Decision Analysis

Introduction
• We need to collect information and consider the
situation and the environment.
• Define the problem.
• List down the alternatives for the problem.
• Each alternative may have different possible outcomes.
• These possible outcomes are called the states of nature.
• For each combination of state of nature and alternative,
the profit or payoff can be calculate.
• Then, the decision-making can be selected.
 Decision Making
• 3 type:
1) Under certainty
2) Under uncertainty
3) Risk
 Decision Making Under Certainty

• The firm knows with certainty each

alternative’s result.
• The choice is therefore obvious that the
alternative with the highest payoff should be
chosen.
 Example
Example 1
1) Invest in Fixed Deposit of Bank A with
interest of RM 200.00 per annum.
2) Invest in Fixed Deposit of Bank B with interest
of RM 250.00 per annum
Result: the obvious is to invest in Fixed Deposit
of Bank B as it yields the highest interest of
RM250.00.
 Decision Making Under Uncertainty
• The firms cannot estimate the outcome’s
probabilities.
• They will make decisions using the following
criteria:
i. Maximax (Optimistic)
ii. Maximin (Pessimistic)
iii. Hurwich’s criterion of realism
iv. Laplace’s equally likely criterion
v. Minimax regret
 Maximax (Optimistic)

1) Identify the best payoff for each alternative

2) Select the alternative with the highest payoff
 Example
Example 2: Alexander Company is going to
introduce one of the three new products,: A, B
and C. As the market conditions (favourable,
stable or unfavourable) tend to affect the payoff
of the products, the company estimates the
following payoffs:
 Example
Market Condition
Product Favourable Stable Favourable

A 18000 9000 - 5000

B 12000 7000 2000
C 11000 10000 -6000
 Example 2
Question: What is the decision under maximax
criterion?
 Maximin (Pessimistic)

• The firms look for the worse possible payoff of

each alternative.
• Select the alternative with the highest value of
the worst payoff of the alternative.
 Example
Example 3: From Example 2, select the
alternative using the maximin criterion.
 Hurwich’s Criterion Of Realism

• Select the coefficient of realism, k.

• k is a degree of optimism, from 0 to 1.
• If k = 1, 100% optimistic
• If k closer to 0, pessimistic
 Example
Example 4: From Example 2, select the
alternative using the criterion of realism. Given
k = 0.7
 Laplace’s Equally Likely Criterion

• Find the mean/average for each alternative

decision.
 Example
Example 5: From Example 2, select the
alternative using the maximin criterion.
 Minimax Regret

• Regret – opportunity loss

• Best alternative – maximum payoff
 Example
Example 6: From Example 2, select the
alternative using the maximin criterion.
 Minimax Regret
1) Calculate the opportunity loss.
2) Find the maximum opportunity loss.
3) The alternative with smallest value is
selected.
 Decision Making Under Risk
• Based on
i. Expected Monetary Value (EMV)
ii. Expected Value Of Perfect Information (EVPI)
iii. Expected Opportunity Loss (EOL)
 Expected Monetary Value

• Formula

• The alternative with higher EMV is chosen.

 Example
Example 7: Alexander Company is going to
introduce one of the three new products,: A, B
and C, or do nothing. As the market conditions
(favourable, stable or unfavourable) tend to
affect the payoff of the products, the company
estimates the following payoffs (in RM) and
probabilities:
 Example
Market Condition
Product Favourable Stable Favourable

A 18000 9000 - 5000

B 12000 7000 2000
C 11000 10000 -6000
Not introducing 0 0 0
Probability 0.3 0.5 0.2
 EXAMPLE
What is the decision under risk using the EMV
method?
Expected Value Of Perfect Information (EVPI)

• Formula

• Expected Value with Perfect Information

(EVWPI) is
 Example
Example 8: Amy Market Research Company has approached
Casmad Company so that he can help Casmad make a decision
about which product to produce. Amy Company would be able
to tell Casmad with certainly whether the market is favourable,
stable or unfavourable by market technical analysis. This will
prevent CasmadCompany from making an expensive mistake
by choosing the wrong product to produce. Thus, the
maximum amount of money thet Casmad is willing to pay Amy
to carry out the market research is called expected value of
perfect information (EVPI)
 Example
Market Condition
Product Favourable Stable Favourable

A 18000 9000 - 5000

B 12000 7000 2000
C 11000 10000 -6000
Not introducing 0 0 0
Probability 0.3 0.5 0.2
 Example
Example 9 : Please refer Example 2
Expected Opportunity Loss (EOL)
 Decision Tree
• To solve problem related to risk
• Drawn from left to right
• First : identify the problem
• Each sate of nature must be furnished with
the probability for the method to be used
Please refer this file
“Chapter 3-Decision Tree”
Expected Value of Sample Information (EVSI)