Decision Analysis

 Every decision problem has four basic features:

1. Alternative Courses of Action or Acts
2. States of Nature
-The consequences of selection of a course of action are dependent upon certain factors that are beyond the control of the
decision-maker.
-each state of nature is assumed to be mutually exclusive and collective exhaustive.
3. Consequences/ Pay-off
-The results or outcomes of selection of a particular course of action. It is assumed that the payoffs of various courses of
action are known to the decision-maker.
4. Decision Criterion
-The criterion for the selection of an optimal course of action.
-Depends upon the attitude of the decision maker.

 Types of Decision-Making Environments

Type 1: Decision making under certainty
The decision maker knows with certainty the consequences of every alternative or decision choice.
Type 2: Decision making under uncertainty
The decision maker does not know or has insufficient information to assign probabilities of the various
outcomes or state of nature.
Type 3: Decision making under risk
The decision maker knows the probabilities of the various outcomes.

 Decision Making Under Uncertainty

1. Maximin (pessimistic) or criterion of pessimism
= implies the maximization of minimum payoff
 Locate the minimum payoff for each alternative.
 Select the alternative with the maximum number
2. Maximax (optimistic) or criterion of optimism
= implies the maximization of maximum payoff.
 Locate the maximum payoff for each alternative.
 Select the alternative with the maximum number.
3. Criterion of realism (Hurwicz)
= This is a weighted average compromise between optimism and pessimism.
 Compute the weighted averages for each alternative.
Weighted average = (a)(maximum in row) + (1 – a)(minimum in row)
 Select the alternative with the highest value.
4. Equally likely (Laplace)
= In the absence of any knowledge about the probabilities of occurrence of various states of nature, one possible
way out is to assume that all of them are equally likely to occur.
= Considers all the payoffs for each alternative.
 Find the average/mean payoff for each alternative.
 Select the alternative with the highest average.
5. Minimax regret
= This criterion focuses upon the regret that the decision-maker might have from selecting a particular course of
action.
= Based on opportunity loss or opportunity cost or regret, this is the difference between the optimal profit and
actual payoff for a decision.
  Create Opportunity Loss Table by not choosing the best alternative
 Subtract each payoff in the column from the best payoff in the column.
 Find the maximum opportunity loss each row
 Pick the lowest number

 Decision Making Under Risk

= This is decision making when there are several possible states of nature, and the probabilities associated with each
possible state are known.
= Whenever the decision maker has some knowledge regarding the states of nature, he/she may be able to assign
subjective probability estimates for the occurrence of each state.
 The choice of an optimal action is based on The Bayesian Decision Criterion according to which an action with maximum
Expected Monetary Value (EMV) or minimum Expected Opportunity Loss (EOL) or Regret is regarded as optimal.

EMV
= It is not guaranteed financial outcome.
= The most popular method is to choose the alternative with the highest expected monetary value (EMV).
= Rather it is a measure taking into account both the outcomes and their likelihood—recollecting that probabilities
themselves should be seen as long term averages.
= The alternative financial outcome weighted by respective probabilities.
= The highest and best EMV

(payoff of first state of nature) x (probability of first state of nature) + (payoff of second state of nature) x (probability of
second state of nature) + … + (payoff of last state of nature) x (probability of last state of nature)

EOL
= Expected opportunity loss (EOL) is the cost of not picking the best solution.
= Minimum EOL will always result in the SAME DECISION as maximum EMV.
= Minimum EOL will always equal EVPI.
= The lowest EOL

• First construct an opportunity loss table.

• For each alternative, multiply the opportunity loss by the probability of that loss for each possible outcome and add these
together.

(payoff of first state of nature) x (probability of first state of nature) + (payoff of second state of nature) x (probability of
second state of nature) + … + (payoff of last state of nature) x (probability of last state of nature)

EVPI
= Expected Value of Perfect Information
= EVPI places an upper bound on what you should pay for additional information.
= helps to determine the worth of an insider who possesses perfect information.
= Perfect information is real to Best pay off

EVwPI = (best payoff n of state of nature) x (probability n of state of nature) + (best payoff of state of nature) x
(probability n of state of nature)

EVPI = EVwPI – Maximum EMV

 Decision Tree
= Any problem that can be presented in a decision table can also be graphically represented in a decision tree.
= Decision trees are most beneficial when a sequence of decisions must be made.
= All decision trees contain decision points or nodes, from which one of several alternatives may be chosen.
= All decision trees contain state-of-nature points or nodes, out of which one state of nature will occur.

Structure of Decision Trees

• Trees start from left to right.
• Trees represent decisions and outcomes in sequential order.
• Squares represent decision nodes.
• Circles represent states of nature nodes.
• Lines or branches connect the decisions nodes and the states of nature.

 Expected Value of Sample Information

= Suppose Thompson wants to know the actual value of doing the survey.

Expected value Expected value

EVSI = with sample of best
– decision
information, without sample
assuming information
no cost to
gather it

= (EV with sample information + cost) – (EV without sample information)