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# Chapter 8 Decision Analysis

Terminology States of nature Payoffs / payoff table

MGS3100
Julie Liggett De Jong

Probability

The payoff table is a fundamental component in decision analysis models
State of Nature 2 … r12 r22 … rn2 … … … …

Terminology Expected Return Regret EVPI EVSI

Decision d1 d2 … dn

1 r11 r21 … rn1

m r1m r2m … rnm

Table 1, p81

Three Classes of Decision Models
Decisions under: certainty risk uncertainty

Decisions under certainty

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If I know for sure that it will be raining when I leave work this afternoon, should I take my umbrella to work today?

If I know for sure that it will be raining when I leave work this afternoon, should I take my umbrella to work today?

Rain Take Umbrella Do Not 0 -7.00

Table 2, p82

Decisions under risk

Multiple states of nature

We size up the likelihood of each state of nature happening

Historical frequencies

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Historical frequencies Subjective estimates

We calculate Expected Returns

E(X) = Σpixi

We choose the alternative that yields the maximum expected return. In other words, i* is the optimal decision where

ERi* = maximum overall i of ERi

All-Ways-Open Market
c) Calculate expected values: expected shortage (S) & expected excess (E) inventory
Week 1 2 3 4 5 6 7 8 9 10 RN .97 .02 .80 .66 .96 .55 .50 .29 .58 .51 Demand 45 40 44 43 45 43 42 42 43 42 Prob. 0.14 0.08 0.16 0.18 0.14 0.18 0.24 0.24 0.18 0.24 Expected 1.70 0.16 1 0.18*1=0.18 2 1 3 1 S 3 2 0.16*2=0.32 0.18*1=0.18 0.14*3=0.42 0.18*1=0.18 E Exp(s) 0.14*3=0.42 0.08*2=0.16 Exp(E)

The Newsvendor Model
Selling Price: \$ .75 Purchase Price: \$ .40 Goodwill cost: \$ .50

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The Newsvendor Model
1 2 3 4 5 6 7 8 9 10 A Selling Price Purchase Cost Goodwill Cost B 75 40 50 States of Nature 1 2 -50 -100 35 -15 -5 70 -45 30 C D E

The Newsvendor Model
Selling Price: \$ .75 Purchase Price: \$ .40 Goodwill cost: \$ .50

Decision 0 1 2 3

0 0 -40 -80 -120

3 -150 -65 20 105

Demand distribution: P0 = Prob(demand = 0) = 0.1 P1 = Prob(demand = 1) = 0.3 P2 = Prob(demand = 2) = 0.4 P3 = Prob(demand = 3) = 0.2
Table 4, p84

The Newsvendor Model
1 2 3 4 5 6 7 8 9 10 11 12 A Selling Price Purchase Cost Goodwill Cost B 75 40 50 States of Nature 1 2 -50 -100 35 -15 -5 70 -45 30 0.3 0.4 C D E F

Decisions under uncertainty
Multiple states of nature Don’t know what state of nature will occur

Decision 0 1 2 3 Probabilities

0 0 -40 -80 -120 0.1

3 Expected Return -150 -85 -65 -12.5 20 22.5 105 7.5 0.2

What is the Expected Return?

Decisions under uncertainty Laplace Maximin Maximax Minimax regret

Laplace

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Laplace
Assume all states of nature are equally likely to occur
1 2 3 4 5 6 7 8 9 10 11 12

The Newsvendor Model
A Selling Price Purchase Cost Goodwill Cost B 75 40 50 States of Nature 1 2 -50 -100 35 -15 -5 70 -45 30 0.3 0.4 C D E F

Decision 0 1 2 3 Probabilities

0 0 -40 -80 -120 0.1

3 Expected Return -150 -85 -65 -12.5 20 22.5 105 7.5 0.2

What is the Expected Return?

Maximin
extremely conservative or pessimistic approach to making decisions

Maximin
Evaluate minimum possible return associated with each decision.

Maximin
Select decision yielding maximum max value of minimum min returns.

Maximin

Table 1, p81

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Different criterion yields different decisions. Consider the decision table below:

Maximax
optimistic approach to making decisions

• Under the Maximin criterion, you would choose decision 1. • Under the Maximax criterion, you would choose decision 2.

Maximax
Evaluate maximum possible return associated with each decision

Maximax
Select decision yielding maximum of these max maximum returns. max

Maximax

Different criterion yields different decisions.

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• Under the Maximin criterion, you would choose decision 1. • Under the Maximax criterion, you would choose decision 2. Which is the best choice?

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Minimax regret

Regret measures the desirability of an outcome.

Choose the decision that minimizes the regret for making that choice.

a) Find the maximum value in column 1 b)Subtract every value in column 1 from this value c) Repeat for each column

a) Find the maximum value in column 1 b)Subtract every value in column 1 from this value c) Repeat for each column

a) Find the maximum value in column 1 b)Subtract every value in column 1 from this value c) Repeat for each column

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After regret table is built: d)Choose the maximum value in each row e) choose the smallest

After regret table is built: d)Choose the maximum value in each row e) Choose the smallest (minimum of the maximum)

Minimax Regret
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 A Selling Price Purchase Cost Goodwill Cost B 75 40 50 States of Nature 1 2 -50 -100 35 -15 -5 70 -45 30 35 70 C D E F

Each method yields different decisions regarding the newsvendor data:
Criteria LaPlace Cash Flow Maximin Cash Flow Decision Order 2 papers Order 1 paper Order 3 papers Order 2 papers

Decision 0 1 2 3

0 0 -40 -80 -120 0

3 -150 -65 20 105 105 MinMax Regret 255 170 85 120 85

Regret 0 1 2 3 0 40 80 120 85 0 40 80 170 85 0 40 255 170 85 0

Maximax Cash Flow Minimax Regret

1 2 3 4 5 6 7 8 9 10 11 12

A Selling Price Purchase Cost Goodwill Cost

B 75 40 50

C

D

E

F

Decision 0 1 2 3 Probabilities

0 0 -40 -80 -120 0.1

States of Nature 1 2 -50 -100 35 -15 -5 70 -45 30 0.3 0.4

3 Expected Return -150 -85 -65 -12.5 20 22.5 105 7.5 0.2

How much would you be willing to pay for perfect information?

What is the most money the newsvendor should be willing to pay for perfect information?

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1 2 3 4 5 6 7 8 9 10 11 12

A Selling Price Purchase Cost Goodwill Cost

B 75 40 50

C

D

E

F

Decision Trees
Graphical tool used to analyze decisions under risk Useful to analyze sequences of decisions

Decision 0 1 2 3 Probabilities

0 0 -40 -80 -120 0.1

States of Nature 1 2 -50 -100 35 -15 -5 70 -45 30 0.3 0.4

3 Expected Return -150 -85 -65 -12.5 20 22.5 105 7.5 0.2

EVPI =

expected return with perfect information

maximum possible expected return without sample information

TreePlan An add-in used to draw decision trees in Excel. Bayes’ Theorem Allows us to incorporate new information into the process.

Sonoralo Cellular Phones 3 strategies

Aggressive
Major commitment Major capital expenditure Large inventory Major global marketing campaign

Basic
Move production to existing facility Modify current line Maintain inventory for popular items Local/regional advertising

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Cautious
Use excess capacity Minimize retooling Produce enough to satisfy demand Advertise at discretion of local dealer

States of Nature
Strong Demand (S) Weak Demand (W)

Sonoralo Cellular Phones Payoff table

A square node represents a point at which a decision must be made. Each line (branch) leading from a square represents a possible decision.

TREE PLAN
A square node represents a point at which a decision must be made. A circular node represents an event (a situation when the outcome is not certain). Each line (branch) leading from a circle represents a possible outcome. • Insert the CD into the CD-ROM drive. • Select Run... from the Windows Start menu. • Type d:\html\TreePlan\Treeplan.xla & select "OK". • TreePlan will launch in Microsoft Excel as an add-in to the Tools menu. • In the Microsoft Excel dialog box, select Enable Macros. • For additional assistance go to Help.

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The Completed Decision Tree

Decision Trees: Incorporating New Information

Before implementing the Basic strategy, the corporate marketing research group performs a marketing study and reports on whether the study is encouraging (E) or discouraging (D).

Terminology

Prior Probabilities Conditional Probabilities / Reliabilities Joint & Marginal Probabilities

We will consider the new information before we make a decision.

Posterior Probabilities

A MARKET RESEARCH STUDY FOR CELLULAR PHONES
Prior Probabilities: Initial estimates, such as P(S) and P(W).

A MARKET RESEARCH STUDY FOR CELLULAR PHONES
Conditional Probabilities / Reliabilities: For two events A and B, the conditional probability [P(A|B)], is the probability of event A occurs given that event B will occur.

Sonorola has estimated the prior probabilities as P(S) = 0.45 and P(W) = 0.55.

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A MARKET RESEARCH STUDY FOR CELLULAR PHONES
Conditional Probabilities / Reliabilities: For example, P(E|S) is the conditional probability that marketing gives an encouraging report given that the market is in fact going to be strong.

A MARKET RESEARCH STUDY FOR CELLULAR PHONES
Conditional Probabilities / Reliabilities: If marketing were perfectly reliable, P(E|S) = 1.

Marketing has the following “track record” in predicting the market:
P(E|S) = 0.6 P(D|S) = 1 - P(E|S) = 0.4

A MARKET RESEARCH STUDY FOR CELLULAR PHONES
Posterior Probabilities: Conditional probabilities, such as P(S|E).

P(D|W) = 0.7 P(E|W) = 1 - P(D|W) = 0.3

We’ll use Bayes’ Theorem to calculate the posterior probabilities.

Calculating Posterior Probabilities:
1. Enter given Reliabilities (conditional probabilities). 2. Calculate Joint Probabilities by multiplying Reliabilities by Prior Probabilities. 3. Compute Marginal Probabilities by summing the entries in each row. 4. Generate Posterior Probabilities by dividing each row entry of joint probability table by its row sum.
P(E|W) P(D|W)

P(S)

P(W)

P(E&S)

P(W|E) P(W|D)

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A new decision tree!
S IV W A II
P( E)
) P(S|E P(W|E) ) P(S|E P(W|E)
P(S|E) P(W |E)

30 -8 20 7 5 15 30 -8 20 7 5 15

B

S V VI W S W

C E I D

A III

B

C

S VII W S VIII W S IX W

) P(S|D P(W|D)
P(S|D) P(W|D)

How much should we be willing to spend on sample information?

Sonoralo Cellular Phones Payoff table (w/out sample info)

THE EXPECTED VALUE OF PERFECT INFORMATION

) D P(

P(S|D)

P(W |D )

THE EXPECTED VALUE OF SAMPLE INFORMATION

EVSI =

maximum possible expected return with sample information

maximum possible expected return without sample information

EVSI = 13.46 – 12.85 = \$0.61 million.

EVSI is the upper bound of how much one would be willing to pay for this particular sample information.

THE EXPECTED RETURN WITH PERFECT INFORMATION

EVPI =

expected return with perfect information

maximum possible expected return without perfect information

EVPI is the maximum possible increase in the expected return that can be obtained from new information.

ERPI = 30(0.45) + 15(0.55) = 21.75

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THE EXPECTED VALUE OF PERFECT INFORMATION

EVPI =

expected return with perfect information

maximum possible expected return without perfect information

EVSI =

maximum possible expected return with sample information

maximum possible expected return without sample information

EVPI = 21.75 – 12.85 = \$8.90 million EVPI = EVPI is the maximum possible increase in the expected return that can be obtained from new information. expected return with perfect information maximum possible expected return without perfect information

Sequential Decisions: To Test or Not to Test
The value in performing the market research test depends on how Sonorola uses the information generated by the test.

The value of an initial decision depends on a sequence of decisions and uncertain events that will follow the initial decision. This is called a sequential decision model. model

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