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- Chap 13
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Decision Analysis

Introduction

Decision

determine the optimal strategies

when a decision-maker is faced with

several decision alternatives and an

uncertain future events.

Introduction

Possibilities

Certainty

Uncertainty

Risk

to consider

Mathematical Expectation

(ME) or Expected Value (EV)

It

that the event will occur and the

amount to be received upon such

occurrence.

Computation of EV

Let

be the amount of money.

EV = P(X)

If

outcomes with probability P1, P2, ...,

Pn and if X denotes a discrete

variable which can assume the

values X1, X2, ..., Xn then

EV = P1X1 + P2X2 +...+ PnXn

Example 1

A

heads, Chito will receive P6, and pay

P4 if it lands tails. Find the EV.

EV

= (0.50)(6) + (0.50)(-4) = P1

This

Chito

Example 2

Consider

the

following

game

of

chance.

Mark pays P200 and roll a fair die. Then

following

schedule.

If

the

event

A={1,2,3} occurs, then he will receive

P100. If the event B={4,5} occurs, Mark

receives P200. If the event C = {6}

occurs, then he will receive P600. What

is the average profit he can make if he

Example 2 - Solution

100-200=-100 (Mark will lose P100)

200-200=0

every time he plays this game.

Example 3

The

manager has to decide whether to

accept a bid or not. If the manager

accepts the bid, the construction

company may gain p3.5 million if it

succeeds, or lose P2.5 million if it

fails. The probability that it will

succeed is 30%. Find the EV if the

company accepts the bid.

Example 3 - Solution

The

decide whether to accept a bid or not. If the manager

accepts the bid, the construction company may gain

p3.5 million if it succeeds, or lose P2.5 million if it fails.

The probability that it will succeed is 30%. Find the EV

if the company accepts the bid.

P1

= 30% X1 = 3.5

P2 = 70% X2 = -2.5

This

EV = -0.7

Decision-making Under

Certainty

The

with the best payof for the known event

Payof consequence resulting from a specific combination of a

Best

alternative

profits

Lowest payoff if the payoffs are expressed as

costs.

Example

problem. It is helpful in selecting among alternatives because

they facilitate comparison of alternatives

Possible Future Demand

Alternative

Low

High

Small Capacity

300

370

Large Capacity

180

900

the costs for each alternative in each event.

What is the best choice if future demand will be low?

Example

The

highest payoff.

P300,000

facility)

(Decision-making without probabilities)

Assumption:

Managers

events but cannot estimate their

probabilities.

Decision-making Under

Uncertainty

Conditions

rules:

1.

Pessimistic Approach

Choose the alternative that is the best of the worst.

It takes into account only the worst possible outcome

for each alternative.

Maximization : maximin

Minimization : minimax

Maximin

Example: Refer to the previous table

Alternative

Small facility

Large facility

P300,000

Worst Payoff

300

180

pessimist will build a small facility.

Decision-making Under

Uncertainty

Conditions

2. Optimistic

best of the best

go for it strategy that has high expectations

Maximization : maximax

Minimization : minimin

build a large facility.

Decision-making Under

Uncertainty

Conditions

3.

Laplace

Treats the state of nature as equally likely to each event

Small facility 0.50(300) + 0.50(370) = 335

Large facility 0.50(180) + 0.50(900)=540

Since P540,000 is the best weighted payoff, the realist

would build a large facility.

Decision-making Under

Uncertainty

4. Minimax Regret

Choose the alternative with the best worst

regret.

It seeks to minimize the difference between

the given payoff and the best payoff for each

state of nature.

For profit: Regret Value = Highest column

entry-every column entry

For cost: Regret Value=Entry every columnlowest column entry

MINIMAX REGRET

Regret

Alternative

Low

Demand

High

Demand

Maximum

Regret

Small

facility

300-300=0

900370=530

530

Large

facility

300180=120

900-900=0

120

Pick

maximum regret.

(Decision-making with probabilities)

The

than with decision-making under

certainty but more information than

with

decision-making

under

uncertainty.

circumstances is the EV

EV

alternative where each payoff is

weighted by the probability for the

relevant state of nature.

state of nature possible outcomes for a

chance event

EV - Example

Which

probability of low demand is

estimated to be 0.40 and the

probability of high demand is

Demand

estimatedPossible

to beFuture

0.60?

Alternative

Low

High

EV

Small Facility

300

370

0.4(300)+0.6(370)

=342

Large Facility

180

900

0.4(180)+0.6(900)

=612

The

Decision Tree

A

available to the decision maker

along wit their possible

consequences

Composed

have branches emanating from it.

Decision Tree

Two

types of nodes

a square

a circle

The

stands for a chance event.

square nodes represent alternatives

and branches having circular nodes

represent chance events.

decide whether to prepare a bid or not. It

costs P5,000 to prepare the bid. If the bid

is submitted, the probability that the

contract will be awarded is 60%. If the

company is awarded the contract, it may

earn an income of P60,000 if it succeeds

or pay a fine of P15,000 if it fails. The

probability of success is estimated to be

70%. Should the owner prepare the bid?

Decision Tree

P = 0.70

P = 0.60

success

60,000-5000

contract awarded

prepare

failure

-15,000-5,000

not awarded

0.30

not prepare

P = 0.40 -5,000

P=

Decision Tree

Compute

position.

EV

= 0.70(55,000) + 0.30(-20,000)

= 32,500

EV = 0.60(32,500)

= 17,500

+ 0.40(-5,000)

Decision Tree

55,000

32,50

P=0.60

0

contract awarded

P17,50

0

success P=0.70

prepare

failure

P=0.30

-20,000

not awarded

P=0.40 -5,000

not prepare

Information (EVPI)

Once

decision to make, the payoff

increases and is now a certainty, not

a probability.

Information (EVPI)

EVPI

certainty

expected payoff

under risk.

EVPI - Example

best payoff for the small capacity and large capacity

are P370 and P900 respectively. Then combine by

weighing each payoff by the probability of that state

of nature and add the amounts.

0.40(370)+0.60(900) = P688

P612.

EVPI = P688-P612=P76

is

Engrande Lechon

at a new location in Pasig or expand the existing branch located

in Marikina City. Demand on the new location is expected to be

60% high and 40% low. Fixed cost will reach the amount

P150,000. If the demand becomes high, he expects to have a

revenue of P250,000, however if the demand becomes low, he

could only expect a revenue of P200,000. Upon analyzing the

situation in his existing branch, he believes that by introducing

new recipes the sales will reach the amount P120,000 if the

demand becomes high. However, if the demand becomes low,

he could only expect P80,000 revenue. Projection on high

demand in the existing branch tends to be 55% and upon

computing the fixed cost it would reach the amount of P50,000.

Exercises

small dress shop near the U-belt, a few blocks

away from her. Her options are to open a small

shop, a medium-sized shop, or no shop at all.

The market for a dress shop can be good,

average, or bad. The probabilities are 0.20 for a

good market, 0.50 for an average, and 0.30 for a

bad market. The no profit loss for the mediumsized or small shops for the various market

conditions are given in the table. Building no

shops at all yields no loss and no gain. What do

you recommend?

Alternatives

Good Market

(PhP)

Ave. Market

(PhP)

Bad Market

(PhP)

Small Shop

85,000

20,000

-30,000

Medium-sized

shop

120,000

45,000

-70,000

No shop

Probabilities

0.20

0.50

0.30

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