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Lecture Outline

     Decision Analysis Decision Making without Probabilities Decision Making with Probabilities Expected Value of Perfect Information Sequential Decision Tree

Decision Making Without Probabilities  States of nature   Events that may occur in the future Examples of states of nature:   high or low demand for a product good or bad economic conditions  Decision making under risk  probabilities can be assigned to the occurrence of states of nature in the future probabilities can NOT be assigned to the occurrence of states of nature in the future  Decision making under uncertainty  .

Payoff Table Payoff: outcome of a decision States Of Nature Decision a b 1 Payoff 1a Payoff 1b 2 Payoff 2a Payoff 2b .

Decision Making Criteria Under Uncertainty  Maximax  Choose decision with the maximum of the maximum payoffs  Maximin  Choose decision with the maximum of the minimum payoffs Choose decision with the minimum of the maximum regrets for each alternative  Minimax regret  .

Decision Making Criteria Under Uncertainty (cont.)  Hurwicz   Choose decision in which decision payoffs are weighted by a coefficient of optimism. alpha Coefficient of optimism is a measure of a decision maker’s optimism. from 0 (completely pessimistic) to 1 (completely optimistic) Choose decision in which each state of nature is weighted equally  Equal likelihood (La Place)  .

300.000 .000 $ 800.000 -150.Southern Textile Company STATES OF NATURE Good Foreign Poor Foreign DECISION Expand Maintain status quo Sell now Competitive Conditions Competitive Conditions 1.000 320.000 320.000 $ 500.

000 320.300.000 $ 800.000 Decision: Expand .Maximax Solution STATES OF NATURE Good Foreign Poor Foreign Competitive Conditions DECISION Expand Maintain status quo Sell now Competitive Conditions 1.300.000 320.000  Maximum $800.000 320.000 Expand: Status quo: Sell: 1.000 $ 500.000 -150.

Maximin Solution STATES OF NATURE Good Foreign Poor Foreign Competitive Conditions DECISION Expand Maintain status quo Sell now Competitive Conditions 1.000 Expand: -150.000 Decision: Maintain status quo .000 $ 800.000 $ 500.000 320.000 -150.000  Maximum Sell: 320.300.000 Status quo: $500.000 320.

800.300.000 .000  Minimum 980.(-150.000 .000)= 650.000 .000= 180.Minimax Regret Solution Good Foreign Competitive Conditions Poor Foreign Competitive Conditions 1.000 $1.000 Expand: Status quo: Sell: 650.320.1.000 .000 = 980.000 .000 = 0 1.300.300.320.300.000 .000 = 0 500.000 = 500.000 $500.000 500.000 Decision: Status Quo .500.000 $500.

000(0.3) -150.000 $ 500.000(0.300.000(0.7) = 320.7 Expand: 1.000 $ 800.3) + 500.000 320.Hurwicz Criteria STATES OF NATURE Good Foreign Poor Foreign Competitive Conditions DECISION Expand Maintain status quo Sell now Competitive Conditions 1.000 Status quo: $800.3 1 .000 Decision: Status Quo .3) + 320. = 0.000(0.7) = 285.000 Maximum Sell: 320.000 -150.000  = 0.000(0.000 320.300.000(0.7) = $590.

000 320.5) -150.5) = 575.000(0.5) = 320.000(0.000 320.5) = $650.000 Decision: Status Quo .000 Status quo: $800.000 1.50 Expand: 1.000(0.5) + 500.5) + 320.000(0.000 -150.300.300.000(0.000 $ 500.000 Two states of nature each weighted 0.000(0.000  Maximum Sell: 320.Equal Likelihood Criteria STATES OF NATURE Good Foreign Poor Foreign Competitive Conditions DECISION Expand Maintain status quo Sell now Competitive Conditions $ 800.

Decision Making with Probabilities  Risk involves assigning probabilities to states of nature  Expected value  a weighted average of decision outcomes in which each future state of nature is assigned a probability of occurrence .

Expected value EV (x) = where xi = outcome i p(xi) = probability of outcome i  p(xi)xi i =1 n .

300.000 EV(sell): 320.300.000 320.000 $ 500.000 -150.000 $ 800.Decision Making with Probabilities: Example STATES OF NATURE Good Foreign Poor Foreign Competitive Conditions DECISION Expand Maintain status quo Sell now Competitive Conditions 1.70 p(poor) = 0.000(0.7) + 320.3) = 865.000(0.000 EV(expand): 1.000  Maximum EV(status quo): $800.000(0.3) = $710.000(0.000(0.30 Decision: Expand .000 p(good) = 0.000 320.7) -150.7) + 500.3) = 320.000(0.

Expected Value of Perfect Information  EVPI  maximum value of perfect information to the decision maker  Maximum amount that an investor would pay to purchase perfect information .

70) + 500.30) = $1.300.000  Poor conditions will exist 30% of the time  choose expand with payoff of $500.000 (0.300.000  Recall that expected value without perfect information was $865.000 .000 (0.060.EVPI Example  Good conditions will exist 70% of the time  choose maintain status quo with payoff of $1.865.000 (maintain status quo)  EVPI= $1.000 = $195.000  Expected value given perfect information = $1.000 .060.

Sequential Decision Trees  A graphical method for analyzing decision situations that require a sequence of decisions over time  Decision tree consists of  Square nodes .indicating decision points  Circles nodes .indicating states of nature  Arcs .connecting nodes .

300.000 $2.40 $225.290.000 $1.000 0.000 $450.000 Market growth $2.000 4 6 0.000 5 7 0.540.160.000 .000 0.000 0.000 $210.000 1 $1.000 0.000.000.390.000.740.80 $3.Decision Tree Analysis $1.60 3 $1.40 $790.30 $2.000 $1.60 2 0.000 0.70 $1.360.20 $700.

000) = $2.Evaluations at Nodes Compute EV at nodes 6 & 7 EV(node 6)= 0.300.000.540.390.000 EV(node 7)= 0.000 for Sell land Choose Expand Repeat expected value calculations and decisions at remaining nodes .80($3.70($1.000.20($700.000) + 0.540.000 for Expand and $450.000) + 0.000 Decision at node 4 is between $2.000)= $1.30($2.