Chapter Four: Decision Analysis

Chapter four
Decision Analysis
To accompany
© 2008 Prentice-Hall, Inc.

© 2009 Prentice-Hall, Inc.
Introduction
 What is involved in making a good

decision?
 Decision theory is an analytic and
systematic approach to the study of
decision making
 A good decision is one that is based
on logic
© 2009 Prentice-Hall, Inc. 3–2

The Six Steps in Decision Making
1. Clearly define the problem at hand

2. List the possible alternatives
3. Identify the possible outcomes or states
of nature
4. List the payoff or profit of each
combination of alternatives and
outcomes
5. Select one of the mathematical decision
theory models
6. Apply the model and make your decision
Thompson Lumber Company
Step 1 – Define the problem

 Expand by manufacturing and
marketing a new product
Step 2 – List alternatives
 Construct a large new plant
 A small plant
 No plant at all
Step 3 – Identify possible outcomes
 The market could be favorable or
unfavorable

Step 4 – List the payoffs

 Identify conditional values for the
profits for large, small, and no plants
for the two possible market
conditions
Step 5 – Select the decision model
 Depends on the environment and
amount of risk and uncertainty
Step 6 – Apply the model to the data
 Solution and analysis used to help the
decision making

STATE OF NATURE
FAVORABLE UNFAVORABLE
ALTERNATIVE MARKET ($) MARKET ($)
Construct a large plant 200,000 –180,000
Construct a small plant 100,000 –20,000
Do nothing 0 0
Table 3.1

Types of Decision-Making
Environments
Type 1: Decision making under certainty

 Decision maker knows with certainty the
consequences of every alternative or
decision choice
Type 2: Decision making under uncertainty
 The decision maker does not know the
probabilities of the various outcomes
Type 3: Decision making under risk
 The decision maker knows the
probabilities of the various outcomes

Decision Making Under
Uncertainty
There are several criteria for making decisions
under uncertainty
1. Maximax (optimistic)
2. Maximin (pessimistic)
3. Criterion of realism (Hurwicz)
4. Equally likely (Laplace)
5. Minimax regret

Maximax
Used to find the alternative that maximizes
the maximum payoff
 Locate the maximum payoff for each alternative
 Select the alternative with the maximum
number
STATE OF NATURE
FAVORABLE UNFAVORABLE MAXIMUM IN
ALTERNATIVE MARKET ($) MARKET ($) A ROW ($)
Construct a large
200,000 –180,000 200,000
plant
Maximax
Construct a small
100,000 –20,000 100,000
plant
Do nothing 0 0 0
Table 3.2
Maximin
Used to find the alternative that maximizes
the minimum payoff
 Locate the minimum payoff for each alternative
 Select the alternative with the maximum
number
STATE OF NATURE
FAVORABLE UNFAVORABLE MINIMUM IN
Construct a large
200,000 –180,000 –180,000
plant
Construct a small
100,000 –20,000 –20,000
plant
Do nothing 0 0 0
Table 3.3
Maximin
© 2009 Prentice-Hall, Inc. 3 – 10
Criterion of Realism (Hurwicz)
A weighted average compromise between
optimistic and pessimistic
 Select a coefficient of realism 
 Coefficient is between 0 and 1
 A value of 1 is 100% optimistic
 Compute the weighted averages for each
alternative
 Select the alternative with the highest value
Weighted average = (maximum in row)

+ (1 – )(minimum in row)

Criterion of Realism (Hurwicz)
 For the large plant alternative using  = 0.8
(0.8)(200,000) + (1 – 0.8)(–180,000) = 124,000
 For the small plant alternative using  = 0.8
(0.8)(100,000) + (1 – 0.8)(–20,000) = 76,000
STATE OF NATURE
CRITERION
FAVORABLE UNFAVORABLE OF REALISM
ALTERNATIVE MARKET ($) MARKET ($) ( = 0.8)$
Construct a large
200,000 –180,000 124,000
plant
Realism
Construct a small
100,000 –20,000 76,000
plant
Do nothing 0 0 0
Table 3.4
Equally Likely (Laplace)
Considers all the payoffs for each alternative
 Find the average payoff for each alternative
 Select the alternative with the highest average
STATE OF NATURE
FAVORABLE UNFAVORABLE ROW
ALTERNATIVE MARKET ($) MARKET ($) AVERAGE ($)
Construct a large
200,000 –180,000 10,000
plant
Construct a small
100,000 –20,000 40,000
plant
Equally likely
Do nothing 0 0 0
Table 3.5

Minimax Regret
Based on opportunity loss or regret,
regret the
difference between the optimal profit and
actual payoff for a decision
 Create an opportunity loss table by determining
the opportunity loss for not choosing the best
alternative
 Opportunity loss is calculated by subtracting
each payoff in the column from the best payoff
in the column
 Find the maximum opportunity loss for each
alternative and pick the alternative with the
minimum number

Minimax Regret
STATE OF NATURE
 Opportunity MARKET ($) MARKET ($)
Loss Tables 200,000 – 200,000 0 – (–180,000)
200,000 – 100,000 0 – (–20,000)
200,000 – 0 0–0
Table 3.6
STATE OF NATURE
ALTERNATIVE MARKET ($) MARKET ($)
Construct a large plant 0 180,000
Construct a small plant 100,000 20,000
Do nothing 200,000 0
Table 3.7
Minimax Regret
STATE OF NATURE
FAVORABLE UNFAVORABLE MAXIMUM IN
Construct a large
0 180,000 180,000
plant
Construct a small
100,000 20,000 100,000
plant
Minimax
Do nothing 200,000 0 200,000
Table 3.8

In-Class Example 1
 Let’s practice what we’ve learned. Use the decision table
below to compute a choice using all the models
 Criterion of realism α =.6
State of Nature
Good Average Poor
Alternative
Market Market Market
($) ($) ($)
Construct a
75,000 25,000 -40,000
large plant
Construct a
100,000 35,000 -60,000
small plant
Do nothing 0 0 0
In-Class Example 1: Maximax
State of Nature
Averag
Good Poor
Alternative e Maximax
Market Market
Market
($) ($)
($)
Construct a
75,000 25,000 -40,000 75,000
large plant
Construct a
100,000 35,000 -60,000 100,000
small plant
Do nothing 0 0 0 0

In-Class Example 1: Maximin
State of Nature
Good Average Poor
Alternative Maximin
($) ($) ($)
Construct a
75,000 25,000 -40,000 -40,000
large plant
Construct a
100,000 35,000 -60,000 -60,000
small plant
Do nothing 0 0 0 0

In-Class Example 1:
Minimax Regret Opportunity Loss Table
State of Nature
Good Average Poor Maximum
Alternative Opp.
Market Market Market Loss
($) ($) ($)
Construct a
25,000 10,000 40,000 40,000
large plant
Construct a
0 0 60,000 60,000
small plant
Do nothing 100,000 35,000 0 100,000

In-Class Example 1: Equally Likely
State of Nature
Good Average Poor
Alternative Avg
($) ($) ($)
Construct a
25,000 8,333 -13,333 20,000
large plant
Construct a
33,333 11,665 -20,000 25,000
small plant
Do nothing 0 0 0 0

In-Class Example 1:
Criterion of Realism
α =.6
State of Nature
Good Average Poor
Alternative Maximum
($) ($) ($)
Construct a
45,000 - -16,000 29,000
large plant
Construct a
60,000 - -24,000 36,000
small plant
Do nothing 0 0 0 0

Decision Making Under Risk
 Decision making when there are several possible
states of nature and we know the probabilities
associated with each possible state
 Most popular method is to choose the alternative
with the highest expected monetary value (EMV)
native i) = (payoff of first state of nature)

x (probability of first state of nature)
+ (payoff of second state of nature)
x (probability of second state of nature)
+ … + (payoff of last state of nature)
x (probability of last state of nature)

EMV for Thompson Lumber
 Each market has a probability of 0.50
 Which alternative would give the highest EMV?
 The calculations are
EMV (large plant) = (0.50)($200,000) + (0.50)(–$180,000)

= $10,000
EMV (small plant) = (0.50)($100,000) + (0.50)(–$20,000)
= $40,000
EMV (do nothing) = (0.50)($0) + (0.50)($0)
= $0

EMV for Thompson Lumber
STATE OF NATURE
ALTERNATIVE MARKET ($) MARKET ($) EMV ($)
Construct a large
200,000 –180,000 10,000
plant
Construct a small
100,000 –20,000 40,000
plant
Do nothing 0 0 0
Probabilities 0.50 0.50
Table 3.9 Largest EMV

Expected Value of Perfect
Information (EVPI)
 EVPI places an upper bound on what you should pay
for additional information
EVPI = EVwPI – Maximum EMV
EVPI is the increase in EMV that results
from having perfect information
 EVwPI is the long run average return if we have perfect
information before a decision is made
 We compute the best payoff for each state of nature since we
don’t know, until after we pay, what the research will tell us
EVwPI = (best payoff for first state of nature)

x (probability of first state of nature)
+ (best payoff for second state of nature)
x (probability of second state of nature)
+ … + (best payoff for last state of
nature)
x (probability of last state of nature)
Information (EVPI)
 Scientific Marketing, Inc. offers analysis
that will provide certainty about market
conditions (favorable)
 Additional information will cost $65,000
 Is it worth purchasing the information?

Information (EVPI)
1. Best alternative for favorable state of nature is
build a large plant with a payoff of $200,000
Best alternative for unfavorable state of nature is
to do nothing with a payoff of $0
EVwPI = ($200,000)(0.50) + ($0)(0.50) = $100,000
2. The maximum EMV without additional
information is $40,000
= $100,000 - $40,000
= $60,000

Information (EVPI)
1. Best alternative for favorable state of nature is
build a large plant with a payoff of $200,000
So the maximum Thompson
Best alternative for unfavorable
should pay for the state of nature is
additional
to do nothinginformation
with a payoff
is of $0
$60,000
EVwPI = ($200,000)(0.50) + ($0)(0.50) = $100,000
2. The maximum EMV without additional
information is $40,000
= $100,000 - $40,000
= $60,000

EVwPI
State of Nature
Alternative Favorable Market Unfavorable EMV
($) Market ($)
Construct a large
200,000 -180,000 10,000
plant
Construct a small
100,000 -20,000 40,000
plant
Do nothing 0 0 0
Perfect Information 200,000 0 EVwPI = 100,000
Compute EVwPI
The best alternative with a favorable market is to build a large
plant with a payoff of $200,000. In an unfavorable market the
choice is to do nothing with a payoff of $0
EVwPI = ($200,000)*.5 + ($0)(.5) = $100,000
Compute EVPI = EVwPI – max EMV = $100,000 - $40,000 = $60,000
The most we should pay for any information is $60,000
In-Class Example
 Using the table below compute EMV, EVwPI,
and EVPI.
State of Nature
Alternative Good Average Poor

($) ($) ($)
Construct
75,000 25,000 -40,000
large plant
Construct
100,000 35,000 -60,000
small plant
Do nothing 0 0 0
Probability 0.25 0.50 0.25
In-Class Example:
EMV and EVwPI Solution
State of Nature
Alternative Good Average Poor EMV

($) ($) ($)
Construct
75,000 25,000 -40,000 21,250
large plant
Construct
100,000 35,000 -60,000 27,500
small plant
Do nothing 0 0 0 0

In-Class Example:
EVPI Solution
EVPI = EVwPI - max(EMV)
EVwPI = $100,000*0.25 + $35,000*0.50

+0*0.25
= $42,500
EVPI = $ 42,500 - $27,500
= $ 15,000
Expected Opportunity Loss
 Expected opportunity loss (EOL) is the

cost of not picking the best solution
 First construct an opportunity loss table
 For each alternative, multiply the
opportunity loss by the probability of
that loss for each possible outcome and
add these together
 Minimum EOL will always result in the
same decision as maximum EMV
 Minimum EOL will always equal EVPI

Thompson Lumber: Payoff Table
State of Nature
Alternative Favorable Unfavorable
Market ($) Market ($)
Construct a
200,000 -180,000
large plant
Construct a
100,000 -20,000
small plant
Do nothing 0 0

Thompson Lumber: EOL
The Opportunity Loss Table
STATE OF NATURE
ALTERNATIVE MARKET ($) MARKET ($) EOL
200,000 -
Construct a large plant 0-(-180,000) 90,000
200,000
200,000
Construct a small plant 0-(-20,000) 60,000
-100,000
Do nothing 200,000 - 0 0-0 100,000


Thompson Lumber:
Opportunity Loss Table
STATE OF NATURE
Construct a large
0 180,000 90,000
plant
Construct a small
100,000 20,000 60,000
plant
Do nothing 200,000 0 100,000

Expected Opportunity Loss
STATE OF NATURE
Construct a large plant 0 180,000 90,000
Construct a small
100,000 20,000 60,000
plant
Do nothing 200,000 0 100,000
Table 3.10 Minimum EOL
EOL (large plant)= (0.50)($0) + (0.50)($180,000) = $90,000
EOL (small plant)=(0.50)($100,000) + (0.50)($20,000) = $60,000
EOL (do nothing)= (0.50)($200,000) + (0.50)($0) = $100,000

EOL
 The minimum EOL will always

result in the same decision (NOT
value) as the maximum EMV
 The EVPI will always equal the

minimum EOL
EVPI = minimum EOL

Sensitivity Analysis
 Sensitivity analysis examines how our
decision might change with different input
data
 For the Thompson Lumber example
P = probability of a favorable market

(1 – P) = probability of an unfavorable market

EMV(Large Plant) = $200,000P – $180,000)(1 – P)
= $200,000P – $180,000 + $180,000P
= $380,000P – $180,000
EMV(Small Plant) = $100,000P – $20,000)(1 – P)
= $100,000P – $20,000 + $20,000P
= $120,000P – $20,000
EMV(Do Nothing) = $0P + 0(1 – P)
= $0

EMV Values
$300,000
$200,000 Point 2 EMV (large plant)
$100,000 Point 1 EMV (small plant)
0 EMV (do nothing)

.167 .615 1
–$100,000 Values of P
–$200,000
Figure 3.1

Point 1:
EMV(do nothing) = EMV(small plant)
20,000
0  $120,000 P  $20,000 P  0.167
120,000
Point 2:
EMV(small plant) = EMV(large plant)
$120,000 P  $20,000  $380,000 P  $180,000
160,000
P  0.615
260,000

BEST RANGE OF P
ALTERNATIVE VALUES
Do nothing Less than 0.167
EMV Values Construct a small plant 0.167 – 0.615
$300,000 Construct a large plant Greater than 0.615
$200,000 Point 2 EMV (large plant)
$100,000 Point 1 EMV (small plant)
0 EMV (do nothing)

.167 .615 1
–$100,000 Values of P
–$200,000
Figure 3.1
Using Excel QM to Solve
Decision Theory Problems
Program 3.1A
Using Excel QM to Solve
Decision Theory Problems
Program 3.1B
Decision Trees
 Any problem that can be presented in a
decision table can also be graphically
represented in a decision tree
 Decision trees are most beneficial when a
sequence of decisions must be made
 All decision trees contain decision points
or nodes and state-of-nature points or
nodes
 A decision node from which one of several
alternatives may be chosen
 A state-of-nature node out of which one state
of nature will occur
Five Steps to
Decision Tree Analysis
1. Define the problem

2. Structure or draw the decision tree
3. Assign probabilities to the states of
nature
4. Estimate payoffs for each possible
combination of alternatives and states of
nature
5. Solve the problem by computing
expected monetary values (EMVs) for
each state of nature node

Structure of Decision Trees
 Trees start from left to right
 Represent decisions and outcomes in
sequential order
 Squares represent decision nodes
 Circles represent states of nature nodes
 Lines or branches connect the decisions
nodes and the states of nature

Thompson’s Decision Tree
A State-of-Nature Node
Favorable Market
A Decision Node
1
Unfavorable Market
uct nt
r
n st Pla
e
Co arg
L Favorable Market
Construct
2
Small Plant Unfavorable Market
Do
No
th
in
g
Figure 3.2

Thompson’s Decision Tree
EMV for Node = (0.5)($200,000) + (0.5)(–$180,000)
1 = $10,000
Payoffs
Favorable Market (0.5)
$200,000
Alternative with best
EMV is selected 1
Unfavorable Market (0.5)
ct nt –$180,000
r u
n st Pla
e
Co a r g
L Favorable Market (0.5)
$100,000
Construct
2
Small Plant Unfavorable Market (0.5)
–$20,000
Do
No
th EMV for Node = (0.5)($100,000)
in
g 2 = $40,000 + (0.5)(–$20,000)
$0
Figure 3.3
Thompson’s Complex Decision Tree
Using Sample Information
 Thompson Lumber has two decisions two make,
with the second decision dependent upon the
outcome of the first
 First, whether or not to conduct their own
marketing survey, at a cost of $10,000, to help
them decide which alternative to pursue (large,
small or no plant)
 The survey does not provide perfect information
 Then, to decide which type of plant to build
 Note that the $10,000 cost was subtracted from
each of the first 10 branches. The, $190,000 payoff
was originally $200,000 and the $-10,000 was
originally $0.
First Decision Second Decision Payoffs
Point Point
$190,000
nt 2 Unfavorable Market (0.22)
S
Re urv
) Pla –$190,000
45 ge
N1e su ey (0 . Lar Favorable Market (0.78)
$90,000
ga lts e(y0 Small
tlitvusrvble .55 Plant
3 Unfavorable Market (0.22)
–$30,000
u
s S rea )
Re avo No Plant
F –$10,000

$190,000
ye
nt 4 Unfavorable Market (0.73)

rv
Pla –$190,000
Su
ge
Lar Favorable Market (0.27)
t
Small $90,000
ke

ar
Plant –$30,000
M
t
uc
No Plant
–$10,000
nd
Co
Do Favorable Market (0.50)

Not $200,000
Con nt 6 Unfavorable Market (0.50)
duc Pla –$180,000
t Su ge
rve Lar Favorable Market (0.50)
$100,000
y Small
Plant
–$20,000
No Plant
$0
Figure 3.4
Given favorable survey results

market favorable for sheds),
EMV(node 2) = EMV(large plant | positive survey)
= (0.78)($190,000) + (0.22)(–$190,000) = $106,400
EMV(node 3) = EMV(small plant | positive survey)
= (0.78)($90,000) + (0.22)(–$30,000) = $63,600
EMV for no plant = –$10,000
Given negative survey results,
EMV(node 4) = EMV(large plant | negative survey)
= (0.27)($190,000) + (0.73)(–$190,000) = –$87,400
EMV(node 5) = EMV(small plant | negative survey)
= (0.27)($90,000) + (0.73)(–$30,000) = $2,400
EMV for no plant = –$10,000
Compute the expected value of the market survey,

EMV(node 1) = EMV(conduct survey)
= (0.45)($106,400) + (0.55)($2,400)
= $47,880 + $1,320 = $49,200
f the market survey is not conducted,
EMV(node 6) = EMV(large plant)
= (0.50)($200,000) + (0.50)(–$180,000) = $10,000
EMV(node 7) = EMV(small plant)
= (0.50)($100,000) + (0.50)(–$20,000) = $40,000
EMV for no plant = $0
Best choice is to seek marketing information

First Decision Second Decision Payoffs
Point Point
$106,400 Favorable Market (0.78)
$190,000
la nt Unfavorable Market (0.22)
$106,400
P –$190,000
a rge $63,600 Favorable Market (0.78)
L $90,000
Small
5) Unfavorable Market (0.22)
0.4 Plant –$30,000
(
e y ts le
v l No Plant
$49,200 ur su rab –$10,000
S Re vo
Su Fa –$87,400 Favorable Market (0.27)
rv $190,000
y
e
Re y (
e
n t Unfavorable Market (0.73)

rv
Ne su 0.5 Pla –$190,000

Su
ga lts 5) rge $2,400

$2,400
La Favorable Market (0.27)
t
tiv Small $90,000

ke
e Unfavorable Market (0.73)

ar
Plant –$30,000
Mt
uc
No Plant
–$10,000
d
on
$49,200
C
Do $10,000 Favorable Market (0.50)

Not $200,000
Con t Unfavorable Market (0.50)
duc P lan –$180,000
ge
$40,000
t Su Lar $40,000 Favorable Market (0.50)

rve Small $100,000
y Unfavorable Market (0.50)
Plant –$20,000
No Plant
$0
Figure 3.4
Complex Decision Tree

Expected Value of Sample Information
 Thompson wants to know the actual value

of doing the survey
Expected value Expected value
with sample of best decision
EVSI = information, assuming – without sample
no cost to gather it information
= (EV with sample information + cost)

– (EV without sample information)
EVSI = ($49,200 + $10,000) – $40,000 = $19,200

Thompson could have paid up to $19,200 for a market
study and still come out ahead since the survey actually
costs $10,000 © 2009 Prentice-Hall, Inc. 3 – 58
 How sensitive are the decisions to

changes in the probabilities?
 How sensitive is our decision to the
probability of a favorable survey result?
 That is, if the probability of a favorable
result (p = .45) where to change, would we
make the same decision?
 How much could it change before we would
make a different decision?

p = probability of a favorable survey
result
(1 – p) = probability of a negative survey
result 1) = ($106,400)p +($2,400)(1 – p)
EMV(node
= $104,000p + $2,400
We are indifferent when the EMV of node 1 is the
same as the EMV of not conducting the survey,
$40,000
$104,000p + $2,400= $40,000
$104,000p = $37,600
p = $37,600/$104,000 = 0.36
p >.36, the decision will stay the same
p< .36, do not conduct survey © 2009 Prentice-Hall, Inc. 3 – 60
EXERCISE FOR THE CHAPTER
Select the best answer

1. In decision theory terminology, a course of action or a strategy that may be
chosen by a decision maker is called
a. a payoff.
b. an alternative.
c.a state of nature.
d. none of the above.
2. In decision theory, probabilities are associated with
a. payoffs.
b. alternatives.
c. states of nature.
d. none of the above.
3. If probabilities are available to the decision maker, then the decision-making
environment is called
a.certainty.
b.uncertainty.
c.risk.
d.none of the above.

4. Which of the following is a decision-making criterion that is used for decision making under risk?
a.expected monetary value criterion
b.Hurwicz criterion (criterion of realism)
c.optimistic (maximax) criterion
d. equally likely criterion
5. The minimum expected opportunity loss
a.is equal to the highest expected payoff.
b. is greater than the expected value with perfect information.
c.is equal to the expected value of perfect information.
d.is computed when finding the minimax regret decision.
6. The minimum EOL criterion will always result in the same decision as
nthe maximax criterion.
n the minimax regret criterion.
n the maximum EMV criterion.
n the equally likely criterion.
7. A decision tree is preferable to a decision table when
na number of sequential decisions are to be made.
n probabilities are available.
n the maximax criterion is used.
n the objective is to maximize regret.


Decision Making Under Conditions of
Uncertainty - Exercise
Maria Rojas is considering the possibility of opening a small dress shop on Fairbanks
Avenue, a few blocks from the university. She has located a good mall that attracts
students. 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 for these
three possibilities are 0.2 for a good market, 0.5 for an average market, and 0.3 for a bad
market. The net profit or loss for the medium-sized and small shops for the various
market conditions are given in the following table. Building no shop at all yields no loss
and no gain.
a. What do you recommend?
b. Calculate the EVPI.
c. Develop the opportunity loss table for this situation. What decisions would be made
using the minimax regret criterion and the minimum EOL criterion?
GOOD AVERAGE BAD
MARKET MARKET MARKET
ALTERNATIVE ($) ($) ($)
Small shop 75,000 25,000 –40,000
Medium-sized shop 100,000 35,000 –60,000
No shop 0 0 0

A financial advisor has recommended two possible mutual funds for
investment: Fund A and Fund B.The return that will be achieved by
each of these depends on whether the economy is good, fair, or poor.
A payoff table has been constructed to illustrate this situation:
STATE OF NATURE
GOOD FAIR POOR
INVESTMENT ECONOMY ECONOMY ECONOMY
Fund A $10,000 $2,000 $5,000
Fund B $6,000 $4,000 0
a. Calculate the EVPI.
b. Develop the opportunity loss table for this situation. What
decisions would be made using the minimax regret criterion and the
minimum EOL criterion?

Even though independent gasoline stations have been having a difficult time, Susan Solomon has
been thinking about starting her own independent gasoline station. Susan’s problem is to decide
how large her station should be. The annual returns will depend on both the size of her station and
a number of marketing factors related to the oil industry and demand for gasoline. After a careful
analysis, Susan developed the following table: GOOD FAIR POOR
SIZE OF MARKET MARKET MARKET
FIRST STATION ($) ($) ($)
Small 50,000 20,000 –10,000
Medium 80,000 30,000 –20,000
Large 100,000 30,000 –40,000
Very large 300,000 25,000 –160,000
For example, if Susan constructs a small station and the market is good, she will realize a profit of
$50,000.
(a) Develop a decision table for this decision.
(b) What is the maximax decision?
(c) What is the maximin decision?
(d) What is the equally likely decision?
(e) What is the criterion of realism decision? Use a value of 0.8.
(f) Develop an opportunity loss table.
(g) What is the minimax regret decision?


Manufactures of goods has only three options available for the existing plant: expand the
present plant, build new plant and subcontract out extra a production to other
Future State of nature of demand

Decision High Moderate Low Failure
alternative
Expand present 500000 250000 -250000 -400000
plant
Construct:
Build new plant 700000 300000 -400000 -800000
What is the maximax 300000
Subcontract decision? 150000 -10000 -100000
What is the maximin decision?
Probabilities 0.4 0.2 0.3 0.1
What is the equally likely decision?
What is the criterion of realism decision? Use a value of 0.6.
Develop an opportunity loss table.
What is the minimax regret decision?
EMV
EVPI
EOL


Chapter Four: Decision Analysis

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Chapter Four: Decision Analysis

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Chapter four

© 2008 Prentice-Hall, Inc.

 What is involved in making a good

© 2009 Prentice-Hall, Inc. 3–2

1. Clearly define the problem at hand

Step 1 – Define the problem

© 2009 Prentice-Hall, Inc. 3–4

Step 4 – List the payoffs

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Construct a small plant 100,000 –20,000

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Type 1: Decision making under certainty

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Weighted average = (maximum in row)

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native i) = (payoff of first state of nature)

© 2009 Prentice-Hall, Inc. 3 – 23

EMV (large plant) = (0.50)($200,000) + (0.50)(–$180,000)

© 2009 Prentice-Hall, Inc. 3 – 24

Table 3.9 Largest EMV

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EVwPI = (best payoff for first state of nature)

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Perfect Information 200,000 0 EVwPI = 100,000

Alternative Good Average Poor

Alternative Good Average Poor EMV

© 2009 Prentice-Hall, Inc. 3 – 32

EVwPI = $100,000*0.25 + $35,000*0.50

EVPI = $ 42,500 - $27,500

 Expected opportunity loss (EOL) is the

© 2009 Prentice-Hall, Inc. 3 – 34

Probabilities 0.50 0.50

Do nothing 200,000 - 0 0-0 100,000

© 2009 Prentice-Hall, Inc. 3 – 36

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EOL (small plant)=(0.50)($100,000) + (0.50)($20,000) = $60,000

EOL (do nothing)= (0.50)($200,000) + (0.50)($0) = $100,000

 The minimum EOL will always

 The EVPI will always equal the

© 2009 Prentice-Hall, Inc. 3 – 39

P = probability of a favorable market

© 2009 Prentice-Hall, Inc. 3 – 40

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$200,000 Point 2 EMV (large plant)

$100,000 Point 1 EMV (small plant)

0 EMV (do nothing)

© 2009 Prentice-Hall, Inc. 3 – 42

© 2009 Prentice-Hall, Inc. 3 – 43

$200,000 Point 2 EMV (large plant)

$100,000 Point 1 EMV (small plant)

0 EMV (do nothing)

1. Define the problem

EVwPI = $100,0000.25 + $35,0000.50