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Introduction to Management Science 8th Edition by Bernard W.

Taylor III

Chapter 12 Decision Analysis

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Chapter Topics
Components of Decision Making Decision Making without Probabilities Decision Making with Probabilities Decision Analysis with Additional Information

Decision Analysis Components of Decision Making

A state of nature is an actual event that may occur in the future.
A payoff table is a means of organizing a decision situation, presenting the payoffs from different decisions given the various states of nature.

Decision Analysis Decision Making without Probabilities

Decision situation:

Table 12.2 Payoff Table for the Real Estate Investments

Decision-Making Criteria: maximax, maximin, minimax, minimax regret, Hurwicz, and equal likelihood
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Decision Making without Probabilities Maximax Criterion

In the maximax criterion the decision maker selects the decision that will result in the maximum of maximum payoffs; an optimistic criterion.

Table 12.3 Payoff Table Illustrating a Maximax Decision

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Decision Making without Probabilities Maximin Criterion

In the maximin criterion the decision maker selects the decision that will reflect the maximum of the minimum payoffs; a pessimistic criterion.

Decision Making without Probabilities Minimax Regret Criterion

Regret is the difference between the payoff from the best decision and all other decision payoffs.
The decision maker attempts to avoid regret by selecting the decision alternative that minimizes the maximum regret.

Table 12.6 Regret Table Illustrating the Minimax Regret Decision

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Decision Making without Probabilities Hurwicz Criterion

The Hurwicz criterion is a compromise between the maximax and maximin criterion.
A coefficient of optimism, , is a measure of the decision makers optimism. The Hurwicz criterion multiplies the best payoff by and the worst payoff by 1- ., for each decision, and the best result is selected.

Decision
Apartment building Office building

Values
\$ 50,000(0.4) + 30,000(0.6) = 38,000 \$ 100,000(0.4) - 40,000(0.6) = 16,000

Warehouse
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Decision Making without Probabilities Equal Likelihood Criterion

The equal likelihood (or Laplace) criterion multiplies the decision payoff for each state of nature by an equal weight, thus assuming that the states of nature are equally likely to occur. Decision Apartment building Office building Warehouse Values \$50,000(0.5) + 30,000(0.5) = 40,000 \$100,000(0.5) - 40,000(0.5) = 30,000 \$30,000(0.5) + 10,000(0.5) = 20,000

Decision Making without Probabilities Summary of Criteria Results

A dominant decision is one that has a better payoff than another decision under each state of nature.
The appropriate criterion is dependent on the risk personality and philosophy of the decision maker. Criterion Maximax Maximin Minimax regret Hurwicz Equal likelihood
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Decision (Purchase) Office building Apartment building Apartment building Apartment building Apartment building
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Decision Making with Probabilities Expected Value

Expected value is computed by multiplying each decision outcome under each state of nature by the probability of its occurrence.
Table 12.7 Payoff table with Probabilities for States of Nature

EV(Apartment) = EV(Warehouse) =
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Decision Making with Probabilities Expected Opportunity Loss

The expected opportunity loss is the expected value of the regret for each decision. The expected value and expected opportunity loss criterion result in the same decision.

Table 12.8 Regret (Opportunity Loss) Table with Probabilities for States of Nature

EOL (Apartment) = \$50,000(0.6) + 0(0.4) = 30,000 EOL (Office)

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Decision Making with Probabilities Expected Value of Perfect Information

The Expected Value of Perfect Information (EVPI) is the maximum amount a decision maker would pay for additional information.

EVPI equals the expected value given perfect information minus the expected value without perfect information.
EVPI equals the expected opportunity loss (EOL) for the best decision.

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Decision Making with Probabilities EVPI Example (2 of 2)

Decision with perfect information: \$100,000(0.60) + 30,000(0.40) = \$72,000 Decision without perfect information: EV(office) = \$100,000(0.60) - 40,000(0.40) = \$44,000 EVPI = \$72,000 - 44,000 = \$28,000 EOL(office) = \$0(0.60) + 70,000(0.4) = \$28,000

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Decision Making with Probabilities Decision Trees (1 of 4)

A decision tree is a diagram consisting of decision nodes, represented as (squares), probability nodes (circles), and decision alternatives (branches).

Table 12.10 Payoff Table for Real Estate Investment Example

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Figure 12.1 Decision Tree for Real Estate Investment Example

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Decision Making with Probabilities Decision Trees (3 of 4)

The expected value is computed at each probability node:
EV(node 2) = 0.60(\$50,000) + 0.40(30,000) = \$42,000

EV(node 3) = 0.60(\$100,000) + 0.40(-40,000) = \$44,000

EV(node 4) = 0.60(\$30,000) + 0.40(10,000) = \$22,000

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Decision Making with Probabilities Decision Trees (4 of 4)

Figure 12.2 Decision Tree with Expected Value at Probability Nodes Chapter 12 - Decision Analysis 19

Decision Analysis with Additional Information Bayesian Analysis (1 of 3)

Bayesian analysis uses additional information to alter the marginal probability of the occurrence of an event. In real estate investment example, using expected value criterion, best decision was to purchase office building with expected value of \$44,000, and EVPI of \$28,000.

Table 12.11 Payoff Table for the Real Estate Investment Example
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Decision Analysis with Additional Information Bayesian Analysis (2 of 3)

A conditional probability is the probability that an event will occur given that another event has already occurred.

Economic analyst provides additional information for real estate investment decision, forming conditional probabilities:
g = good economic conditions

p = poor economic conditions

P = positive economic report N = negative economic report

P(Pg) = 0.80
P(Pp) = 0.10
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P(Ng) = 0.20
P(Np) = 0.90
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Decision Analysis with Additional Information Bayesian Analysis (3 of 3)

A posteria probability is the altered marginal probability of an event based on additional information.

Prior probabilities for good or poor economic conditions in real estate decision: P(g) = 0.60; P(p) = 0.40 Posteria probabilities by Bayes rule:

P( P / g ).P( g ) P( g / P) P( P / g ).P( g ) P( P / p).P( p) (0.8)(0.6) 0.923 (0.8)(0.6) (0.1)(0.4)

Posteria (revised) probabilities for decision: P(gN) = 0.250 P(pP) = 0.077 P(pN) = 0.750
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Decision Analysis with Additional Information Computing Posterior Probabilities with Tables

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Decision Analysis with Additional Information Decision Trees with Posterior Probabilities (1 of 4)
Decision tree with posterior probabilities differ from earlier versions in that: Two new branches at beginning of tree represent report outcomes.

Probabilities of each state of nature are posterior

probabilities from Bayes rule.

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Decision Analysis with Additional Information Decision Trees with Posterior Probabilities (2 of 4)

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Decision Analysis with Additional Information Decision Trees with Posterior Probabilities (3 of 4)
EV (apartment building) = \$50,000(0.923) + 30,000(0.077) = \$48,460 EV (strategy) = \$89,220(0.52) + 35,000(0.48) = \$63,194

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Decision Analysis with Additional Information Decision Trees with Posterior Probabilities (4 of 4)

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Decision Analysis with Additional Information Expected Value of Sample Information

The expected value of sample information (EVSI) is the
difference between the expected value with and without information:

For example problem, EVSI = \$63,194 - 44,000 = \$19,194

The efficiency of sample information is the ratio of the expected value of sample information to the expected value of perfect information: efficiency = EVSI /EVPI = \$19,194/ 28,000 = .68

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Decision Analysis with Additional Information Utility (2 of 2)

Expected Cost (insurance) = 0.992(\$500) + 0.008(500) = \$500

Expected Cost(no insurance)= 0.992(\$0) + 0.008(10,000) = \$80

Decision should be do not purchase insurance, but people almost always do purchase insurance.

Utility is a measure of personal satisfaction derived from money

Utiles are units of subjective measures of utility. Risk averters forgo a high expected value to avoid a lowprobability disaster. Risk takers take a chance for a bonanza on a very lowprobability event in lieu of a sure thing.
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Decision Analysis Example Problem Solution (1 of 9)

States of Nature Decision Expand Maintain Status Quo Sell now Good Foreign Competitive Conditions \$ 800,000 1,300,000 320,000 Poor Foreign Competitive Conditions \$ 500,000 -150,000 320,000

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Decision Analysis Example Problem Solution (2 of 9)

a. Determine the best decision without probabilities using the 5 criteria of the chapter. b. Determine best decision with probabilities assuming 0.70 probability of good conditions, 0.30 of poor conditions. Use expected value and expected opportunity loss criteria. c. Compute expected value of perfect information. d. Develop a decision tree with expected value at the nodes. e. Given following, P(Pg) = 0.70, P(Ng) = 0.30, P(Pp) = 20, P(Np) = 0.80, determine posteria probabilities using Bayes rule. f. Perform a decision tree analysis using the posterior probability obtained in part e.
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Decision Analysis Example Problem Solution (3 of 9)

Step 1 (part a): Determine decisions without probabilities.
Maximax Decision: Maintain status quo Decisions Maximum Payoffs

Expand Status quo Sell

Decisions Expand Status quo Sell
Chapter 12 - Decision Analysis

\$800,000 1,300,000 (maximum) 320,000

Minimum Payoffs \$500,000 (maximum) -150,000 320,000
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Decision Analysis Example Problem Solution (4 of 9)

Minimax Regret Decision: Expand
Decisions Expand Maximum Regrets \$500,000 (minimum)

Status quo
Sell

650,000
980,000

Expand
Status quo Sell

\$800,000(0.3) + 500,000(0.7) = \$590,000

\$1,300,000(0.3) - 150,000(0.7) = \$285,000 \$320,000(0.3) + 320,000(0.7) = \$320,000

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Decision Analysis Example Problem Solution (5 of 9)

Equal Likelihood Decision: Expand
Expand Status quo \$800,000(0.5) + 500,000(0.5) = \$650,000 \$1,300,000(0.5) - 150,000(0.5) = \$575,000

Sell

\$320,000(0.5) + 320,000(0.5) = \$320,000

Step 2 (part b): Determine Decisions with EV and EOL. Expected value decision: Maintain status quo

Expand
Status quo Sell

\$800,000(0.7) + 500,000(0.3) = \$710,000

\$1,300,000(0.7) - 150,000(0.3) = \$865,000 \$320,000(0.7) + 320,000(0.3) = \$320,000

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Decision Analysis Example Problem Solution (6 of 9)

Expected opportunity loss decision: Maintain status quo
Expand Status quo \$500,000(0.7) + 0(0.3) = \$350,000 0(0.7) + 650,000(0.3) = \$195,000

Sell

\$980,000(0.7) + 180,000(0.3) = \$740,000

Step 3 (part c): Compute EVPI. EV given perfect information = 1,300,000(0.7) + 500,000(0.3)

= \$1,060,000
EV without perfect information = \$1,300,000(0.7) - 150,000(0.3) = \$865,000

EVPI = \$1.060,000 - 865,000 = \$195,000

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Decision Analysis Example Problem Solution (7 of 9)

Step 4 (part d): Develop a decision tree.

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Decision Analysis Example Problem Solution (8 of 9)

Step 5 (part e): Determine posterior probabilities.
P(gP) = P(Pg) P(g) / [P(Pg) P(g) + P(Pp) P(p)] = (0.70)(0.70)/[(0.70)(0.70) + (0.20)(0.30)] = 0.891 P(pP) = 0.109

P(gN) = P(Ng) P(g) / [P(Ng) P(g) + P(Np) P(p)]

= (0.30)(0.70)/[(0.30)(0.70) + (0.80)(0.30)] = 0.467 P(pN) = 0.533

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Decision Analysis Example Problem Solution (9 of 9)

Step 6 (part f):
Decision tree analysis.

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