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Problem Formulation Decision Making without Probabilities Decision Making with Probabilities Risk Analysis and Sensitivity Analysis Decision Analysis with Sample Information Computing Branch Probabilities Utility and Decision Making

Dr. C. Lightner Fayetteville State University

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Problem Formulation

A decision problem is characterized by decision alternatives, states of nature, and resulting payoffs. The decision alternatives are the different possible strategies the decision maker can employ. The states of nature refer to future events, not under the control of the decision maker, which will ultimately affect decision results. States of nature should be defined so that they are mutually exclusive and contain all possible future events that could affect the results of all potential decisions.

Dr. C. Lightner Fayetteville State University

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**Decision Theory Models
**

Decision theory problems are generally represented as one of the following:

± Influence Diagram ± Payoff Table ± Decision Tree

Dr. C. Lightner Fayetteville State University

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Influence Diagrams

An influence diagram is a graphical device showing the relationships among the decisions, the chance events, and the consequences. Squares or rectangles depict decision nodes. Circles or ovals depict chance nodes. Diamonds depict consequence nodes. Lines or arcs connecting the nodes show the direction of influence.

Dr. C. Lightner Fayetteville State University

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Payoff Tables

The consequence resulting from a specific combination of a decision alternative and a state of nature is a payoff. A table showing payoffs for all combinations of decision alternatives and states of nature is a payoff table. Payoffs can be expressed in terms of profit, cost, time, distance or any other appropriate measure.

Dr. C. Lightner Fayetteville State University

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At the end of each limb of a tree are the payoffs attained from the series of branches making up that limb. C. The branches leaving each round node represent the different states of nature while the branches leaving each square node represent the different decision alternatives. Lightner Fayetteville State University 6 . round nodes correspond to the states of nature while square nodes correspond to the decision alternatives. Each decision tree has two types of nodes. Dr.Decision Trees A decision tree is a chronological representation of the decision problem.

C. The profitability of this complex depends upon the future level of demand for the complex·s condominiums. Dr. or large.Example: CAL Condominium Complex A developer must decide how large a luxury condominium complex to build ² small. Lightner Fayetteville State University 7 . medium.

Dr.CAL Condos: Elements of Decision Theory States of nature: The states of nature could be defined as low demand and high demand. Alternatives: CAL could decide to build a small. medium. or large condominium complex. We develop different models for this problem on the following slides. C. Payoffs: The profit for each alternative under each potential state of nature is going to be determined. Lightner Fayetteville State University 8 .

Lightner Fayetteville State University 9 . C.CAL Condos: Payoff Table THIS IS A PROFIT PAYOFF TABLE States of Nature Alternatives Low High Small 8 8 Medium 5 15 Large -11 22 (payoffs in millions of dollars) Dr.

C. Lightner Fayetteville State University 10 .CAL Condos: Decision Tree 8 8 5 Medium Complex 15 11 22 Dr.

Lightner Fayetteville State University 11 . Dr.Decision Making without Probabilities Three commonly used criteria for decision making when probability information regarding the likelihood of the states of nature is unavailable are: ± the optimistic approach ± the conservative approach ± the minimax regret approach. C.

the decision with the highest profit would be chosen. Dr. the decision with the lowest cost would be chosen. If the payoff table was in terms of profits. C. The decision with the best possible payoff is chosen.Optimistic Approach The optimistic approach would be used by an optimistic decision maker. Lightner Fayetteville State University 12 . If the payoff table was in terms of costs.

Conservative Approach The conservative approach would be used by a conservative decision maker. the maximum possible cost is minimized. the minimum possible profit is maximized. the worst possible payoff is maximized.) If the payoff was in terms of profits. Lightner Fayetteville State University 13 . (Hence. (Hence.) Dr. the minimum profits would be determined for each decision and then the decision corresponding to the maximum of these minimum profits is selected. the maximum costs would be determined for each decision and then the decision corresponding to the minimum of these maximum costs is selected.) If the payoff was in terms of costs. For each decision the worst payoff is listed and then the decision corresponding to the best of these worst payoffs is selected. (Hence. C.

using this regret table. 3.Minimax Regret Approach 1. the maximum regret for each possible decision is listed. Lightner Fayetteville State University 14 . Then. C. The minimax regret approach requires the construction of a regret table or an opportunity loss table. This is done by calculating for each state of nature the difference between each payoff and the best payoff for that state of nature. Dr. The decision chosen is the one corresponding to the minimum of the maximum regrets. 2.

and complains about or ³regrets´ their decisions based upon the profits that they could have made (or cheaper costs that they could have spent) had a different decision been selected.Solving CAL Condominiums Problem Suppose that information regarding the probability (or likelihood) that there will be a high or low demand is unavailable. ± A conservative or pessimistic decision maker would select the decision alternative determined by the conservative approach. ± The minimax regret approach is generally selected by a decision maker who reflects on decisions ³after the fact´. Dr. C. ± An optimistic decision maker would select the decision alternative rendered by the optimistic approach. Lightner Fayetteville State University 15 .

CAL Condos: Optimistic Decision If the optimistic approach is selected: STATES OF NATURE Alternatives Low High Small 8 8 Medium 5 15 Large -11 22 Maximax decision BEST PROFIT 8 15 22 Maximax payoff Dr. C. Lightner Fayetteville State University 16 .

Lightner Fayetteville State University 17 .CAL Condos: Conservative Decision If the conservative approach is selected: STATES OF NATURE Alternatives Low High Small 8 8 Medium 5 15 Large -11 22 WORST PROFIT 8 5 -11 Maximi n decision Maximin payoff The decision with the best profit from the column of worst profits is selected Dr. C.

C. Alternatives Small Medium Large STATES OF NATURE Low High 8 8 5 15 -11 22 Best Profit for Low 8 Best Profit for High 22 Dr. Lightner Fayetteville State University 18 .CAL Condos: Minimax Regret Decision If the minimax regret approach is selected: Step 1: Determine the best payoff for each state of nature and create a regret table.

they would have built a small complex. they would regret building a medium complex because they only made 5 million dollars instead of 8 million had they built a small facility instead. If they knew in advanced that the demand would be low. Dr. Lightner Fayetteville State University 19 . if they decided to build a medium facility and the demand turned out to be low. C. Alternatives Small Medium Large STATES OF NATURE Low High 0 14 3 7 19 0 For a profit payoff table.CAL Condos: Minimax Regret Decision If the minimax regret approach is selected: Step 1: Create a regret table (continued). entries in the regret table represent profits that could have been earned. Without this ³psychic insight´. They regret their decision by 3 million dollars.

Alternatives Small Medium Large STATES OF NATURE Low High 0 14 3 7 19 0 Max Regret 14 7 19 Regret not getting a profit of 19 more than not making a profit of 0.CAL Condos: Minimax Regret Decision If the minimax regret approach is selected: Step 2: Create a regret table (continued). Dr. Step 3: Determine the maximum regret for each decision. C. Lightner Fayetteville State University 20 .

C. Lightner Fayetteville State University 21 .CAL Condos: Minimax Regret Decision If the minimax regret approach is selected: Step 4: Select the decision with the minimum value from the column of max regrets. Minimax Regret decision Alternatives Small Medium Large STATES OF NATURE Low High 0 14 3 7 19 0 Max Regret 14 Minima x 7 Regret payoff 19 Dr.

Lightner Fayetteville State University 22 . C.Generic Example Consider the following problem with three decision alternatives and three states of nature with the following payoff table representing costs: States of Nature s1 s2 s3 COST PAYOFF TABLE d1 Decisions d2 d3 4.5 0.5 1 3 4 5 2 1 3 Dr.

Lightner Fayetteville State University 23 . Decision d1 d2 d3 Best Cost 2 0. We choose the decision that has the best single value in the payoff table.5 1 Maximax decision Maximax payoff Dr. C.Generic Example : Optimistic Decision Optimistic Approach An optimistic decision maker would use the optimistic (maximax) approach.

Choose the decision with the best of these worst payoffs.Generic Example: Conservative Approach Conservative Approach A conservative decision maker would use the conservative (maximin) approach.5 4 5 Maximin payoff Decision d1 d2 d3 Dr. Lightner Fayetteville State University 24 . List the worst payoff for each decision. Maximin decision Worst Payoff 4. C.

e.5 1 3 4 5 2 1 3 For a cost payoff table. Best cost for each state of nature.Generic Example: Minimax Regret Decision Minimax Regret Approach States of Nature s1 s2 s3 d1 Decisions d2 d3 4. Dr. C. higher costs incurred).5 0. Lightner Fayetteville State University 25 . entries in the regret table represent overpayments (i.

Choose the decision with the minimum of these values. C. Lightner Fayetteville State University Max Regret 4 1 2 0 1 2 1 0 2 Minimax regret 26 .Example Minimax Regret Approach (continued) For each decision list the maximum regret.5 Minimax decision Dr. States of Nature s1 s2 s3 d1 4 Decisions d2 0 d3 0.

Lightner Fayetteville State University 27 . one may use the expected value (EV) approach. C.Decision Making with Probabilities Expected Value Approach ² If probabilistic information regarding the states of nature is available. ² The decision yielding the best expected return is chosen. ² Here the expected return for each decision is calculated by summing the products of the payoff under each state of nature and the probability of the respective state of nature occurring. Dr.

Lightner Fayetteville State University 28 . The expected value (EV) of decision alternative di is defined N as: EV( d i ) ! § P( s j )Vij j !1 where: N = the number of states of nature P(sj ) = the probability of state of nature sj Vij = the payoff corresponding to decision alternative di and state of nature sj Dr.Expected Value of a Decision Alternative The expected value of a decision alternative is the sum of weighted payoffs for the decision alternative. C.

Example: Burger Prince Burger Prince Restaurant is contemplating opening a new restaurant on Main Street. Lightner Fayetteville State University 29 . It has three different models. C. 100. Dr. or 120. Burger Prince estimates that the average number of customers per hour will be 80. The payoff table (profits) for the three models is on the next slide. each with a different seating capacity.

000 $14.000 Dr.000 $12.Example: Burger Prince Payoff Table Average Number of Customers Per Hour s1 = 80 s2 = 100 s3 = 120 Model A Model B Model C $10.000 $ 8.000 $18.000 $16. C.000 $ 6.000 $15. Lightner Fayetteville State University 30 .000 $21.

Example: Burger Prince Expected Value Approach Calculate the expected value for each decision. Here d1. C. and 120. and s1. Dr. d3 represent the decision alternatives of models A. Lightner Fayetteville State University 31 . 100. d2. C. B. s3 represent the states of nature of 80. s2. The decision tree on the next slide can assist in this calculation.

000 d3 3 s2 s3 s1 s2 s3 4 Dr.Example: Burger Prince Decision Tree 2 d1 1 d2 Payoffs s1 s2 s3 s1 .000 8. Lightner Fayetteville State University 32 .000 12.000 14.000 15.4 .2 .000 16.2 .4 10.000 21.2 .4 .4 . C.000 18.000 6.4 .4 .

000 Choose the model with largest EV.600 Model A 1 Model 3 EMV = .600 Model C 4 EMV = .000) + .4(10.000) + . Lightner Fayetteville State University 33 .4(21.000) = $14.000) = $11.4(14.2(16.000) + .2(18.4(8.000) + .000) + .2(15.000) = $12.4(6.4(12. Dr. Model C.Example: Bur er Pri ce Expected Value For Each Decision d1 d2 d3 2 EMV = . C.000) + .

CAL Condos Revisited Suppose market research was conducted in the community where the complex will be built. C. Which decision alternative should they select. Dr. Lightner Fayetteville State University 34 . and the probability of high demand will be 0. This research allowed the company to estimate that the probability of low demand will be 0.35.65.

Lightner Fayetteville State University 35 .35) High (0.CAL Condos Revisited STATES OF NATURE Low (0. C.65) 8 8 5 15 -11 22 Alternatives Small Medium Large Dr.

5 -11(0.35) + 22(0. Lightner Fayetteville State University 36 . Thus since the decision to build a medium complex has the highest expected profit.65) Small 8 8 Medium 5 15 Large -11 22 Expected value (EV) 8(0. this is our best decision.65) = 8 5(0.35) + 15(0.35) (0.45 Recall that this is a profit payoff table. Dr.65) = 10. C.65) = 11.35) + 8(0.CAL Condos Revisited STATES OF NATURE Alternatives Low High (0.

The expected value of perfect information (EVPI) is the increase in the expected profit that would result if one knew with certainty which state of nature would occur. The EVPI provides an upper bound on the expected value of any sample or survey information.Expected Value of Perfect Information Frequently information is available which can improve the probability estimates for the states of nature. Dr. Lightner Fayetteville State University 37 . C.

² Step 3: Subtract the EV of the optimal decision from the amount determined in step (2). Dr.Expected Value of Perfect Information EVPI Calculation ² Step 1: Determine the optimal return corresponding to each state of nature. Lightner Fayetteville State University 38 . ² Step 2: Compute the expected value of these optimal returns. C.

EVPI= . Lightner Fayetteville State University 39 .000) + .000) + .000 = $2.Example: Burger Prince Expected Value of Perfect Information Calculate the expected value for the optimum payoff for each state of nature and subtract the EV of the optimal decision.000 Dr. C.4(10.000) .14.4(21.2(18.

Dr. particularly the probabilities. It is important to accompany any decision analysis with a sensitivity analysis. Lightner Fayetteville State University 40 . are often intelligent guesses at best. Sensitivity analysis can be used to determine how changes to the following inputs affect the recommended decision alternative: ² probabilities for the states of nature ² values of the payoffs If a small change in the value of one of the inputs causes a change in the recommended decision alternative. extra effort and care should be taken in estimating the input value. C.Sensitivity Analysis Some of the quantities in a decision analysis.

For the special case of two states of nature. Lightner Fayetteville State University 41 . C. then you know that the solution is sensitive to the changes. a graphical technique can be used to determine how sensitive the solution is to the probabilities associated with the states of nature.Sensitivity Analysis One approach to sensitivity analysis is to arbitrarily assign different values to the probabilities of the states of nature and/or the payoffs and resolve the problem. Dr. If the recommended decision changes.

we stated that CAL Condominiums estimated that the probability of future low demand is 0.35 and 0. In order to see how sensitive this recommendation is to changing probability values. Lightner Fayetteville State University 42 . Therefore EV( small) = 8*p + 8*(1-p)= 8 EV( medium) = 5*p + 15*(1-p) = 15 ² 10p EV( large) = -11*p + 22*(1-p) = 22 ² 33p Dr. we will let p equal the probability of low demand. C. These probabilities yielded the recommended decision to build the medium complex. Thus (1-p) is the probability of high demand.CAL Condos: Sensitivity Analysis This problem has two states of nature. Previously.65 is the probability of high demand.

CAL Condos: Sensitivity Analysis Next we will plot the expected value lines for each decision by plotting p on the x axis and EV on the y axis. C. EV( small) = 8 EV( medium) = 15 ² 10p EV( large) = 22 ² 33p Dr. Lightner Fayetteville State University 43 .

Lightner Fayetteville State University 44 .CAL Condos: Sensitivity Analysis EV( small) Dr. C.

we know that the highest profits is desirable. Lightner Fayetteville State University 45 . C. Dr. Look over the entire range of p (p=0 to p=1) and determine the range over which each decision yields the highest profits.CAL Condos: Sensitivity Analysis Since CAL condominiums list payoffs are in terms of profits.

Lightner Fayetteville State University B2 46 .CAL Condos: Sensitivity Analysis EV( small) B1 Dr. C.

3403 p=7/23= 0. Lightner Fayetteville State University 47 . C. 22-33p= 15-10p 7= 23p So B1 equals 0.7 Dr.3403 B2 is the point where the EV( medium) line intersects with the EV( small) line: 15-10p = 8 So B2 equals 0.7 7 = 10p p = 0.CAL Condos: Sensitivity Analysis Do not estimate the values of B1 or B2 (the points where the intersection of lines occur). Determine the exact intersection points. B1 is the point where the EV( large) line intersects with the EV( medium) line: To find this point set these two lines equal to each other and solve for p.

7 48 .3403 Dr.CAL Condos: Sensitivity Analysis EV( small) 0. C. Lightner Fayetteville State University 0.

From the graph we see that if the probability of low demand (p) is between 0. the recommended decision would change. Lightner Fayetteville State University 49 . we recommend building a medium complex. From this sensitivity analysis we see that if CAL Condos estimate of 0.CAL Condos: Sensitivity Analysis From the graph we see that if the probability of low demand (p) is between 0 and 0.7.3403.3403 and 0. From the graph we see that if the probability of low demand (p) is between 0. we recommend building a large complex.35 for the probability of low demand was slightly lower. Dr. we recommend building a large complex. C.7 and 1.

End of Chapter 14 See your textbook for more examples and detailed explanations of all topics discussed in these notes. C. Lightner Fayetteville State University 50 . Dr.

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