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Problem Formulation Decision Making without Probabilities Decision Making with Probabilities Risk Analysis and Sensitivity Analysis Decision Analysis with Sample Information Computing Branch Probabilities Utility and Decision Making
Problem Formulation
A decision problem is characterized by decision alternatives, states of nature, and resulting payoffs. The decision alternatives are the different possible strategies the decision maker can employ. The states of nature refer to future events, not under the control of the decision maker, which will ultimately affect decision results. States of nature should be defined so that they are mutually exclusive and contain all possible future events that could affect the results of all potential decisions.
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.
Payoff Tables
The consequence resulting from a specific combination of a decision alternative and a state of nature is a payoff. 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.
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.
States of Nature Alternatives Low High Small 8 8 Medium 5 15 Large -11 22 (payoffs in millions of dollars)
8 5 Medium Complex 15
11 22
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the optimistic approach the conservative approach the minimax regret approach.
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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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BEST PROFIT 8 15 22
Maximax payoff
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Maximi n decision
Maximin payoff
The decision with the best profit from the column of worst profits is selected.
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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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Max Regret 14 7 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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Maximax decision
Maximax payoff
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Maximin decision
Decision d1 d2 d3
Maximin payoff
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For a cost payoff table, entries in the regret table represent overpayments (i.e. higher costs incurred).
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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 s1 s2 s3 d1 Decisions d2 d3 Minimax decision
Dr. C. Lightner Fayetteville State University
Max Regret 4 1 2
4 0 0.5
0 1 2
1 0 2
Minimax regret
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EV( d i ) ! P( s j )Vij
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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Payoffs
s1 s2 s3 s1 .4 .2 .4 .4 .2 .4 .4 .2 .4
d3
s2 s3 s1 s2 s3
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Model A
Model
Model C
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Recall that this is a profit payoff table. Thus since the decision to build a medium complex has the highest expected profit, this is our best decision.
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Sensitivity Analysis
Some of the quantities in a decision analysis, particularly the probabilities, are often intelligent guesses at best. It is important to accompany any decision analysis with a sensitivity analysis. Sensitivity analysis can be used to determine how changes to the following inputs affect the recommended decision alternative: probabilities for the states of nature values of the payoffs If a small change in the value of one of the inputs causes a change in the recommended decision alternative, extra effort and care should be taken in estimating the input value.
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Sensitivity Analysis
One approach to sensitivity analysis is to arbitrarily assign different values to the probabilities of the states of nature and/or the payoffs and resolve the problem. If the recommended decision changes, then you know that the solution is sensitive to the changes. For the special case of two states of nature, a graphical technique can be used to determine how sensitive the solution is to the probabilities associated with the states of nature.
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EV( small)
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B1
B2
EV( small)
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0.3403
0.7
"
!
#"
EV( small)
"
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End of Chapter 14
See your textbook for more examples and detailed explanations of all topics discussed in these notes.
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