3

Decision Analysis
 Decision Analysis

• For evaluating and choosing among

alternatives

• Considers all the possible alternatives and

possible outcomes
New Chocolate Plant
 STAR Chocolate Bar Factory
1. Decision: Whether or not to make and sell
storage sheds
2. Alternatives:
• Build a large plant
• Build a small plant
• Do nothing
3. Outcomes: Demand for sheds will be high,
moderate, or low
Given the following payoff matrix, find the right
decision under the following conditions:
Outcomes (Demand)
Alternatives High Moderate Low
Large plant 200,000 100,000 -120,000
Small plant 90,000 50,000 -20,000
No plant 0 0 0
1. Maximax
2. Maximin
3. Realism (Hurwicz) α = 0.45
4. Equally Likely (Laplace)
5. Minimax Regret (Regret)
 1-Maximax Criterion
• The optimistic approach
• Assume the best payoff will happen for each
alternative
Outcomes (Demand)
Alternatives High Moderate Low
Large plant 200,000 100,000 -120,000
Small plant 90,000 50,000 -20,000
No plant 0 0 0
• The pessimistic approach
• Assume the worst payoff will occur for each
alternative
Outcomes (Demand)
Alternatives High Moderate Low
Large plant 200,000 100,000 -120,000
Small plant 90,000 50,000 -20,000
No plant 0 0 0
3- Realism Criterion (Hurwicz criterion)
Suppose
Realism (Hurwicz) criterion α = 0.45 (for
MAX)
Outcomes (Demand)
1- α = 1- 0.45 = 0.55 (for MIN)
High Moderate Low
Alternatives
Large plant 200,000 100,000 -120,000
MAX MIN
Small plant 90,000 50,000 -20,000
MAX MIN
No plant 0 0 0
 Suppose α = 0.45

Outcomes (Demand)

High Moderate Low

Alternatives
Large plant 200,000 100,000 -120,000
x 0.45 x 0.55
Small plant 90,000 50,000 -20,000
x 0.45 x 0.55
No plant 0 0 0
Alternatives Realism Payoff
Large plant 200,000x0.45 - 120,000x0.55
= 24,000
Small plant 90,000x0.45 - 20,000x0.55
= 29,500
No plant 0

The right decision under Realism (Hurwicz)

Small plant $ 29,500
 Outcomes (Demand) Average
Alter. High Moderate Low
Large (200,000 + 100,000 -120,000)/3 60,000
Small (90,000 + 50,000 - 20,000)/3 40,000
No plant (0 + 0 + 0)/3 0

The right decision under Laplace

Large plant $ 60,000
 5- Minimax Regret Criterion
• Regret or opportunity loss measures much
better we could have done
Regret = (best payoff) – (actual payoff)
Outcomes (Demand)
Alternatives High Moderate Low
Large plant 200,000 100,000 -120,000
Small plant 90,000 50,000 -20,000
No plant 0 0 0
The best payoff for each outcome is highlighted
 Minimax Regret Criterion

Outcomes (Demand) Max

Alternatives High Moderate Low Regret
Large plant 0 0 120,000 120,000
Small plant 110,000 50,000 20,000 110,000
No plant 200,000 100,000 0 200,000

We want to minimize the amount of regret

The right decision under Minimax Regret
Small plant $ 110,000
 Decision Making Under Risk

Outcomes (Demand)

High Moderate Low

Alternatives 0.3 0.5 0.2
Large plant 200,000 100,000 -120,000
Small plant 90,000 50,000 -20,000
No plant 0 0 0
 Decision Making Under Risk

• Where probabilities of outcomes are available

• Expected Monetary Value (EMV) uses the

probabilities to calculate the average payoff
for each alternative

EMV (for alternative i) =

∑(probability of outcome) x (payoff of
outcome)
 Outcomes (Demand)

High Moderate Low

Alternatives 0.3 0.5 0.2 EMV

Large plant 200,000 100,000 -120,000 86,000
x 0.3 x 0.5 x0.2
Small plant 90,000 50,000 -20,000 48,000
x 0.3 0.5 x 0.2
No plant 0 0 0 0

The right decision under EMV

Large plant $ 86,000
 2- Expected Opportunity Loss (EOL)

• How much regret do we expect based on the

probabilities?

EOL (for alternative i) =

∑(probability of outcome) x (regret of outcome)
 2- Expected Opportunity Loss (EOL)

The best payoff for each outcome is highlighted

 2- Expected Opportunity Loss (EOL)

Outcomes (Demand)
High Moderate Low
Alternative 0.3 0.5 0.2 EOL
Large 0 0 120,000 24,000
plant x0.2
Small 110,000 50,000 20,000 62,000
plant X0.3 x0.5 x0.2
No plant 200,000 100,000 0 110,000
x0.3 x0.5
 Outcomes (Demand)
High Moderate Low
Alternative 0.3 0.5 0.2 EOL
Large 0 0 120,000 24,000
plant x0.2
Small 110,000 50,000 20,000 62,000
plant X0.3 x0.5 x0.2
No plant 200,000 100,000 0 110,000
x0.3 x0.5
The right decision under EOL
Large plant $ 24,000
 Perfect Information

• Having Perfect Information would allow

choosing the best payoff outcome

The expected value when perfect information is available

EVwPI = ∑ (probability of outcome)
x ( best payoff of outcome)

 EVPI an increase in value as a result of perfect

information

EVPI = EVwPI – EMV

Payoffs in blue would be chosen based on
perfect information (knowing demand level)
Demand
High Moderate Low
Alternatives 0.3 0.5 0.2
Large plant 200,000 100,000 -120,000
x0.3 x0.5
Small plant 90,000 50,000 -20,000
No plant 0 0 0
x0.2

EVwPI = $110,000
 Expected Value of Perfect Information

EVPI = EVwPI – EMV

= $110,000 - $86,000 = $24,000

• The “perfect information” increases the

expected value by $24,000
• Would it be worth to obtain the perfect
information when it costs $ 30,000?
• Answer is NO
Because cost is greater than EVPI
 Problem
Maryam: the movie writer
Maryam is a writer of romance novels. A movie
company and a TV network both want exclusive
rights to one of her more popular works. If she
signs with the network, she will receive a single
lump sum, but if she signs with the movie
company, the amount she will receive depends
on the market response to her movie. What
should she do?
Payouts and Probabilities
 Movie company Payouts
 Small box office - $200,000
 Medium box office - $1,000,000
 Large box office - $3,000,000
 TV Network Payout
 Flat rate - $900,000
 Probabilities
 P(Small Box Office) = 0.3
 P(Medium Box Office) = 0.6
 P(Large Box Office) = 0.1
 Maryam - Payoff Table
States of Nature

Small Box Medium Box Large Box

Decisions Office Office Office

Sign with Movie

$200,000 $1,000,000 $3,000,000
Company

Sign with TV
$900,000 $900,000 $900,000
Network
Prior
0.3 0.6 0.1
Probabilities
 Maryam - How to Decide?

 What would be her decision based on:

Maximax?
Maximin?
Expected Return?
Using Expected Return Criteria
EMVmovie=0.3(200,000)+0.6(1,000,000)+0.1(3,000,000)
= $960,000 =

EMVtv =0.3(900,000)+0.6(900,000)+0.1(900,000)
= $900,000
Therefore, using this criteria, Maryam should select the
movie contract.
 EVPI Calculation
EVwPI
=0.3(900,000)+0.6(1,000,000)+0.1(3,000,000) = $1,170,000
EMVBest (calculated to be EMVMovie from the previous page)
=0.3(200,000)+0.6(1,000,000)+0.1(3,000,000) = $960,000
EVPI = $1,170,000 - $960,000 = $210,000

Therefore, Maryam would be willing to spend up to $210,000

to learn additional information before making a decision.
 Using Decision Trees
 Can be used as visual aids to
structure and solve sequential
decision problems
 Especially beneficial when the
complexity of the problem grows
Decision Trees
 Three types of “nodes”
 Decision nodes - represented by squares (□)
 Chance nodes - represented by circles (Ο)
 Terminal nodes - represented by triangles (optional)
 Solving the tree involves pruning all but the best
decisions at decision nodes, and finding expected
values of all possible states of nature at chance
nodes
 Create the tree from left to right
 Solve the tree from right to left
Example Decision Tree

Chance
Event 1
node
Decision 1 Event 2
ion
node Decis Event 3
De c
ision
2
Maryam Decision Tree

Small Box Office

$200,000

Sign with Movie Co. Medium Box Office

$1,000,000

Large Box Office

$3,000,000

Small Box Office

$900,000

Sign with TV Network Medium Box Office

$900,000

Large Box Office

$900,000
Maryam Decision Tree

Small Box Office

ER .3 $200,000
?
Sign with Movie Co. .6 Medium Box Office
$1,000,000
ER .1
? Large Box Office
$3,000,000

Small Box Office

ER .3 $900,000
?
Sign with TV Network .6 Medium Box Office
$900,000
.1
Large Box Office
$900,000
Maryam Decision Tree - Solved

Small Box Office

ER .3 $200,000
960,000
Sign with Movie Co. .6 Medium Box Office
$1,000,000
ER .1
960,000 Large Box Office
$3,000,000

Small Box Office

ER .3 $900,000
900,000
Sign with TV Network .6 Medium Box Office
$900,000
.1
Large Box Office
$900,000
Solved Problems
Are you ready !
Q1- Given the following payoff table for NOOR construction company,
find the right decision under the following conditions:
a) Maximax b) Maximin
c) EMV when probability = 0.2 and 0.5 for low and medium demand
d) Expected value of perfect information
e) would you pay 120,000 to buy perfect information
Answer
a) Under Maximax
Kelly Construction
State of Nature
Maximax
Demand Criterion
Alternative
Actions
Low Medium High Max

UAE Factory 400,000 400,000 400,000 400,000

India Factory 100,000 800,000 800,000 800,000

China Factory (200,000) 500,000 1,200,000 1,200,000

a) under Maximax: China  1,200,000

 b) Under Maximin

Kelly Construction
State of Nature
Maximin
Demand Criterion
Alternative
Actions
Low Medium High Min

UAE Factory 400,000 400,000 400,000 400,000

India Factory 100,000 800,000 800,000 100,000

China Factory (200,000) 500,000 1,200,000 (200,000)

b) under Maximin: UAE  400,000

 c) Expected Return
State of Nature
Expected
Demand Return
Alternative
Actions
Low Medium High ER

UAE 400,000 400,000 400,000 400,000

India 100,000 800,000 800,000 660,000

China (200,000) 500,000 1,200,000 570,000

Probability 0.2 0.5 0.3 1.0

c) under Expected Return: India  660,000

d) EVPI = value of perfect information – EMV
840,000 – 660,000 = 180,000
e) YES since EVPI < information cost
State of Nature
Expected
Demand Return
Alternative
Actions
Low Medium High ER

UAE 400,000 400,000 400,000 400,000

INDIA 100,000 800,000 800,000 660,000

CHINA (200,000) 500,000 1,200,000 570,000

Probability 0.2 0.5 0.3 1.0

Best Decision 400,000 800,000 1,200,000 840,000

EVPI 180,000
Q2- A glass factory specializing in crystal is experiencing a substantial bottleneck,
and the firm's management is considering three courses of action:
A) Arrange for subcontracting
B) Construct new facilities
The correct choice depends largely upon demand, which may be low, medium, or
high. Management estimates the respective demand probabilities as 0.1, 0.5, and
0.4. The management estimates the profits when choosing from the two alternatives
(A and B) under the differing probable levels of demand. These profits, in thousands
of dollars are presented in the table below

0.1 0.5 0.4

Low Medium High
A 10 50 90
B -120 25 200
C 20 40
Create a decision tree and find the best option
60
Factory Decision Tree
Low
EMV .1 $10,000

Subcontracting .5 Medium
$ 50,000
.4
High
$90,000

EMV Low
EMV .1 $ -120,000

New facilities .5 Medium

$ 25,000
.4
High
$ 200,000
 Factory Decision Tree
Low
EMV .1 $10,000
62,000
Subcontracting .5 Medium
$ 50,000
.4
High
EMV $90,000
80,500
Low
EMV .1 $ -120,000
80,500
New facilities .5 Medium
$ 25,000
.4
High
$ 200,000

The best option is new facility  80,500