, and nodes 2, 3, and 4 are
chance nodes. The branches, which connect the nodes, leaving the decision node correspond to the
decision alternatives. The branches leaving each chance node correspond to the states of nature. The
payoffs are shown at the end of the states-of-nature branches. We now turn to the question: How can the
decision maker use the information in the payoff table or the decision tree to select the best decision
alternative?
The figure below shows the decision tree for the PDC project. The decision tree is a graphical representation of the decision-making
process with the sequences of decision alternatives and states of nature that will occur over time and as result provide possible
payoffs for PDC.
More specifically:
1. PDC must make a decision regarding the size of the condominium complex (small d1, medium d2, or large d3);
2. For each one of the possible decisions either state of nature s1 (strong demand) or s2 (weak demand) will occur;
3. The decision tree shows four notes, numbered 1 to 4. Note 1 is a decision note (square) and notes 2, 3, and 4 are chance
notes (circles);
4. Branches connect the notes: (i) those leaving the decision note correspond to the decision alternatives; (ii) those leaving
each chance note correspond to the states of nature;
5. The number at each end point of the tree (end point of the states-of-nature branches) indicates the payoff associated with a
particular sequence: V11 = $8M or V12 = $7M or V21 = $14M or V22 = $5M or V31 = $20M or V32 = -$9M.
How can the decision maker use the information in the payoff table or the decision tree to select the best decision alternative?
The following approaches are appropriate in situations where state-of-nature probabilities are
not available or cannot be obtained easily or where, considering best and worst analyses,
independent of state-of-nature probabilities, is desirable.
This approach evaluates each decision alternative in terms of the best payoff that could occur.
For problems in which maximum profit is desired, the optimistic approach would lead to the
decision maker to recommend the alternative corresponding to the largest profit. The procedure
is as follows:
From the payoff table, identify the maximum payoff for each of the decision alternatives
Compare these payoffs and select the decision alternative that provides the maximum
Table B.1.1
Note
This approach is also called the maximax criterion since it selects the decision alternative
that maximizes the maximum payoff.
For problems involving minimization, the optimistic approach will lead the decision maker to
choose the alternative with the smallest payoff.
The pessimist tends to be more cautious about future outcomes and would like to be in the best
position if the worst were to happen. The conservative approach evaluates the decision
alternative in terms of the worst payoff that could occur and recommends the alternative that
provides the best payoff of these. The procedure is as follows:
From the payoff table, identify the minimum payoff for each of the decision alternatives
Compare these payoffs and select the decision alternative that provides the maximum
In our above example, we would go for no system since, in an unfavorable market, it
yields a maximum of R 0.
Table B.1.2
Note
This approach is also called the maximin criterion since it selects the decision alternative that
maximizes the minimum payoff.
For problems involving minimization, the optimistic approach will lead the decision maker to
choose the alternative with the maximum payoff.
Opportunity loss or regret occurs when we have not made the decision that best suits the state
of nature. For example, if Carl decides to buy a less expensive system and that, after a while, he
finds that the market is favorable, he will definitely regret his decision because he could have
made more money had he bought an expensive system!
Rij =V j* Vij
where
Rij is the regret associated with decision alternative di and state of nature s j ,
V j* is the payoff value corresponding to the best decision for state of nature s j
and Vij is the payoff value associated with decision alternative di and state of nature
s j.
Note
State of nature
Decision Favourable Unfavourable
alternative market market
Expensive system 0 8 000
Less expensive 2 000 4 000
system
No system 10 000 0
Table B.3.1
From the above regret table, list the maximum regret for each decision alternative before
finally selecting the decision alternative with the minimum regret from the list.
Table B.3.2
The minimax regret approach recommends that Carl and Betty buy a less expensive
system with a corresponding maximum regret of R 4 000.
Note
This approach is called the minimax regret approach since it selects the decision alternative
that minimizes the maximum regret
The minimax regret approach is the same for both minimization and maximization problems.
The best decision alternative for a minimizations problem is the smallest entry in a
column.
The three above approaches simply show the difference in decision-making philosophies.
At the end of the day, it is up to the decision-maker to choose the most appropriate approach
and then make the final decision accordingly.
C. Decision Making With Probabilities
2. And;
Example 1:
PDC is optimistic about the potential for the luxury high-rise condominium
complex. Suppose the optimum leads to an initial subjective probability assessment of
0.8 and a corresponding probability of 02. Using the expected Value Approach, find the
optimal decision. Use the given data from the table below:
P(s1) = 0.8
P(s2) = 0.2
To help determine the decision strategy for PDC, we have reproduced PDCs payoff table
as Table 4.6. Note that, if PDC knew for sure that state of nature s1 would occur, the
best decision alternative would be d3, with a payoff of $20 million. Similarly, if PDC
knew for sure that state of nature s2 would occur, the best decision alternative would be
d1, with a payoff of $7 million. Thus, we can state PDCs optimal decision strategy when
the perfect information becomes available as follows:
If s1, select d3 and receive a payoff of $20 million.
If s2, select d1 and receive a payoff of $7 million.
What is the expected value for this decision strategy? To compute the expected value
with perfect information, we return to the original probabilities for the states of nature:
P(s1) -0.8, and P(s2) -0.2. Thus, there is a 0.8 probability that the perfect information
will indicate state of nature s1 and the resulting decision alternative d3 will provide a
$20 million profit. Similarly, with a 0.2 probability for state of nature s2, the optimal
decision alternative d1 will provide a $7 million profit. Thus, from equation (4.4), the
expected value of the decision strategy that uses perfect information is 0.8(20) 0.2(7) -
17.4 We refer to the expected value of $17.4 million as the expected value with perfect
information (EVwPI).
Earlier in this section we showed that the recommended decision using the expected
value approach is decision alternative d3, with an expected value of $14.2 million.
Because this decision recommendation and expected value computation were made
without the benefit of perfect information, $14.2 million is referred to as the expected
value without perfect information (EVwoPI).
The expected value with perfect information is $17.4 million, and the expected value
without perfect information is $14.2; therefore, the expected value of the perfect
information on (EVPI) is $17.4 $14.2 -$3.2 million. In other
words, $3.2 million represents the additional expected value that can be obtained if
perfect information were available about the states of nature.
Generally speaking, a market research study will not provide perfect information;
however, if the market research study is a good one, the information gathered might be
worth a sizable portion of the $3.2 million. Given the EVPI of $3.2 million, PDC should
seriously consider the market survey as a way to obtain more information about the
states of nature.
Example 2.
A manufacturer has two different kinds of machines, M1and M2. He has received
an order which can be processed either on M1 or M2. The following data is available.
M1 M2
Set up time, min 90 120
Tooling up cost $600 $120
Machine time per piece, 12 4
min
Machine cost per hour $40 $90
Which of the following will be chosen to do the job if the order quantity is 100?
For M1:
1. Set up time-> 90 min
$40 1
= 90 min x x = $60
60
2. Tooling up cost-> $600
1 $40
= 12 x 100 pieces x x = $8,000
60
3. Total Cost
= $60 + $600 +$8,000
= $8,660
For M2:
1. Set up time-> 120 min
$90 1
= 120 min x x = $180
60
2. Tooling up cost-> $1,800
1 $90
= 4x 100 pieces x x = $6,000
60
3. Total Cost
= $180 + $1,800 +$6,000
= $7,980
Therefore M2 is more economical machine than M1.
D. Risk Analysis and Sensitivity Analysis
Risk Analysis
The study of the possible payoffs and probabilities associated with a decision alternative or a decision
strategy
A decision alternative and a state of nature combine to generate the payoff associated with a decision.
The risk profile for a decision alternative shows the possible payoffs along with their associated
probabilities.
Through risk analysis the decision maker is provided with probability information about the favorable as
well as the unfavorable consequences that may occur.
Risk analysis can be used to provide probabilities for the payoffs associated with a decision alternative.
As a result, risk analysis helps the decision maker recognize the difference between the expected value of a
decision alternative and the payoff that may actually occur.
TECHNIQUES FOR DECISION MAKING UNDER RISK
Wherein,
Si = strategies or decision alternatives
Pi = probability
Xij = pay off
Nj = events
Therefore, the EMV for this Matrix is
For S1 is EMV = X1P1 + X1P2 +X1P3 + XnPn
For S2 is EMV = X2P1 + X2P2 +X2P3 + XnPn and so on
NOTE: All EMVs are calculated for all strategies, alternative that offers the highest EMV is selected and
implemented.
Steps in Risk analysis:
1. Identify the strategies
2. List the events
3. Estimate probabilities corresponding to each row
4. Determine the payoff each combination of strategy and an event
5. Calculate payoff
If Demand quantity
Payoff = (selling price per unit cost per unit) (quantity)
If Demand less than Quantity
Payoff = (selling price per unit cost per unit) (demand)
(quantity demand)( cost per unit )
6. Compute for the EMV. The EMV identifies the amount to be bought which can provide maximum
profits over a number of periods as compared to any other strategies.
7. Select optimal alternative. The strategy with the greatest EMV is the optimal alternative.
Sample Problem:
A department stores purchases Christmas Trees which can be ordered only in lots of 100. Each tree costs
25.00 dollars and sells at 40.00 dollars each. Unsold trees, however, have no salvage value. The probability
distribution obtained from the analysis of the past sales data are given below. How much quantity should the
department stores buy to maximize profit?
Trees Sold Probability
100 0.20
200 0.35
300 0.25
400 0.15
500 0.05
Available Events
Strategies N1 N2 N3 N4 N5 EMV,
0.2 0.35 0.25 0.25 0.05 Dollars
S1- 100 1500 1500 1500 1500 1500 1500
S2- 200 1000 3000 3000 3000 3000 2200
S3- 300 -3500 500 4500 4500 4500 1500
S4-400 -6000 -2000 2000 6000 6000 -200
S5- 500 -8500 -4500 -500 3500 7500 -2500
EMV S1= (1500x0.2) + (1500x0.35) + (1500x0.25) +(1500x0.15) + (1500x0.05)
= 1500 Dollars
EMV S2 = 2200
EMV S3 =1500
EMV S4 =-200
EMV S5 =-2500
Step 6.
THEREFORE, S2 MUST BE SELECTED WHERE 200 CHRISTMAS TREES MUST BE BOUGHT.
SENSITIVITY ANALYSIS
o It is also known as the what if analysis.
o Sensitivity Analysis is a tool used in financial modeling to analyze how the different
values of a set of independent variables affect a specific dependent variable under
certain specific conditions.
o Decision-makers use the model to understand how responsive the output is to
changes in certain variables. This relationship can help an analyst in deriving
tangible conclusions and be instrumental in making optimal decisions.
o Sensitivity analysis works on the simple principle: Change the model and
observe the behavior.
EXAMPLE:
Sue, a sales manager, wants to understand the impact of customer traffic on total
sales. She determines that sales are a function of price and transaction volume.
The price of a widget is $1,000 and Sue sold 100 last year for total sales of
$100,000. Sue also determines that a 10% increase in customer traffic increases
transaction volume by 5%, which allows her to build a financial model and
sensitivity analysis around this equation based on what-if statements. It can tell
her what happens to sales if customer traffic increases by 10%, 50% or 100%.
Based on 100 transactions today, a 10%, 50% or 100% increase in customer
traffic equates to an increase in transactions by 5, 25 or 50. The sensitivity
analysis demonstrates that sales are highly sensitive to changes in customer
traffic.
Utility is the measure of the total worth or relative desirability of a particular outcome;it reflects the decision
makers attitude toward a collection of factors such as profit,loss,and risk.
SAMPLE PROBLEM:
Decision Making under Certainty:
A certain plant wants to add an equipment for the production of pencil to have greater amount being produced. They have
3 certain equipment to choose from (E1, E2 and E3). Which of the 3 equipments will be chosen to have an additional
production of 400?
E1 E2 E3
Set up time, mins. 30 40 45
stooling up cost, $ 500 550 500
Machine time per piece, mins 8 6 5
Machine cost per hour, $ 55 45 60