Chapter 1 – p.

39

Huynh Ai Van, MIT

In this chapter, you will learn about:
1. Decision Analysis
2. Sequential Decision Tree
3. Practice

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Decision analysis: § A quantitative method
§ a tool for operations managers
§ A generic technique
§ can be applied to a number of different types of
operational decision-making areas
§ Example of an uncertain situation
§ demand for a product may vary between 0 and 200 units,
depending on the state of market

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States of nature: Should I accept a new job offer?
events that may occur in the Suppose that you have a job as an assistant for
future the CEO of a company, this job helps you earn
$30,000 every month. Due to the recruitment
Pay off: need, your boss nominates you as the director of
the outcome of the decision a branch and raises your salary by $20,000. If you
get this position, you will have to commute for 1
hour and a half every day to get to your new
workplace. You need to consider your extra
benefits.

Decline offer Accept offer

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Sequential decision tree: § A graphical method for analyzing decision situations
that require a sequence of decisions over time
a graphical method for
§ Decision tree consists of:
analyzing decision
§ Square nodes - indicating decision points
situations that require a
sequence of decisions § Circles nodes - indicating states of nature
over time.
§ Arcs - connecting nodes
Expected value (EV): 1 …
a weighted average of
decision outcomes in
which each future state of 2 …
nature is assigned a
probability of occurrence.

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§ John would like to start an own business. He has two options: (1) open a store and (2) not open a
store. He must consider two possible situations occurring in a growth economy or a declining
economy. The probability of each situation determined from his experience and knowledge is
50%. John estimates the financial outcomes of opening a store will be a profit of $40,000 in the
growth situation, a loss of $30,000 in the declining ones.

0.50 40000
Market growth
2
0.50No
e
m
or

gro arket -30000

st

wth
a
ng
ni
pe
O

(3) = 40000 x 0.5 = 20000

1 (4) = -30000 x 0.5 = -15000
(2) = 20000 – 15000 = 5000

(5) = 0
op
No ning
e

5 Compare (2) and (5) à choose (2)

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§ S1-29/49
§ S1-32/49-50
§ S1-33/50
§ S1-35/50
§ S1-36/50

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 S1-29/49
The management of State Union Bank was concerned about the potential
loss that might occur in the event of a physical catastrophe such as a power
failure or a fire. The bank estimated that the loss from one of these
incidents could be as much as $100 million, including losses due to
interrupted service and customer relations. One project the bank is
considering is the installation of an emergency power generator at its
operations headquarters. The cost of the emergency generator is $900,000,
and if it is installed no losses from this type of incident will be incurred.
However, if the generator is not installed, there is a 10% chance that a
power outage will occur during the next year. If there is an outage, there is
a 0.04 probability that the resulting losses will be very large, or
approximately $90 million in lost earnings. Alternatively, it is estimated that
there is a 0.96 probability of only slight losses of around $2 million.
Using decision tree analysis, determine whether the bank should
install the new power generator.
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 S1-32/49-50
Tech is playing State in the last conference game of the season. Tech is trailing
State 21 to 14 with 7 seconds left in the game, when they score a touchdown.
Still trailing 21 to 20, Tech can either go for two points and win or go for one
point to send the game into overtime. The conference championship will be
determined by the outcome of this game. If Tech wins they will go to the Sugar
Bowl, with a payoff of $9.2 million; if they lose they will go to the Gator Bowl,
with a payoff of $1.5 million. If Tech goes for two points there is a .30% chance
they will be successful and win (and a .70% chance they will fail and lose). If
they go for one point there is a 0.98 probability of success and a tie and a 0.02
probability of failure. If they tie they will play overtime, in which Tech believes
they have only a 20% chance of winning because of fatigue.
a) Use decision-tree analysis to determine if Tech should go for one point or
two points.
b) What would Tech’s probability of winning the game in overtime have to be
to make Tech indifferent between going for one point or two points?

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 S1-33/50
Mary Decker is suing the manufacturer of her car because of a defect
that she believes caused her to have an accident, and kept her out of
work for a year. She is suing the company for $3.5 million. The
company has offered her a settlement of $700,000, of which Mary
would receive $600,000 after attorneys’ fees. Her attorney has advised
her that she has a 50% chance of winning her case. If she loses she will
incur attorneys’ fees and court costs of $75,000. If she wins she is not
guaranteed her full requested settlement. Her attorney believes that
there is a 50% chance she could receive the full settlement, in which
case Mary would get $2 million after her attorney takes his cut, and a
50% chance that the jury will award her a lesser amount of $1,000,000,
of which Mary would get $500,000.
§ Using decision-tree analysis, decide if Mary should sue the
manufacturer
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S1-35/50

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 S1-36/50
Huntz Food Products is attempting to decide if it should introduce a new line of
salad dressings called Special Choices. The company can test market the salad
dressings in selected geographic areas or bypass the test market and introduce
the product nationally. The cost of the test market is $150,000. If the company
conducts the test market, it must wait to see the results before deciding
whether or not to introduce the salad dressings nationally. The probability of a
positive test market result is estimated to be 0.6. Alternatively, the company
cannot conduct the test market and make the decision to introduce the
dressings or not. If the salad dressings are introduced nationally and are a
success, the company estimates it will realize an annual profit of $1,600,000
while if the dressings fail it will incur a loss of $700,000. The company believes
the probability of success for the salad dressings is 0.50 if it is introduced
without the test market. If the company does conduct the test market and it is
positive, the probability of successfully introducing the salad dressings
increases to 0.8. If the test market is negative and the company introduces the
salad dressings anyway, the probability of success drops to 0.30
§ Using decision-tree analysis, determine if the company should conduct the test
market

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A logistics provider plans to have a new warehouse built to handle increasing demands
for its services. Although the company is unsure of how much demand there will be, it
must decide now on the size (large or small) of the warehouse. Preliminary estimates are
that if a small warehouse is built and demand is low, the monthly income will be $700,000.
If demand is high, it will have to either expand the facility or lease additional space.
Leasing will result in a monthly income of $100,000 while expanding will result in a
monthly income of $500,000.
If a large warehouse is built and demand is low, monthly income will only be $40,000,
while if demand is high, monthly income will be $2 million.
a) Construct a tree diagram for this decision.
b) Using your tree diagram, identify the choice that would be made using each of the
four approaches for decision making under uncertainty.

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