DECISION SCIENCE LECTURE # 2

DECISION ANALYSIS - The Decision Analysis Process - The 2 Classes of Decision Models - Expected value of perfect information

DECISION ANALYSIS - The

Decision Analysis Process

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.
2

DECISION ANALYSIS - The

Decision Analysis Process

In such a problem,
1. Several scenarios should be developed to describe how the various factors combine to form the possible uncertain future 2. Probabilities can be assigned to the events 3. Using Profit or Cost as a measure of the consequence for each decision alternative and each future combination, the best plant location can be selected.
3

DECISION ANALYSIS - The

Decision Analysis Process

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.
4

DECISION ANALYSIS - The

Decision Analysis Process

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.
5

DECISION ANALYSIS
-The
1. 2. 3.

Steps

Step 1: Problem Formulation

A verbal statement of the problem Identify the decision alternatives Identify the uncertain future events (chance events) Identify the consequences associated with each decision alternative and each chance event outcome
6

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.

Case Study - Problem Formulation

1.

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.
8

Case Study - Problem Formulation

2. Identify the decision alternatives
- 3 decision alternatives d1 = a small complex with 30 condos d2 = a medium complex with 60 condos

d3 = a large complex with 90 condos

9

Case Study - Problem Formulation

3. Identify the uncertain future events (chance events) In Decision Analysis, the possible outcomes for a chance event are referred to as the state of nature - 2 state of nature are identified s1 = strong demand for the condos s2 = weak demand for the condos
10

Case Study - Problem Formulation

4. Identify the consequences associated with each decision alternative and each chance event outcome The consequence is the NDC profit.

11

Case Study : Influence

Diagram (for the NDC)

States of Nature Strong (d1)

Complex Size
profit Decision Alternatives Small Complex (d1) Medium Complex (d1) Large Complex (d1)

Weak (d2)

Consequence Profit
12

Case Study : Payoff Table

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.

Case Study : Payoff Table

Payoff Table for the NDC Condo Project

(PAYOFF IN $M) State of Nature Weak Demand
(s2)

Strong Decision Alternative Demand

(s1) Small Complex (d1) Medium Complex (d2)

8 14

7 5

Large Complex (d3)

20

-9

14

Case Study :

A decision tree provides a graphical representation of the decision making process

Strong (s1) 8 2

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
15

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

The Payoffs are shown at the end of the states-ofnature branches

16

Case Study :

A decision tree provides a graphical representation of the decision making process

Strong (s1) 8 2

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

17

The 2 Classes of Decision Models

Class 1. Decision Making under Uncertainty

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.)
18

Class 1. Decision Making under Uncertainty

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
19

Optimistic Approach Maximum Pay-off (20)

State of Nature
Strong Decision Alternative Demand
(s1)
Small Complex (d1) Medium Complex (d2)

Weak Demand
(s2)

14

5
-9
20

Large Complex (d3)

20

Pessimistic Approach Best of the Worst (7))

State of Nature
Strong Decision Alternative Demand
(s1)
Small Complex (d1) Medium Complex (d2)

Weak Demand
(s2)

7
5
-9
21

14
20

Large Complex (d3)

Minimax Regret Approach

Given the Payoff Table for the NDC Condo Project State of Nature
(s1)

Strong Decision Alternative Demand

Small Complex (d1) Medium Complex (d2)

Weak Demand
(s2)

8 14

7 5

Large Complex (d3)

20

-9

22

Minimax Regret Approach

The Opportunity Loss or Regret Table is
State of Nature
Strong Demand Decision Alternative Small Complex (d1) Medium Complex (d2)
(s1)

Weak Demand
(s2)

Maximum Regret

12 6 0

0 2 16

12 6 16
23

Large Complex (d3)

Minimax Regret Approach

IN $M)

Decision Alternative
Small Complex (d1)

Strong Demand 8

State of Nature
(s1)

Weak Demand
(s2)

7 5 -9
Weak Demand
(s2)

Medium Complex (d2)

14 20
Strong Demand (s1)

Large Complex (d3)

Decision Alternative
Small Complex (d1)

Maximum Regret

12 6

0 2

12 6

Medium Complex (d2)

Large Complex (d3)

16

16

24

Minimax Regret Approach

Therefore the Minimum of the Maximum (Minimax) Regret is 6.

Decision Alternative
Small Complex (d1)

Strong Demand (s1)

Weak Demand
(s2)

Maximum Regret

12 6 0

0 2 16

12

Medium Complex (d2)

6
16
25

Large Complex (d3)

The 2 Classes of Decision Models

Class 2. Decision Making under Risk (Decision Making with Probabilities ) When probability assessments for the state of nature are available, we can use the EXPECTED MONEY VALUE (EMV) APPROACH to identify the best decision alternative i.e. n

EmV(di) = P (sj) Vij

j=1 For all N => the number of states of nature

P (sj) => the probability of state of nature sj

Vij

=> The pay-off values

26

Decision Making under Risk Calculations

Decision Alternative
Small Complex (d1) Medium Complex (d2)

Strong Strong Demand Demand

( (s s1 ) ) 1

Weak Demand
(s2)

8 14

7 5

Large Complex (d3)

20
0.8

-9
0.2
27

Probability

Decision Making under Risk Calculations

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

28

Decision Making under Risk Interpretation of results

EMV(d1) EMV(d2) EMV(d3)

= 0.8(8) +0.2(7) = 0.8(14) +0.2(5) = 0.8(20) +0.2(-9)

= 7.8 = 12.2 = 14.2

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.
29

Class 1. Decision Making under Uncertainty the EMV Approach using Decision Trees
Small (d1) 2

EMV(d1)

= 0.8(8) +0.2(7) = 7.8

Medium (d2)

EMV(d2)

= 0.8(14) +0.2(5) =12.2

Large (d3) 4

EMV(d3) = 0.8(20) +0.2(-9)=14.2

30

Expected value of perfect information

EVPI Although perfect information is almost never available in practice, determining its value can be very useful i.e.

It places an upper bound on what we should be willing to spend on any information.

31

Expected value of perfect information

Two related issues to investigate

1.

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.
32

Expected value of perfect information

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)
33

Calculating the EVwPI

Decision Alternative
Small Complex (d1)

Strong Demand 8 14 20

Weak Demand
(s1) (s2)

7 5 -9

Medium Complex (d2)

Large Complex (d3)

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

Therefore EVPI = EVwPI Maximum EMV = 17.4 14.2 = $3.2 million

Thus, the most that National Development Company (NDC) should pay for perfect information is $$3.2 million. END OF LECTURE
34