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**Decision-Making Tools
**

A-1

Outline

♦ Decision Making & Models. ♦ Decision Tables.

♦

Decision making under uncertainty. ♦ Decision making under risk. ♦ Expected value of perfect information (EVPI).

♦ Decision Trees.

A-2

**The Decision-Making Process
**

Quantitative Analysis Logic Historical Data Marketing Research Scientific Analysis Modeling Qualitative Analysis Emotions Intuition Personal Experience and Motivation Rumors

A-3

Problem

Decision

**Models and Scientific Management
**

♦ Can Help Managers to: to

♦ Gain

**deeper insights into the business. better decisions!
**

♦ Better

♦ Make

assess alternative plans and actions.

♦ Quantify,

reduce and understand the uncertainty surrounding A-4 business plans and actions.

♦ Establish decision criteria. Steps to Good Decisions . ♦ Identify and evaluate alternatives using decisionmaking tool (model).♦ Define problem and influencing factors. ♦ Select decision-making tool (model). A-5 ♦ Implement decision. ♦ Select best alternative.

A-6 ♦ .Benefits of Models ♦ Allow better and faster decisions. ♦ Allow managers to ask “What if…?” questions. ♦ Force a consistent and systematic approach to the analysis of problems. ♦ Less expensive and disruptive than experimenting with the real world system.

♦ May downplay the value of qualitative information. ♦ Due to mathematical and logical complexity. ♦ May be unused. misused or misunderstood (and feared!). A-7 . ♦ May use assumptions that oversimplify the real world.Limitations of Models ♦ May be expensive and timeconsuming to develop and test.

A-8 . Decision-maker chooses among alternatives.Decision Theory Terms: Alternative: Course of action or choice. State of nature: An occurrence over which the decision maker has no control.

Decision Table States of Nature State 1 State 2 Alternativ Outcome 1 Outcome 2 e1 Alternativ Outcome 3 Outcome 4 e2 A-9 .

or (2) construct a small plant. then the result is a profit of $100.A firm has two options for expanding production of a product: (1) construct a large plant. If a small plant is constructed and the market is favorable. Of A-10 Example . If a large plant is constructed and the market is unfavorable. If a small plant is constructed and the market is unfavorable.000. If a large plant is constructed and the market is favorable. Whether or not the firm expands.000. the future market for the product will be either favorable or unfavorable.Decision Making Under Uncertainty . then the result is a profit of $200.000. then the result is a loss of $20. then the result is a loss of $180.000.

Example .000 $0 $0 A-11 .000 -$20.Decision Making Under Uncertainty States of Nature Alternatives avorable F Unfavorable large plant Construct $100.000 -$180.000 small plant Do nothing Market Market Construct $200.

Criteria ♦ Maximax .Choose A-12 alternative with the highest .Choose alternative that maximizes the minimum outcome for every alternative (Pessimistic criterion). ♦ Maximin . ♦ Expected Value .Decision Making Under Uncertainty .Choose alternative that maximizes the maximum outcome for every alternative (Optimistic criterion).

000 -$20.Example .000 $0 $0 Maximax decision is to construct large plant.Maximax States of Nature Alternatives avorable F Unfavorable large plant Construct $100.000 small plant Do nothing Market Market Construct $200. A-13 .000 -$180.

000 -$180. (Maximum of minimums for each A-14 alternative) .Example .000 -$20.000 $0 $0 $0 Maximin decision is to do nothing.000 -$20.000 small plant Do nothing in Row Market Market Construct $200.000-$180.Maximin States of Nature Alternatives avorable F Unfavorable Minimum large plant Construct $100.

♦ EV = Average return for alternative if decision were repeated many times. ♦ Select alternative with largest expected value (EV).♦ Probabilistic decision situation. Decision Making Under Risk ♦ States of nature have probabilities of occurrence. A-15 .

Expected Value Equation Number of states of nature Value of Payoff Probability of payoff EV (Ai )= Σ Vi *P (Vi ) i=1 N =V1 *P (V1)+V2 * P (V2 )+..+ N * P (VN ) V Alternative i A-16 ..

Expected Value large plant Construct $100.000 -$180.000 -$20.000 $0 $0 $0 Decision is to “Construct small plant”.000 $10.5 States of Nature Alternatives avorable F Unfavorable Example . A-17 .000 small plant Do nothing Expect ed Market Market Value Construct $200.Suppose: Probability of favorable market = 0.000 $40.5 Probability of unfavorable market = 0.

000 $64.000 $86.000 $0 $0 $0 Now. . decision is to “Construct large A-18 plant”.000 small plant Do nothing Expect ed Market Market Value Construct $200.Expected Value large plant Construct $100.3 States of Nature Alternatives avorable F Unfavorable Example .7 Probability of unfavorable market = 0.000 -$180.Suppose: Probability of favorable market = 0.000 -$20.

000x .20.000x .000 -$180.180.Expected Value States of Nature Alternatives avorable F Unfavorable large plant Construct $100.Over what range of values for probability of favorable market is “Construct large plant” preferred? Example .000 -$20.000 small plant Do nothing Expected Market Market Value Construct $200.000 380.000 $0 $0 Solve for x: 380000x-180000 > 120000x-20000 A-19 .000 120.

180000 > 120000x .6154. as long as probability of a favorable market exceeds 0.Over what range of values for probability of favorable market is “Construct large plant” preferred? Solve for x: 380000x .Expected Value .20000 x > 0.6154 So. A-20 Example . then “Construct large plant”.

♦ EVPI is the maximum you should pay to learn the future.maximum EV A-21 . ♦ EVPI is the expected value under certainty (EVUC) minus the maximum EV. EVPI = EVUC .Expected Value of Perfect Information (EVPI) bound on ♦ EVPI places an upper what one would pay for additional information.

Expected Value Under Certainty (EVUC) EVU = ∑ (Best outcome for the state of * P(Sj ) j= 1 nature j) C where: P(Sj ) = The probability of state of nature j. n A-22 . n = Number of states of nature.

EVUC States of Nature Alternatives avorable F Unfavorable large plant Construct $100.000 -$20.000 $0 $0 Best outcome for Favorable Market = $200.000 small plant Do nothing Market Market Construct $200.Example .000-$180.000 Best outcome for Unfavorable A-23 .

000*0.000 Thus.Expected Value of Perfect Information Suppose: Probability of favorable market = 0.$40.000 = $60. you should be willing to pay up to $60.max(EV) EVPI = 0.5 Probability of unfavorable market = EVUC .50 + 0*0.5 EV = ($200.000 to learn whether A-24 the market will be favorable or .50) .

70 + 0*0.000 Now.Expected Value of Perfect Information Now suppose: Probability of favorable market = 0.30) .000 to learn whether A-25 the market will be favorable or .000 = $54.000*0.$86.3 EV = ($200. you should be willing to pay up to $54.7 Probability of unfavorable market = EVUC .max(EV) EVPI = 0.

♦ Used for solving problems with several sets of alternatives and states of nature (sequential decisions). ♦ Expected Value criterion is used. A-26 .Decision Trees ♦ Graphical display of decision process. ♦ Decision tables can not be used for more than one decision.

Using Decision Trees ♦ Define the problem. ♦ Estimate payoffs for each combination of alternatives and states of nature. ♦ Draw the decision tree. ♦ Solve the problem: ♦ Compute expected values for each state-of-nature node moving right A-27 . ♦ Assign probabilities to all states of nature.

Symbols used in decision tree: A decision node from which one of several alternatives may be selected. A-28 A state of nature node out of which .Decision Theory Terms: ♦ Alternative: Course of action or choice. ♦ State of nature: An occurrence over which the decision maker has no control.

Decision Tree State 1 e1 tiv a rn lte A lt ern ati ve 2 1 State 2 State 1 Outcome 1 Outcome 2 2 Decision Node Outcome 3 State 2 Outcome 4 State of Nature Node A-29 .

000 $0 A-30 .7) rge Unfavorable Mkt (0.000 th in g $200.000 d uil B Bui ld S Favorable Mkt (0.7) ma $100.3) no -$20.000 ll Do Unfavorable Mkt (0.Decision Tree for Example Favorable Mkt (0.3) La -$180.

Decision Tree for Example .000 d uil B Bui ld S $64.000 ll 0 Do Unfavorable Mkt (0.7) ma $100.Solution $86.000 Favorable Mkt (0.00 Favorable Mkt (0.7) rge Unfavorable Mkt (0.3) La -$180.000 th in g $0 $200.000 $0 A-31 .3) no -$20.

they can do nothing and payoff is $45 million. there is a 30% chance the demand drops off and the payoff will be $35 million.Decision Tree Example A firm can build a large plant or small plant initially (for a new product). If they expand. (The probability of low demand is 0. they can do nothing and payoff is - . If they build “large” and demand is “high”. or they can expand. If they build “small” and demand is “high”. the payoff is $40 million.) If they build “small” and demand is “low”. and a 70% chance the demand grows and the payoff is $48 million. the payoff is $60 million. The probability of high demand is 0. Demand for the new product will be high or low initially.6.4. If they build “large” and A-32 demand is “low”.

then demand “Grows” A-33 (0.4) initially. If build “Small” and demand is “High”.7) or demand “Drops” (0. demand is “High”. 3. then decide to “Reduce prices” or “Do nothing”. 2. then “Expand” or “Do nothing”. 2. Two states of nature: 1. If build “Large” and demand is “Low”. Demand is “High” (0. and decision is “Expand”.3).Decision Tree Example Three decisions: 1. . Build “Large” or “Small” plant initially.6) or “Low” (0. If build “Small”.

Decision Tree Demand grows (0. 4) $20 -$10 3 Do nothing A-34 .7) ) .6 2 (0 $48 $35 $45 d an p Ex Demand drops (0. 4) $40 $60 Reduce prices 1 Bu ild lar ge .6) igh (0 H Lo w (0.3) d uil B all m s h ig H Do nothing Low (0.

A-35 . Choose “Reduce prices” (20 > -10).Decision Tree Solution Work right to left (from end back to beginning). Start with Decision 3: “Reduce prices” or “Do nothing”.

6) igh (0 H Lo w (0. 4) $20 3 $20 -$10 A-36 .3) d uil B all m s h ig H Do nothing Low (0.Decision Tree Demand grows (0. 4) $40 $60 Reduce prices Do nothing 1 Bu ild lar ge .7) ) .6 2 (0 $48 $35 $45 d an p Ex Demand drops (0.

To compare outcomes we need expected value if we “Expand”: (48*0. A-37 .7) + (35*0.1).1 Choose “Do nothing” (45 > 44.3) = 44.Decision Tree Solution Consider Decision 2: “Expand” or “Do nothing”.

4) $40 $60 Reduce prices Do nothing 1 Bu ild lar ge .3) $48 $35 $45 $45 Do nothing d uil B all m s Low (0. d an 1 $45xp Demand grows (0.Decision Tree h ig H ) E .7) Demand drops (0.6) igh (0 H Lo w (0. 4) $20 3 $20 -$10 A-38 .6 2 (0 $44.

Decision Tree $43 ig H h ) E . 4) $20 3 $20 -$10 A-39 .6 2 (0 $44. d an 1 $45xp Demand grows (0. 4) $40 $60 Reduce prices Do nothing 1 Bu ild lar ge $44 igh (0.3) $48 $35 $45 $45 Do nothing d uil B all m s Low (0.6) H Lo w (0.7) Demand drops (0.

Expected payoff = $44 million.Decision Tree Final Solution Decisions: 1. Build “Large”. 2. A-40 . If demand is “Low”. then “Reduce prices”.

6 $8 $12 $9 $11 $6 $12 $8 $9 $8 .3 0.3 A-41 0.Larger Decision Tree $10 2 0.4 0.4 0.4 0.5 1 0.3 0.6 3 0.2 0.

4 0.3 A-42 1 $9.4 0.2 $10.6 0.6 $8 $12 $9 $10.Larger Decision Tree Solution $10 $10.4 0.4 0.6 $9.3 0.28 0.4 2 0.6 3 $6 $12 $8 $9 $8 $8.3 0.5 $11 0.3 .

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