QBA Decision Analysis PRESENTED BY: DR SAMAR ELTANBOULY > Introduction >The Six Steps in Decision Making > Types of Decision-Making Environments Decision Making Under Uncertainty eacaoMe ns » Decision Making Under Risk >A Minimization Example > Using Software for Payoff Table Problems > Decision Trees >How Probability Values Are Estimated by Bayesian Analysis > Utility TheoryIntroduct The success or failure of a person is mainly depending on decision he or she made. Decision making process helps people to make their decisions & choose among alternatives. - aa ' 2 t “Decision theory is an analytic and systematic a approach to the study of decision-making process carried out by managers to choose among multiple alternatives. Good decision is based on @ Logic (consider all possible outcomes). @ Studying all the available data & possible alternatives. |X Using the suitable quantitative techniques.Steps of Decision-Making Process 1) Define the problem in hand The Problem should be clearly defined and stated. 2) List the Possible Alternatives. ¥ Provided that one of the biggest mistakes that the decision makers make is to leave out some important alternatives. 3) Identify the Possible Outcomes or States of Nature. Yin this concem possible outcomes may be favorable or unfavorable “Optimistic decision makers tend to ignore bad outcomes, whereas pessimistic managers may discount a favorable outcome. In decision theory, those outcomes over which the decision maker has little, or no control are called states of nature Steps of Decision-Making Process 4) List the payoff (profits) of each combination of alternatives and outcomes. This step can be carried out through preparing the decision (payoff) table Y Conditional values: (the payoffs results from each possible combination of alternatives and outcomes) 5) Select one of the mathematical decision theory models. ¥ Selecting the model depends on the environment in which the organization is operating, whether itis certain, risky, or uncertain. 6) Apply the model and make your deExample of Thompson Lumber Company + The Problem that John Thompson identifies is whether to expand his product line by manufacturing and marketing a new product, backyard storage sheds. AEE Suy ene Construct a large plant 180,000 Construct a small plant 20,000 Do nothing 0 0 Types of Decision-Making Environments Decision-making under _* The consequences of every alternative are carakcty known + There are several possible outcomes to LESSTUT Tu auicg§) each decision, but the probabilities of each outcome are known There are several possible outcomes to Cee ag et ae each decision, but the probabilities of each outcome are unknownDecision- Making under Certainty Pam Pte ela maton -me lacie certainty “ Decision maker is certain about the consequence of every alternative. + Let's say you have $1000 to invest for a year period: 1) To open saving account paying 6% interest 2) To invest in a treasury bond paying 10% interest “Both investment are safe and secured “ Solution: The treasury bond will pay a higher return of $100 better than $60.Decision- Making under Risk “Decision theory models for business problems in this environment typically employ 2 equivalent criteria 1) Maximization of expected monetary value. 2)Minimization of expected opportunity loss. + Decision making under risk is a probabil ic decision situation. Several possible states of nature may occur, each with a given probability. * Decision maker will select the alternative with the highest expected monetary value and lowest expected opportunity losses.A. Expected Monetary Value (EMV): v Itis defined as the weighted sum of possible payoffs for each alternative. Y Expected value (Mean Value): is the long-run average value of that decision v EMV for an alternative is just the sum of possible payoffs of the alternative, each weighted by the probability of that payoff occurring A. Expected Monetary Value (EMV): EMV (alternative ¢) = Y X;P(X;) X; = payoff for the alternative in state of nature 4 P(X,) = probability of achieving payoff X; (state of nature <) = Summation symbol EMV 1alternative2 = (Payoff in 1st state of nature) X (Probability of 1st state of nature) + (Payoff in 2nd state of nature) X (Probability of 2nd state of nature) +... + (Payoff in last state of nature) X (Probability of last state of nature)|(3200, 000)(0.: 50) + + ENTE) [= \ a) POC) A (-$180,000)(0.50) = $40,600 (3) ($) > EMV (small plant) = large plant 200,000 -180,000 [syasuile soy Small plant sooeee -20,000 > EMV (do nothing) = DONT 6 ($0)(0.50) + ($0)(0.50) = 86 B. Expected Value with Perfect Information (EVwPI): v Itis the expected or average return, in the long run, if we have perfect information before a decision should be made. EV wPI =5 (Best payoff in state of nature i) (probability of state of nature i) + BV wPI Rest payoff in first state of nature) x (Probability of first state of nature) +(Best payoff in Second state of nature) x (Probability of second state of nature) + + (Best payoff in last state of nature) x (Probability of last state of nature) Inthe Example: EVwPI = ($200, 000)(0.5) + ($0)(0.5) = $100,000C. Expected Value of Perfect Information (EVPI): Y tis the expected value with perfect information minus the expected value without perfect information (the best or maximum EMV). v_EVPI places an upper ceiling on what to pay in return of information EVPI = EVwPI — Best EMV In the Example: EVP] = EVwPI — Maximum EMV } [Olt UnUee) Aenea eens ied (3) Large plant 200,000 -180,000 10,000 Smallplant 100,000 -—-20,000 40,000 Do nothing 0 0 0 Probabilities. 50% 50%D. Expected Opportunity Loss (EOL) (Regret): v Itis an alternative approach to minimize expected opportunity loss (EOL) Y EOLis the cost of not picking the best solution. ¥ The minimum (EOL) can be identified through creating the opportunity loss table. Ist Step: To subtract each pay off in the column (under each state of nature) from the best payoff in the same column. $ _ Incaseof favorable market, we subtract the payotfs of each alternative from the best payoff ($200,000). ¥ _ In case of unfavorable market, we subtract the payoffs of each alternative from the best pay off ($0). Be 15* Step to calculate ari EOL Large plant 200,000-200,000= 0~(-180,000) ° 180,000 ‘Small plant 200,000- 100,000= ‘0-(-20,000)= 100,000 20,000 Do nothing 200,000- 0 = oa 200,000 Cmte Probabilities 50% 50%2°4 Step to calculate EOL EMV (large plant) = (0)(0.50) + ($180,000}(0.50) = Bae Favorable | Unfavorable Market ry ean iS) EMV (small plant) = ($100,000)(0.50) + EeWO Me (520,000)(0.50) = $60,000 Large plant 0 180,000 90,000 Emry (do nothing) = ‘Small plant 100,000 20,000 60,000 a ,000}(0.50) + ($0)(0.50) = Do nothing 200,000 0 100,000 Probabilities 50% 50% EMV =$60,000 is the lowest EVPI = Minimum EO. Example (2) Maria Rojas is considering the possibility of opening a small dress shop on Fairbanks Avenue, a few blocks from the university. She has located a good mall that attracts students. Her options are to open a small shop, a medium-sized shop, or no shop at all. The market for a dress shop can be good, average, or bad. The probabilities for these three possibilities are 0.2 for a good market, 0.5 for an average market, and 0.3 for a bad market. The net profit or loss for the medium-sized and small shops for the various market conditions are given in the following table. Building no shop at all yields no loss and no gain.Ua ECs Pond ey -40000 Wee) 60000 Per) ° eet . . 03 a) What do you recommend? b) Calculate the EVPI. ) Develop the opportunity loss table for this situation, What decisions would be made using the minimum EOL criterion? [EEE Solution Lilet em eI CT MMe ote Meade ay * EMV (1) = (75000*0.2) + (25000*0.5) + (-40000*0.3)= * EMV (2) = (100000*0.2) + (35000*0.5) + (-60000*0.3) =$ 19500 * EMV (N) = (0*0.2) + (0*0.5) + (0*0.3) =$0 Based on EMV, building a medium sized shop will be Te a alaSecond: Calculating the opportunity loss table. Alternative! Good | Average | Bad Market| IVE IE Bone! ach GSE} 25000 10000 40000 Pon eacons coco 0 0 60000 00*0.2) + (o*03) 100000 35000 0 Based on EOL, building a medium sized shop will be the best choice. Seren Calculati i meme value of fi information EVwPI = (100000*0.2) + (35000* 0.5) + (0*0.3) VEZ cet ) NCR ne eeeSensitivity Analysis Sensitivity Analysis > Sensitive analysis investigates how our decision might change with different input data. P = probability of a favorable market > EMV (large plant) = $200,000 P- $180,000 (1-P) = $380,000 P- $180,000 EMV (small plant) = $100,000 P- $20,000 (1-P) = $120,000 P- $20,000 EMV (Do nothing) = $0 P- $0 (1-P) = $0oe than 0.167 ena 0167-0615 Construct large plant Greater than 0.615 Decision- Making under UncertaintyDecision Making Under Uncertainty Several criteria exist for making decisions Peet eae ecm Rieter Rees ‘L.Optimistic (Maximax) 2.Pessimistic (Maximin) 3.Criterion of realism (Hurwicz) 4.Equally likely (Laplace) 5.Minimax regret sO Re) Lelia Maximax) . Ameen le Cele sll Market | Market | maximax nea rear 5) (Ce ned) We choose, the best (maximum) payoff for Large plant $200,000 180,000 each alternative is Small lant 100,000 -20,000 100,000 considered, and the alternative with the Bonothing a g o best (maximum) of these is selected. ‘Maximax is an2) Pessimistic (Maximin) worst (minimum) payoff for each alternative is considered, and the alternative with the best (maximum) of these is selected 3) Criterion of Realism (Hurwicz Criterion) [/ Criterion of realism uses the| ‘weighted average approach. JV itis a compromise between fan optimistic and a pessimistic decision. J’ The advantage of this approach is that it allows the decision maker to build in personal feelings about relative optimism and pessimism, Ameen Coca cy Cram meLCame VTC o) (of) CE) Large plant $200,000 -180,000 ~180,000 ‘Small plant 100,000 -20,000 -20,000 Do nothing 0 0 0 weighted average ~ a(Best in row) + (1 ~ a)(Worst in row) Bre ee ead Ne aes bid (o) (o} 3 ESE 0.8) () Large plant $200,000 -180,000 ‘Small plant 100,000 -20,000 eer Do nothing 0 ° 0OE el) VAM Col (Laplace) [” Equally likely criterion uses the average outcome. JV This involves finding the average payoff for each alternative and selecting the alternative with the best or highest average. JV ttassumes that all probabilities of occurrence| for the states of nature are equal, and thus each state of nature is equally ikely CyB cbantetcia (EOL) JY Minimax regret criterion is based on opportunity loss. IV Opportunity loss refers to the difference between the} optimal profit or payoff for a given state of nature and the actual payoff received for a particular decision for that state of nature. |’ Itis the amount lost by not picking the best alternative} ina given state of nature Large plant ‘Small plant Do nothing Large plant ‘Small plant Do nothing Been ee WES Oc (3) 3) eT LMT tcd (s) $200,000 —-180,000 100,000 20,000 40,000 o 0 0 Been Ec eM Merc os Dec ny Hy IIS TO} 100,000 20,000 200,000 0 200,000Decision Tree Decision Trees 1) Define the problem. 2), Structure or draw the decision tree. 3) Assign probabilities to the states of nature. 4) Estimate payoffs for each possible combination of alternatives and states of nature 5) Solve the problem by computing EMVs for each state-of-nature node. This is done by working backward, that is, starting at the right of the tree and working back to decision nodes on the left. Also, at each decision node, the alternative with the best EMV is selected.a larolal essen Decision Tree A decision node: from crs eee Pee eee Can occur. Example on Decision Tree Thompson’s Decision Tree A Siate-of.Nature Node Favorable Market ADecislonNode Ee Snel Fane Thompson’s Decision Tree += (0.5)200,000) + (0.5)(-$180,000) Payotts $200,000 $20,000 (0.5($100,000) + (0:5)(-$20,000) #Example on Thompson’s 1D-el (eo) ga =12 Seo on Pore eens eet 1. Given favorable survey results, ¥ EMV (node 2) = EMV (large plant|positive survey) = (0.75)($190,000) + (0.25)(—$190,000) = $95,000 ¥ EMV (node 3) = EMV (smail plant|positive survey) = (0.75)($90,000) + (0.25)(—$30,000) = $60,000 2. Given negative survey results, v EMV (node 4) = EMV (large plant|negative survey) = (0.25)($190,000) + (0.75)(—$190,000) = -$95,000 ~ EMV (node 5) = EMV(small plant\negative survey) = (0.25)($90,000) + (0.75)(—$30,000) = $03. Continuing the upper part of the tree and moving backward, we compute the expected value of conducting the market survey. EMV (node 1) = EMV (conduct survey) (0.5)($95,000) + (0.5)($0) = $95,000 4, Ifthe market survey is not conducted, EMV (node 6) = EMV large plant)=$10,000 ¥ EMV (node 7) = EMV (smail plant)=$40,000 ¥ EMV of no plant is$O 5. Expected value of Sample information (EVSI) EVSI = (EV with SI + cost) — (EV without ST) EYVSI = ($47,500 + $10,000) — $40,000 = $17,500 . VSI 17,500 = 6. Efficiency of Sample Information = "100% = =" 100% = 29% The market survey is 108% as efficient as perfect information