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Economy, 6

th

Edition, 2005

2005 by McGraw-Hill, New York, N.Y All Rights Reserved

19-1

Developed By:

Dr. Don Smith, P.E.

Department of Industrial

Engineering

Texas A&M University

College Station, Texas

Executive Summary Version

Chapter 19

More on Variation and

Decision Making

Under Risk

Slide Sets to accompany Blank & Tarquin, Engineering

Economy, 6

th

Edition, 2005

2005 by McGraw-Hill, New York, N.Y All Rights Reserved

19-2

LEARNING OBJECTIVES

1. Certainty and

risk

2. Variables and

distributions

3. Random samples

4. Average and

dispersion

5. Monte Carlo

simulation

Slide Sets to accompany Blank & Tarquin, Engineering

Economy, 6

th

Edition, 2005

2005 by McGraw-Hill, New York, N.Y All Rights Reserved

19-3

Sct 19.1 Interpretation of Certainty, Risk,

and Uncertainty

Certainty Everything know for sure; not present in

the real world of estimation, but can be assumed

Risk a decision making situation where all of the

outcomes are know and the associated probabilities

are defined

Uncertainty One has two or more observable values

but the probabilities associated with the values are

unknown

Observable values states of nature

See Example 19.1 about risk

Slide Sets to accompany Blank & Tarquin, Engineering

Economy, 6

th

Edition, 2005

2005 by McGraw-Hill, New York, N.Y All Rights Reserved

19-4

Types of Decision Making

Decision Making under Certainty

Process of making a decision where all of the input

parameters are known or assumed to be known

Outcomes known

Termed a deterministic analysis

Parameters are estimated with certainty

Decision Making under Risk

Inputs are viewed as uncertain, and element of chance is

considered

Variation is present and must be accounted for

Probabilities are assigned or estimated

Involves the notion of random variables

Slide Sets to accompany Blank & Tarquin, Engineering

Economy, 6

th

Edition, 2005

2005 by McGraw-Hill, New York, N.Y All Rights Reserved

19-5

Two Ways to Consider Risk in

Decision Making

Expected Value (EV) analysis

Applies the notion of expected value (Chapter 18)

Calculation of EV of a given outcome

Selection of the outcome with the most

advantageous outcome

Simulation Analysis

Form of generating artificial data from assumed

probability distributions

Relies on the use of random variables and the laws

associated with the algebra of random variables

Slide Sets to accompany Blank & Tarquin, Engineering

Economy, 6

th

Edition, 2005

2005 by McGraw-Hill, New York, N.Y All Rights Reserved

19-6

Sct 19.2 Elements Important to Decision

Making Under Risk

The concept of a random variable

A decision rule that assigns an outcome to a

sample space

Discrete variable or Continuous variable

Discrete variable finite number of outcomes possible

Continuous variable infinite number of outcomes

Probability

Number between 0 and 1

Expresses the chance in decimal form that a

random variable will take on any specific value

Slide Sets to accompany Blank & Tarquin, Engineering

Economy, 6

th

Edition, 2005

2005 by McGraw-Hill, New York, N.Y All Rights Reserved

19-7

Types of Random Variables

Continuous

Discrete

Slide Sets to accompany Blank & Tarquin, Engineering

Economy, 6

th

Edition, 2005

2005 by McGraw-Hill, New York, N.Y All Rights Reserved

19-8

Distributions - Continuous Variables

Probability Distribution (pdf)

A function that describes how

probability is distributed over the

different values of a variable

P(X

i

) = probability that X = X

i

Cumulative Distribution (cdf)

Accumulation of probability over

all values of a variable up to and

including a specified value

F(X

i

) = sum of all probabilities

through the value X

i

= P(X s X

i

)

Slide Sets to accompany Blank & Tarquin, Engineering

Economy, 6

th

Edition, 2005

2005 by McGraw-Hill, New York, N.Y All Rights Reserved

19-9

Three Common Random Variables

Uniform equally likely

outcomes

Triangular

Normal

Study

Example 19.3

Slide Sets to accompany Blank & Tarquin, Engineering

Economy, 6

th

Edition, 2005

2005 by McGraw-Hill, New York, N.Y All Rights Reserved

19-10

Discrete Density and Cumulative Example

pdf cdf

Slide Sets to accompany Blank & Tarquin, Engineering

Economy, 6

th

Edition, 2005

2005 by McGraw-Hill, New York, N.Y All Rights Reserved

19-11

Sct 19.3 Random Samples

Random Sample

A random sample of size n is the selection in a

random fashion with an assumed or known

probability distribution such that the values of the

variable have the same chance of occurring in the

sample as they appear in the population

Basis for Monte Carlo Simulation

Can sample from:

Discrete distributions or

Continuous distributions

Slide Sets to accompany Blank & Tarquin, Engineering

Economy, 6

th

Edition, 2005

2005 by McGraw-Hill, New York, N.Y All Rights Reserved

19-12

Sampling from a Continuous Distribution

Form the cumulative

distribution in closed

form from the pdf

Generate a uniform random

number on the interval

{0 1}, called U(0,1)

Locate U(0,1) point on y-axis

Map across to intersect the cdf

function

Map down to read the outcome

(variable value) on x-axis

Slide Sets to accompany Blank & Tarquin, Engineering

Economy, 6

th

Edition, 2005

2005 by McGraw-Hill, New York, N.Y All Rights Reserved

19-13

Sct 19.4 Expected Value and Standard

Deviation

Two important parameters of a given random

variable:

Mean -

Measure of central tendency

Standard Deviation - o

Measure of variability or spread

Two Concepts to work within

Population

Sample from a population

Slide Sets to accompany Blank & Tarquin, Engineering

Economy, 6

th

Edition, 2005

2005 by McGraw-Hill, New York, N.Y All Rights Reserved

19-14

Sample

Population vs Sample

Population

- population mean

o

2

- population

variance

o - population

standard deviation

Often sample from a

population in order to

make estimates

X

2

s

s

Sample mean

Sample variance

Sample standard

deviation

These values, properly sampled,

attempt to estimate their population

counterparts

Slide Sets to accompany Blank & Tarquin, Engineering

Economy, 6

th

Edition, 2005

2005 by McGraw-Hill, New York, N.Y All Rights Reserved

19-15

Important Relationships

Population Mean

Distribution

E(x) =

Sample

Measure of the central tendency of the population

If one samples from a population the hope is that

sample mean is an unbiased estimator of the true,

but unknown, population mean

( )

i i

X P X

i i i

X f X

n n

=

Slide Sets to accompany Blank & Tarquin, Engineering

Economy, 6

th

Edition, 2005

2005 by McGraw-Hill, New York, N.Y All Rights Reserved

19-16

Variance and Standard Deviation

Notes relating to

variance and standard

deviation properties

Illustration of variances

for discrete and

continuous distributions

Slide Sets to accompany Blank & Tarquin, Engineering

Economy, 6

th

Edition, 2005

2005 by McGraw-Hill, New York, N.Y All Rights Reserved

19-17

Population vs. Sample

Variance of a population

Standard deviation of a

population:

N

2

i

i=1

(x )

N

o

=

2

Var(X)

X X

o o = =

N

2

i

2

i=1

(x )

N

o

=

Variance of a sample

Standard deviation of a sample

2

2 2

1 1

i

X

n

s X

n n

=

population standard deviation

Slide Sets to accompany Blank & Tarquin, Engineering

Economy, 6

th

Edition, 2005

2005 by McGraw-Hill, New York, N.Y All Rights Reserved

19-18

Combining the Average and Standard

Deviation

Determine the percentage or fraction of the sample

that is within 1, 2, 3 standard deviations of the

sample mean . . .

In terms of probability

Virtually all of the sample values will fall within the

3s range of the sample mean

See example 19.6

, t = 1,2,3 X ts

P( ) X ts X X ts s s +

Slide Sets to accompany Blank & Tarquin, Engineering

Economy, 6

th

Edition, 2005

2005 by McGraw-Hill, New York, N.Y All Rights Reserved

19-19

Continuous Random Variables

Expected value:

Variance:

For uniform pdf in Example 19.3:

( ) ( )

R

Xf x dx E X =

}

2 2

( ) ( ) [ ( )]

R

Var x X f X dX E X =

}

R represents the defined range of the

variable in question.

10

2 15

R

2 2 3 15 2

10

1

0.2 $10 X $15

5

E(X)= (0.2)Xdx=0.1X 0.1(225 100) $12.50

0.2

( ) (0.2) (12.5) (12.5)

3

=0.06667(3375-1000)-156.25=2.08

2.08 $1.44

( )

R

X

Var X X dX X

f x

o

= s s

= =

= =

= =

=

}

}

Slide Sets to accompany Blank & Tarquin, Engineering

Economy, 6

th

Edition, 2005

2005 by McGraw-Hill, New York, N.Y All Rights Reserved

19-20

Sct 19.5 Monte Carlo Sampling and

Simulation Analysis

Simulation involves the generation of artificial

data from a modeled system

Monte Carlo Sampling

The generation of samples of size n for selected

parameters of formulated alternatives

The sampled parameters are expected to vary

according to a stated probability distribution

(assumed)

Slide Sets to accompany Blank & Tarquin, Engineering

Economy, 6

th

Edition, 2005

2005 by McGraw-Hill, New York, N.Y All Rights Reserved

19-21

Key Assumption - Independence

For a given problem:

All parameters are assumed to be independent

One variables distribution in no way impacts any

other variables distribution

Termed:

Property of independent random variables

The modeling approach follows a 7-step

process (page 678)

Slide Sets to accompany Blank & Tarquin, Engineering

Economy, 6

th

Edition, 2005

2005 by McGraw-Hill, New York, N.Y All Rights Reserved

19-22

Simulation

Monte Carlo Sampling is a traditional

approach (method) for generating pseudo-

random numbers (RN) to sample from a

prescribed probability distribution.

Pseudo-random refers to the fact that a digital

computer can generate approximately random

numbers due to fixed word size and round off

problems.

Slide Sets to accompany Blank & Tarquin, Engineering

Economy, 6

th

Edition, 2005

2005 by McGraw-Hill, New York, N.Y All Rights Reserved

19-23

Sampling Process

Requires:

The cdf of the assumed pdf;

A uniform random number generator;

Application of the inverse transform approach.

Why require the cdf?

The y-axis of a cdf is scaled from 0 to 1.

That is the same as the range of U(0,1).

Facilitates mapping a RN to achieve the outcome value on

the x-axis.

The U(0,1) selects a X-value from the cdf.

Slide Sets to accompany Blank & Tarquin, Engineering

Economy, 6

th

Edition, 2005

2005 by McGraw-Hill, New York, N.Y All Rights Reserved

19-24

The Need for the cdf

x-axis: Outcome values

Cumulative probability on the y-axis

Generate a

U(0,1) random

number: Locate

that value on the

y-axis: Map

across to the cdf

then map down

to the x-axis to

obtain the

outcome

Slide Sets to accompany Blank & Tarquin, Engineering

Economy, 6

th

Edition, 2005

2005 by McGraw-Hill, New York, N.Y All Rights Reserved

19-25

Summary of the Modeling Steps

Formulate the economic analysis:

The alternatives if more than one;

Define which parameters are constants and

which are to be viewed as random variables.

For the random variables, assign the appropriate

pdf:

Discrete and or continuous.

Apply Monte Carlo sampling a sample size of n

where it is suggested that n = 30.

Compute the measure of worth (PW, AW, . . )

Evaluate and draw conclusions.

Slide Sets to accompany Blank & Tarquin, Engineering

Economy, 6

th

Edition, 2005

2005 by McGraw-Hill, New York, N.Y All Rights Reserved

19-26

Examples to Study

Examples 19.7 and 19.8 offer detailed

analyses of a simulated economic analysis

Also, refer to the Additional Examples at the

end of the chapter

Example 19.10 applying the normal distribution

Slide Sets to accompany Blank & Tarquin, Engineering

Economy, 6

th

Edition, 2005

2005 by McGraw-Hill, New York, N.Y All Rights Reserved

19-27

Chapter Summary

To perform decision making under risk implies

that some parameters of an engineering

alternative are treated as random variables.

Assumptions about the shape of the variable's

probability distribution are used to explain how the

estimates of parameter values may vary.

Additionally, measures such as the expected

value and standard deviation describe the

characteristic shape of the distribution.

Slide Sets to accompany Blank & Tarquin, Engineering

Economy, 6

th

Edition, 2005

2005 by McGraw-Hill, New York, N.Y All Rights Reserved

19-28

Summary - continued

In this chapter, we learned several of the simple,

but useful, discrete and continuous population

distributions used in engineering economy -

uniform and triangular - as well as specifying our

own distribution or assuming the normal

distribution.

It is important to note that a sound

background in applied statistics is vital to the

complete understanding of the simulation

process

Slide Sets to accompany Blank & Tarquin, Engineering

Economy, 6

th

Edition, 2005

2005 by McGraw-Hill, New York, N.Y All Rights Reserved

19-29

Chapter 19

End of Set

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