Quantitative Analysis

for Business Decisions

by

Adel Sakr

dr.adelmsakr.qa@gmail.com

Whatsapp: 01112183988

MBA - 2019
 DECISION ANALYSIS

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 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, considers all available data

and possible alternatives, and the
quantitative approach described here

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 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

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 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

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 Deterministic D.M.
(D.M. under certainty)
◦ Only one “state of nature”,
◦ Payoff of an alternative is known,
◦ Examples:
 Problems for LP, IP, transportation, and network
flows.

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 D.M. without probabilities
(D.M. under uncertainty)

◦ More than one states of nature;

◦ Payoff of an alternative is not known at the time
of making decision;
◦ Probabilities of states of nature are not known.

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 D.M. with probabilities
(D.M. under risk)

◦ More than one states of nature;

◦ Payoff of an alternative is not known at the time
of making decision;
◦ Probabilities of states of nature are known or
given.

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 Components of Decision Making
(D.M.)
 Decision alternatives - for managers to
choose from.
 States of nature - that may actually occur

in the future regardless of the decision.

 Payoffs - payoff of a decision alternative in

a state of nature.
The components are given in Payoff Tables.

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 D.M. in competition
(Game theory)

◦ Making decision against a human competitor.

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 Components of Decision Making
(D.M.)
 Decision alternatives - for managers to choose
from.
 States of nature - that may actually occur in the
future regardless of the decision.
 Payoffs - payoff of a decision alternative in a state
of nature.
The components are given in Payoff Tables.

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 Production Company Decision

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

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 Decision Making Under Uncertainty
There are several criteria for making decisions
under uncertainty
Five criteria (approaches) for a decision maker
to choose from, depending on his/her
preference.
1. Maximax (optimistic)
2. Maximin (pessimistic)
3. Criterion of realism (Hurwicz)
4. Equally likely (Laplace)
5. Minimax regret
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 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 –
plant 200,000 180,000
Construct a small
–20,000
plant 100,000
Do nothing 0 0
 What is your decision?

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 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 –
plant 200,000 180,000 200,000
Construct a small
Maximax
–20,000
plant 100,000 100,000
Do nothing 0 0 0

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Whom Is MaxiMax for?
 MaxiMax method is for optimistic decision
makers who tend to grasp every chance of
making money, who tend to take risk, who
tend to focus on the most fortunate
outcome of an alternative and overlook the
possible catastrophic outcomes of an
alternative.

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 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
ALTERNATIVE MARKET ($) MARKET ($) A ROW ($)
Construct a large –
plant 200,000 180,000
Construct a small
–20,000
plant 100,000
Do nothing 0 0
 What is our decision?

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 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
ALTERNATIVE MARKET ($) MARKET ($) A ROW ($)
Construct a large – –
plant 200,000 180,000 180,000
Construct a small –
–20,000
plant 100,000 20,000
Do nothing 0 0 0
Maximin

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Whom Is MaxiMin for?
 MaxiMin method is for pessimistic decision
makers who tend to be conservative, who
tend to avoid risks, who tend to be more
concerned about being hurt by the most
unfortunate outcome than the opportunity
of being fortunate.

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 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)

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 Criterion of Realism (Hurwicz)
 For the large plant alternative using  = 0.8
(0.8)(200,000) + (1 – 0.8)(–180,000) = ?
 For the small plant alternative using  = 0.8
(0.8)(100,000) + (1 – 0.8)(–20,000) = ?
STATE OF NATURE
CRITERION
FAVORABLE UNFAVORABLE OF REALISM
ALTERNATIVE MARKET ($) MARKET ($) ( = 0.8)$
Construct a large –
plant 200,000 180,000
Construct a small
–20,000
plant 100,000
Do nothing 0 0

 What is your decision?

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 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 –
plant 200,000 180,000 124,000
Construct a small Realism
–20,000
plant 100,000 76,000
Do nothing 0 0 0

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Whom Is Hurwicz for?
 Hurwicz method is not for an extreme risk
taker (=1), or an extreme risk averter
(=0), it’s for a person between the two
extremes ( is somewhere between 1 and 0)
.

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Equally Likely (Laplace)
 Pick the maximum of the average payoffs of
decision alternatives. (Best of the plain
averages)
 Average payoff of a decision alternative

sum of all payoffs of that alternative


number of states of nature

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 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 –
plant 200,000 180,000
Construct a small
–20,000
plant 100,000
Do nothing 0 0

 What is our decision?

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 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 –
plant 200,000 180,000 10,000
Construct a small
–20,000
plant 100,000 40,000
Do nothing 0 0
Equally likely
0

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Whom Is Laplace for?
 Equally likelihood method is for a decision
maker who tends to simply use the average
payoff to judge an alternative.

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 Minimax Regret
Based on opportunity loss or 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
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 Minimax Regret
STATE OF NATURE
FAVORABLE UNFAVORABLE
 Opportunity MARKET ($) MARKET ($)
Loss Tables 200,000 – 200,000 0 – (–180,000)
200,000 – 100,000 0 – (–20,000)
200,000 – 0 0–0

STATE OF NATURE
FAVORABLE UNFAVORABLE
ALTERNATIVE MARKET ($) MARKET ($)
Construct a large plant 0 180,000

Construct a small plant 20,000

100,000
Do nothing 0
200,000
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 Minimax Regret
STATE OF NATURE
FAVORABLE UNFAVORABLE MAXIMUM IN
ALTERNATIVE MARKET ($) MARKET ($) A ROW ($)
Construct a large
0 180,000
plant 180,000
Construct a small
20,000
plant 100,000 100,000
Minimax
Do nothing 0
200,000 200,000

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Whom Is Regret for?
 MiniMax regret method is for a decision
maker who is afraid of being hurt by the
feeling of regret and tries to reduce the
future regret on his/her current decision to
minimum. “I concern more about the regret
I’ll have than how much I’ll make or lose.”

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 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

Alternative Good Average Poor

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

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 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

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 In-Class Example 1: Maximin

State of Nature
Good Average Poor
Alternative Maximin
Market Market Market
($) ($) ($)
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

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 In-Class Example 1:
Criterion of Realism

α =.6
State of Nature
Alternative Good Average Poor Maximum
Market Market Market
($) ($) ($)
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

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 In-Class Example 1: Equally
Likely

State of Nature
Alternative Good Average Poor Avg
Market Market Market
($) ($) ($)
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

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 In-Class Example 1:
Minimax Regret Opportunity Loss Table

State of Nature
Maximum
Alternative Good Average Poor 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

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 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)

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 EMV for the Production Company

 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

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 EMV for the Production Company

STATE OF NATURE
FAVORABLE UNFAVORABLE
ALTERNATIVE MARKET ($) MARKET ($) EMV ($)
Construct a large –
plant 200,000 180,000 10,000
Construct a small
–20,000
plant 100,000 40,000
Do nothing 0 0 0
Probabilities 0.50 0.50

Largest EMV

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 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)
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 Expected Value of Perfect 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?

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 Expected Value of Perfect 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
EVPI = EVwPI – Maximum EMV
= $100,000 - $40,000
= $60,000

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 Expected Value of Perfect Information (EVPI)

1. Best alternative for favorable state of nature is

build a large plant with a payoff of $200,000
So the maximum that company
Best alternative forpay
should unfavorable state of nature is
for the additional
to do nothing with a payoff
information of $0
is $60,000
EVwPI = ($200,000)(0.50) + ($0)(0.50) = $100,000
2. The maximum EMV without additional
information is $40,000
EVPI = EVwPI – Maximum EMV
= $100,000 - $40,000
= $60,000

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 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

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 In-Class Example
 Using the table below compute EMV, EVwPI,
and EVPI.
State of Nature
Alternative Good Average Poor
Market Market Market
($) ($) ($)
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

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 In-Class Example:
EMV and EVwPI Solution

State of Nature
Alternative Good Average Poor EMV
Market Market Market
($) ($) ($)
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
Probability 0.25 0.50 0.25

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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

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 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
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 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
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 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

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Structure of Decision Trees
 It is actually a process of marking numbers on
nodes.
 Mark numbers from left to right .
 For a chance (circle) node, mark it with its
expected value.
 For a decision (square) node, select a decision and
mark the node with the number associated with
the decision.

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Production Company Decision Tree
A State-of-Nature Node
Favorable Market
A Decision Node
1
Unfavorable Market
uct nt
r
n st P l a
e
Co arg
L Favorable Market
Construct
2
Small Plant Unfavorable Market
Do
No
th
in
g

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Production Company 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 P l a
e
Co arg
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
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 Production Company Complex Decision Tree Using Sample
Information

 The Production Company has two decisions to

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.

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Production CompanyComplex Decision Tree

First Decision Second Decision Payoffs

Point Point
Favorable Market (0.78)
$190,000
nt 2 Unfavorable Market (0.22)
Pla –$190,000
ge
Lar Favorable Market (0.78)
$90,000
) Small
. 45 Plant
3 Unfavorable Market (0.22)
(0 –$30,000
e y ts le
u rv sul ab No Plant
–$10,000
S Re vor
a
1 S ur v F Favorable Market (0.27)
e $190,000
y

Re y (
ve

nt 4 Unfavorable Market (0.73)

Ne s u 0 . 5 Pla
ur

e –$190,000
5) g
Lar
tS

ga lts Favorable Market (0.27)

ti v Small $90,000
ke

e 5 Unfavorable Market (0.73)

ar

Plant –$30,000
Mt
uc

No Plant
–$10,000
nd
Co

Do Favorable Market (0.50)

Not $200,000
Con nt 6 Unfavorable Market (0.50)
duc ePla –$180,000
t g
Sur
ve y Lar Favorable Market (0.50)
$100,000
Small
Plant
7 Unfavorable Market (0.50)
–$20,000
No Plant
$0

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 Production Company Complex Decision Tree

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

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 Production Company Complex Decision Tree

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

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Production Company Complex Decision Tree
First Decision Second Decision Payoffs
Point Point
$106,400 Favorable Market (0.78)
$190,000
n t Unfavorable Market (0.22)
Pla –$190,000

$106,400
a rge $63,600 Favorable Market (0.78)
L $90,000
) Small
. 45 Plant
Unfavorable Market (0.22)
–$30,000
(0
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
e
y

Re y (
ve

n t Unfavorable Market (0.73)

Ne s u 0 . 5 Pla
ur

–$190,000
5) rge
tS

ga lts $2,400 Favorable Market (0.27)

$2,400
La
ti v Small $90,000
ke

e Unfavorable Market (0.73)

ar

Plant –$30,000
M
ct

No Plant
du

–$10,000
on
$49,200
C

Do $10,000 Favorable Market (0.50)

Not $200,000
Con nt Unfavorable Market (0.50)
duc e Pla –$180,000
$40,000

t g
Sur
ve y Lar $40,000 Favorable Market (0.50)
$100,000
Small
Unfavorable Market (0.50)
Plant –$20,000
No Plant
$0

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 DECISION TREE ASSIGNMENT
 Sun and Earth (S&E) is a company set up to
conduct geological explorations of parcels of
land in order to ascertain whether significant
metal deposits (worthy of further commercial
exploitation) are present or not. Current (S&E)
has an option to purchase outright a parcel of
land for £3m.
 If (S&E) purchases this parcel of land then it will
conduct a geological exploration of the land. Past
experience indicates that for the type of parcel of
land under consideration geological explorations
cost approximately £1m and yield significant
metal deposits as follows:
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manganese 1% chance
gold 0.05% chance
silver 0.2% chance
 Only one of these three metals is ever found (if at all), i.e.
there is no chance of finding two or more of these metals
and no chance of finding any other metal.
 If manganese is found then the parcel of land can be sold
for £30m, if gold is found then the parcel of land can be
sold for £250m and if silver is found the parcel of land can
be sold for £150m.
 (S&E) can, if they wish, pay £750,000 for the right to
conduct a three-day test exploration before deciding
whether to purchase the parcel of land or not. Such three-
day test explorations can only give a preliminary indication
of whether significant metal deposits are present or not
and past experience indicates that three-day test
explorations cost £250,000 and indicate that significant
metal deposits are present 50% of the time.
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 If the three-day test exploration indicates
significant metal deposits then the chances of
finding manganese, gold and silver increase to 3%,
2% and 1% respectively. If the three-day test
exploration fails to indicate significant metal
deposits then the chances of finding manganese,
gold and silver decrease to 0.75%, 0.04% and
0.175% respectively.
 What would you recommend (S&E) should do and
why?
 A company working in a related field to (S&E) is
prepared to pay half of all costs associated with
this parcel of land in return for half of all revenues.
Under these circumstances what would you
recommend (S&E) should do and why?

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 THANK YOU

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