Decision Analysis

Two reasons for making decision analysis

1. Most quantitative techniques solve

specific problems, and do not take into
account how the solution to one problem
can create further problems elsewhere

Example
The solution to an inventory problem may
cause problems on the:
*shop floor, and
*for the sales department

2. Decisions often have to be made under

conditions of uncertainty, that is,
knowledge about particular aspects of a
problem are vague

Many strategic decisions have to be made

with incomplete knowledge
Example
A car accessory company has developed a
new car immobiliser, and has to decide
whether to:
*market the product nationwide
*sell by mail order, or
*sell the patent to a large chain of motor
accessory shops

The cost of distributing nationwide is very

high, but:
*the potential profits could also be large

There is less risk with selling by mail order,

but:
*the potential profits would also be less

The safe option is to sell the patent, but:

*in this case, the chance of making large
profits would be lost
How does this company make their decision
given that they have limited knowledge of
the likely demand for the product?

Many decision analysis techniques

Some involve complex maths models

Others require subjective approach

Some techniques are only suitable for

single stage decisions (one decision)

In many cases the outcome of one decision

leads to subsequent decisions

Let’s review the techniques for solving both

single and multi-stage decision problems
Payoff Tables

Used for single stage decisions

Represent the outcome of a decision given a

particular state of nature

In the example given above:

The state of nature is the level of demand
that could occur

These will be defined as:

*High demand
*Medium demand, and
*Low demand

Various payoffs are usually written in a

payoff table

Decisions made according to a decision rule

Many decision rules are available

Some assume that all outcomes are known

with certainty

Others assume that a probability can be

assigned to each one

Decision rules that do not require the use

of probability are the:

*Maximax rule

*Maximin rule

*Minimax rule, and

*Hurwicz criterion
Let’s look at the previous example

Payoffs evaluated for the first year

according to decisions available to the
company, based on:
Nationwide distribution;
Mail order;
Sell patent.

Payoffs (in £000’s), after costs have been

deducted

* State of the market

Decision High Medium Low
Demand Demand Demand
Profit in Profit in Profit in
£000’s £000’s £000’s
Nationwide 95 52 (26)
Mail Order 48 24 19
Sell Patent 25 25 25

Nationwide distribution gives the greatest

payoff, but there is the chance that a loss
of £26,000 will be made
Maximax

The maximax rule chooses:

*the 'best of the best’ (maximises the
maximum possible profit)

The largest payoff for each decision is:

?????????????????
*£95000, £48000 & £25000 resp’ly

The best of these is £95,000

Decision is to ‘distribute nationwide’

A decision rule used by decision-makers,

who are:
*prepared to take risks
Maximin

The maximin rule chooses:

*the 'best of the worst’ (maximises the
minimum possible profit)

Worst payoff for each decision is noted

and the best is chosen

Worst payoffs are:

??????????????????
*£-26000, £19000 & £25,000 resp’ly

The best of these is £25,000

Decision would be to ‘sell the patent’

This decision rule is for people who are:

*adverse to risk taking
Minimax

The minimax rule:

*minimises the maximum opportunity loss

Opportunity loss is the loss that occurs:

*through not taking the best option

To work out the opportunity loss, subtract

each payoff for a particular state of
nature from the best

The best option given high demand is to

distribute nationwide at £95000, but if
instead the ‘mail order’ was chosen:
*£47000 ‘loss’ would be made
i.e. £95000 - £48000 = 47000

The remaining opportunity loss values can

be seen in the table below
* State of the market
Decision High Medium Low
Demand Demand Demand
Loss in Loss in Loss in
£000’s £000’s £000’s
Nationwide 0 0 51
Mail Order 47 28 6
Sell Patent 70 27 0

Largest opportunity loss for each option:

??????????????????
*£51000, £47000 & £70000, resp’ly

Minimum of these is £47000

Under this decision rule:

*’mail order’ option would be chosen

This is a 'Middle of the road' rule which

would suit people who are:
*neither risk takers nor risk avoiders
Hurwicz criterion

Like the minimax rule, attempts to give a

compromise between
the optimistic maximax rule and
the cautious maximin rule

However, unlike the minimax rule:

*weights are assigned to the best and
worst payoff for each decision option and
the option with the highest weighted
payoff is chosen

The weighted payoff is calculated as:

*α x worst + (1 - α ) x best

The value of an (alpha) depends on the:

*decision-maker's attitude to risk

The smaller the value, the bigger risk the

decision-maker is prepared to take
With α=0, the decision is the same as:??
*maximax rule

Using α = 0.6 (i.e. slightly cautious)

The weighted payoffs in £000’s become:
*Nationwide: 0.6x(-26) + 0.4x95 = 22.4
*Mail order: 0.6x19 + 0.4x48 = 30.6
*Sell patent: 0.6x25 + 0.4x25 = 25
*Therefore, the decision is ‘mail order’

Decision rules assumes that each state of

nature is equally likely

In reality, some states are more likely than

others, and this allows probabilities to be
assigned to each state

The probabilities allow expected values to

be calculated, and therefore, two further
rules follow:
*Maximise expected monetary value
*Minimise expected opportunity loss
EMV
(Maximise Expected Monetary Value)

EMV is the long run average return (or

cost) of making a particular decision

Let’s say, there is a probability of:

*0.45 that the demand will be low, and
*0.25 that demand will be high

So, the probability of medium demand:??

*1- 0.45 - 0.25 = 0.3

The EMV for each decision is as follows:

Nationwide:???
*0.25x95 + 0.3x52 + 0.45x(-26) = 27.65
Mail order:????
*0.25x48 + 0.3x24 + 0.45x19 = 27.75
Sell patent:???
*0.25x25 + 0.3x25 + 0.45x25 = 25
On average, the mail order option gives a
slightly higher payoff at £27,750
Important

EMV calculations are a very useful method

of comparing alternatives

However, the assumptions behind this

method should be borne in mind

Expected values are based on what would

be expected if the decision were repeated
many times (long run average)

One-off decisions cannot, of course, be

repeated and the results obtained from
using this technique should be viewed with
care

However, the technique is so popular &

useful that most decision-makers:
*ignore this reservation
EOL
(Minimise Expected Opportunity Loss)

EOL is essentially the same as the EMV

method, except that the probabilities are
applied to the opportunity loss table and
the option that minimises the expected
opportunity loss is chosen

The EOL values are:

Nationwide:???
*0.25x0 + 0.3x0 + 0.45x51 = 22.95
Mail order:???
*0.25x47 + 0.3x28 + 0.45x6 = 22.85
Sell patent:???
*0.25x70 + 0.3x27 + 0.45x0 = 25.6

The decision that would minimise the EOL

is again the ‘mail order’ option

The EMV and EOL decision rules should

always agree
Value of Perfect Information

A perfect decision could be made every

time, if the state of the market were
known before the decision was made

If it were known that demand would be low,

the best option would be to:???
*sell the patent

And, if demand were known to be high, the

best option would be to:???
*distribute nationwide

The expected value given this perfect

information would be:???
*0.25x95 + 0.3x52 + 0.45x25 = 50.6

The difference between this value and that

obtained earlier for EMV is:???
*50.6 - 27.75 = 22.85, or £22,850
This is known as the:
*value of perfect information

which is:
*the maximum amount that a decision-
maker would be prepared to pay for this
information

You should note that this is the same

figure as the minimum EOL calculated
above