Decision Analysis

Decision Analysis (Theory)
To accompany Quantitative Analysis for Management, 8e by Render/Stair/Hanna
3-1
2003 by Prentice Hall, Inc. Upper Saddle River, NJ 07458
Introduction
Decision theory is an analytical and systematic way to tackle problems A good decision is based on logic.
3-2
The Six Steps in Decision Theory

1) Clearly define the problem at hand 2) List the possible alternatives
3) Identify the possible outcomes

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
3-3
Decision Table for Thompson Lumber

State of Nature Favorable Unfavorable Market Market $200,000 -$180,000 $100,000 $0 -$20,000 0
Alternative Construct a large plant Construct a small plant Do nothing
3-4
Types of DecisionMaking 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 risk

The decision-maker does know the probabilities of the various outcomes
Type 3: Decision-making under uncertainty

The decision-maker does not know the probabilities of the various outcomes
3-5
Decision-Making Certainty
Knows with certainty the result of every alternative
3-6
Decision-Making Under Risk

Expected Monetary Value
EMV(Altern ative) Payoff S j * P( S j )

j 1
where n number of stages of nature.
3-7
Decision Table (Matrix) for Thompson Lumber

Favorable Unfavorable Market Market Alternative State of Nature Construct a $200,000 -$180,000 $10,000 large plant Construct a $100,000 -$20,000 $40,000 small plant Do nothing $0 0 0.50 0.50
3-8
Expected Value of Perfect Information (EVPI)

EVPI places an upper bound on what one would pay for additional information EVPI is the expected value with perfect information minus the maximum EMV
3-9
Expected Value With Perfect Information (EV | PI)

n
EV | PI (Best outcomefor state of nature) * P(Sj )

j1
n number of states of nature.
3-10
Expected Value of Perfect Information

EVPI = EV|PI - maximum EMV
3-11

State of Nature Alternative Favorable Unfavorable EMV Market Market Construct a $200,000 large plant Construct a small plant Do Nothing 0.50 $0 0.50 $40,000
3-12

EVPI = expected value with perfect information - max(EMV)
= $200,000*0.50 + $0*0.50 - $40,000
= $60,000
3-13
Expected Opportunity Loss

EOL is the cost of not picking the best solution EOL = Expected Regret
3-14
Computing EOL - The Opportunity Loss Table
State of Nature Favorable Market ($) 200,000 - 200,000 200,000 - 100,000 200,000 - 0 0.50 Unfavorable Market ($) 0 - (-180,000) 0 -(-20,000) 0-0 0.50
Alternative Large Plant Small Plant Do Nothing Probability
3-15
The Opportunity Loss Table continued
State of Nature Alternative Large Plant Small Plant Do Nothing Probability Favorable Market 0 $100,000 $200,000 0.50 Unfavorable Market $180,000 $20,000 0 0.50
3-16
The Opportunity Loss Table - continued
Alternative Large Plant Small Plant Do Nothing
EOL (0.50)*$0 + $90,000 (0.50)*($180,000) (0.50)*($100,000) $60,000 + (0.50)(*$20,000) (0.50)*($200,000) $100,000 + (0.50)*($0)
3-17
Sensitivity Analysis
EMV(Large Plant) = $200,000P - (1P)$180,000 EMV(Small Plant) = $100,000P $20,000(1-P) EMV(Do Nothing) = $0P + 0(1-P)
3-18
Sensitivity Analysis continued

250000 200000 150000 EMV Values 100000 50000 0 Point 1 Point 2 Small Plant
-50000 0 -100000
-150000 -200000
0.2
0.4
0.6
0.8
Large Plant EMV Values of P
3-19
Decision Making Under Uncertainty

Maximax Maximin
Equally likely (Laplace)

Criterion of Realism Minimax
3-20

Maximax - Choose the alternative with the maximum output
State of Nature Alternative Favorable Unfavorable Market Market Construct a 200,000 -180,000 large plant Construct a 100,000 -20,000 small plant Do nothing 0 0 Probability 0.50 0.50
3-21

Maximin - Choose the alternative with the maximum minimum output
Alternative Construct a large plant Construct a small plant Do nothing Probabilities
State of Nature Favorable Unfavorable Market Market 200,000 -180,000 100,000 0 -20,000 0
3-22

Equally likely (Laplace) - Assume all states of nature to be equally likely, choose maximum Average States of Nature Favorable Unfavorable Avg. Market Market
$200,000 100,000 -$180,000 -20,000 10,000 40,000
Alternative Construct Large Plant Construct small plant Do nothing
3-23

Criterion of Realism (Hurwicz):
CR = *(row max) + (1-)*(row min)

State of Nature Alternative Favorable Unfavorable Market Market
Construct large plant Construct small plant Do nothing $200,000
$100,000 0 0.80
CR
124,000
76,000 0
-180,000
-20,000 0 0.20
3-24

Minimax - choose the alternative with the minimum maximum Opportunity Loss
Regret Matrix
States of Nature Alternative Favorable Unfavorable

Market Construct a large plant Construct a small plant Do nothing 0$ $100,000 200,000 Market $180,000 20,000 0 $180,000 100,000 200,000
Max
3-25
Marginal Analysis Discrete Distributions

Steps using Normal Distributions:
Determine the value for P.
ML
+MP ML
Locate P on the normal distribution. For a given area under the curve, we find Z from the standard Normal table. Using
X -m
*
we can now
solve for X*
3-26
Joes Newsstand Example A

ML = 4 MP = 6
m = Average demand = 50
papers per day
s = Standard deviation of
demand = 10
3-27
Joes Newsstand Example A - continued

ML 4 Step 1: p 0.40 ML + MP 4 + 6
Step 2: Look in the Normal table for P = 0.6 (i.e., 1 0.4)
X * - 50 Z 0.25 10 . or X * 10 * 0.25 + 50 52.5 or 53 newspapers

3-28
Joes Newsstand Example A continued
3-29
Joes Newsstand Example B

ML = 8 MP = 2
m = Average demand = 100

papers per day s = Standard deviation of
demand = 10
3-30
Joes Newsstand Example B - continued

ML 8 Step 1: p 0.80 ML + MP 8 + 2
Step 2: Z = -0.84 for an area of 0.80 and
X - 1000 - 0.84 10
*
or:
X * 0 - 0.84(10) + 100 91.6 or 92 newspapers
3-31
Joes Newsstand Example B continued
3-32
3-33
3-34
3-35
3-36

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Decision Analysis (Theory)

To accompany Quantitative Analysis for Management, 8e by Render/Stair/Hanna

2003 by Prentice Hall, Inc. Upper Saddle River, NJ 07458

To accompany Quantitative Analysis for Management, 8e by Render/Stair/Hanna

2003 by Prentice Hall, Inc. Upper Saddle River, NJ 07458

The Six Steps in Decision Theory

3) Identify the possible outcomes

2003 by Prentice Hall, Inc. Upper Saddle River, NJ 07458

Decision Table for Thompson Lumber

Alternative Construct a large plant Construct a small plant Do nothing

To accompany Quantitative Analysis for Management, 8e by Render/Stair/Hanna

2003 by Prentice Hall, Inc. Upper Saddle River, NJ 07458

Types of DecisionMaking Environments

Type 2: Decision-making under risk

Type 3: Decision-making under uncertainty

To accompany Quantitative Analysis for Management, 8e by Render/Stair/Hanna

2003 by Prentice Hall, Inc. Upper Saddle River, NJ 07458

To accompany Quantitative Analysis for Management, 8e by Render/Stair/Hanna

2003 by Prentice Hall, Inc. Upper Saddle River, NJ 07458

Decision-Making Under Risk

EMV(Altern ative) Payoff S j * P( S j )

where n number of stages of nature.

To accompany Quantitative Analysis for Management, 8e by Render/Stair/Hanna

2003 by Prentice Hall, Inc. Upper Saddle River, NJ 07458

Decision Table (Matrix) for Thompson Lumber

To accompany Quantitative Analysis for Management, 8e by Render/Stair/Hanna

2003 by Prentice Hall, Inc. Upper Saddle River, NJ 07458

Expected Value of Perfect Information (EVPI)

To accompany Quantitative Analysis for Management, 8e by Render/Stair/Hanna

2003 by Prentice Hall, Inc. Upper Saddle River, NJ 07458

Expected Value With Perfect Information (EV | PI)

EV | PI (Best outcomefor state of nature) * P(Sj )

n number of states of nature.

To accompany Quantitative Analysis for Management, 8e by Render/Stair/Hanna

2003 by Prentice Hall, Inc. Upper Saddle River, NJ 07458

Expected Value of Perfect Information

To accompany Quantitative Analysis for Management, 8e by Render/Stair/Hanna

2003 by Prentice Hall, Inc. Upper Saddle River, NJ 07458

Expected Value of Perfect Information

To accompany Quantitative Analysis for Management, 8e by Render/Stair/Hanna

2003 by Prentice Hall, Inc. Upper Saddle River, NJ 07458

Expected Value of Perfect Information

= $200,000*0.50 + $0*0.50 - $40,000

To accompany Quantitative Analysis for Management, 8e by Render/Stair/Hanna

2003 by Prentice Hall, Inc. Upper Saddle River, NJ 07458

Expected Opportunity Loss

To accompany Quantitative Analysis for Management, 8e by Render/Stair/Hanna

2003 by Prentice Hall, Inc. Upper Saddle River, NJ 07458

Computing EOL - The Opportunity Loss Table

Alternative Large Plant Small Plant Do Nothing Probability

To accompany Quantitative Analysis for Management, 8e by Render/Stair/Hanna

2003 by Prentice Hall, Inc. Upper Saddle River, NJ 07458

The Opportunity Loss Table continued

To accompany Quantitative Analysis for Management, 8e by Render/Stair/Hanna

2003 by Prentice Hall, Inc. Upper Saddle River, NJ 07458

The Opportunity Loss Table - continued

Alternative Large Plant Small Plant Do Nothing

To accompany Quantitative Analysis for Management, 8e by Render/Stair/Hanna

2003 by Prentice Hall, Inc. Upper Saddle River, NJ 07458

To accompany Quantitative Analysis for Management, 8e by Render/Stair/Hanna

2003 by Prentice Hall, Inc. Upper Saddle River, NJ 07458

Sensitivity Analysis continued

Large Plant EMV Values of P

= $200,0000.50 + $00.50 - $40,000

CR = (row max) + (1-)(row min)