Managerial Decision Modeling

with Spreadsheets

Chapter 8
Decision Theory
Learning Objectives
• List steps of decision making process.
• Describe different types of decision making
environments.
• Make decisions under uncertainty when
probabilities are not known.
• Make decisions under risk when probabilities are
known.
• Use Excel for problems involving decision tables.
• Develop accurate and useful decision trees.
• Revise probability estimates using Bayesian
analysis
8.1 Introduction
• Decision theory is analytic and systematic approach to
study of decision-making.
• What makes difference between good and bad
decisions?
• Good decisions may be defined as:
– Based on logic,
– Considered all possible decision alternatives,
– Examined all available information about future, and
– Applied decision modeling approach.
• Bad decision may be defined as:
– Not based on logic,
– Did not use all available information,
– Did not consider all alternatives, and
– Did not employ appropriate decision modeling techniques.
8.2 Five Steps of Decision Making
1. Clearly define problem at hand.
2. List all possible decision alternatives.
3. Identify possible future outcomes for each decision
alternative.
4. Identify payoff (usually, profit or cost) for each
combination of alternatives and outcomes.
5. Select one of decision theory modeling techniques,
apply decision model, and make decision.
Thompson Lumber Co. Example
Decision: Whether or not to make and sell
storage sheds
Alternatives:
Build a large plant
Build a small plant
Do nothing
Outcomes: Demand for sheds will be high,
moderate, or low
Thompson Lumber Co
Alternatives
Outcomes (Demand)
High Moderate Low
Large plant 200,000 100,000 -120,000
Small plant 90,000 50,000 -20,000
No plant 0 0 0
Payoff Table
Components of Decision Making
Payoff Table
• A state of nature is an actual event that may occur in the
future.
• A payoff table is a means of organising a decision
situation, presenting the payoffs from different decisions
given the various states of nature.
8.3 Types Of Decision Making
Environments
Type 1: Decision Making under Certainty. Decision maker
knows with certainty consequence of every decision alternative.
Type 2: Decision Making under Uncertainty. Decision maker
has no information about various outcomes.
Type 3: Decision Making under Risk. Decision maker has
some knowledge regarding probability of occurrence of each
outcome or state of nature.
Examples:
• Probability of being dealt club from deck of cards is 1/4.
• Probability of rolling 5 on die is 1/6.

8.4 Decision Making Under Uncertainty
• Criteria for making decisions under uncertainty.
1. Maximax.
2. Maximin.
3. Equally likely (LaPlace).
4. Criterion of realism (Hurwicz).
5. Minimax (or minmax) regret.
• First four criteria calculated directly from decision
payoff table.
• Fifth minmax regret criterion requires use of
opportunity loss (regret) table.
Maximax Criterion (Profits)
•Maximax criterion selects alternative maximises
maximum (best) payoff over all alternatives.
•First locate maximum (best) payoff for each alternative.
•Select alternative with maximum (best) number.
•Criterion locates alternative with highest possible gain.
•Called optimistic criterion.
Alternatives Maximum
Large plant 200,000
Small plant 90,000
No plant 0
Decision: Since Large
Plant carries the
maximum of 200,000,
the decision is to build
Large Plant
Thompson Lumber
Maximin Criterion (Profits)
•Maximin criterion finds alternative which maximises
minimum payoff over all alternatives.
•First locate minimum (worst) payoff for each alternative.
•Select alternative with maximum (best) number.
•Criterion locates alternative that has least possible loss.
•Called pessimistic criterion.
Alternatives Minimum
Large plant -120,000
Small plant -20,000
No plant 0
Decision: Since No Plant
carries the maximum of min
(best of the worst) 0, the
decision is No Plant
Thompson Lumber
Equally Likely (LaPlace) Criterion
•Equally likely, also called LaPlace, criterion finds
decision alternative with highest average payoff (profits);
lowest average payoff (costs).
•Calculate average payoff for every alternative.
•Pick alternative with maximum average payoff.
•Assumes all probabilities of occurrence for states of
nature are equal.
Choices Average
Large plant (200,000+100,000-120,000)/3 = 60,000
Small plant (90,000 + 50,000 - 20,000)/3 = 40,000
No plant (0 + 0 + 0)/3 = 0
Decision: Large plant
Thompson Lumber
Criterion of Realism (Hurwicz)
• Often called weighted average, the criterion of
realism (or Hurwicz) decision criterion is a
compromise between optimistic and pessimistic
decision.
• Select coefficient of realism, o, with value between 0
and 1.
– When o is close to 1, decision maker is optimistic
about future.
– When o is close to 0, decision maker is pessimistic
about future.
Hurwicz Criterion
Apply o to the BEST payoff and (1- o ) to the WORST
For Hurwicz in PROFITS = o*(max) + (1-o)*(min)
Assume coefficient of realism o = 0.45. So 1- o = 0.55
Choices Average
Large plant 0.45*200,000 + 0.55*(-120,000) = 24,000
Small plant 0.45* 90,000 + 0.55 * (-20,000) = 29,500
No plant 0.45*0+0.55*0 = 0
Decision: Small plant
Thompson Lumber
Not that when applied to the Costs, α goes with the
LOWEST
Minimax Regret Criterion
• Final decision criterion is based on opportunity loss.
• Opportunity loss, also called regret, is difference between
optimal payoff and actual payoff received.
• Develop opportunity loss (regret) table.
• Determine opportunity loss of not choosing best alternative for
each state of nature.
• Opportunity loss for any state of nature, or any column, is
calculated by subtracting each outcome in column from best
outcome in same column. PROFITS
• Opportunity loss for any state of nature, or any column, is
calculated by subtracting best outcome in same column
from each outcome in column: COSTS
Payoffs are Profits
States of Nature (Market)
Decision High Moderate Low
Large Plant 200,000 – 200,000 100,000 – 100,000 0 – –120,000
Small Plant 200,000 – 90,000 100,000 – 50,000 0 – – 20,000
No Plant 200,000 – 0 100,000 – 0 0 – 0
Calculating Regrets
Note that for each STATE OF NATURE, we find the best
(highest) payoff and FROM it we subtract all the rest. If
the payoffs were cost, then the best is the LOWEST and it
is SUBTRACTED FROM all the rest in that state of
nature. We cannot have negative regrets.
Minimax Regret Criterion
Thompson Lumber
Regrets
States of Nature (Market)
Alternatives High Moderate Low
Large Plant 0 0 120,000
Small Plant 110,000 50,000 20,000
No Plant 200,000 100,000 0
Maximum
120,000
110,000
200,000
Decision. Choose Small Plant for it has the minimum
of the max regrets.
Note that we do not ADD regrets, but find the maximum.
8.5 Decision Making Under Risk
• Common for decision maker to have some idea about
probabilities of occurrence of different outcomes or
states of nature.
• Probabilities may be based on decision maker’s
personal opinions about future events, or on data
obtained from market surveys, expert opinions, etc.
• When probability of occurrence of each state of nature
can be assessed, problem environment is called
decision making under risk.

Expected Monetary Value
• Given decision table with conditional values (payoffs) and
probability assessments, determine expected monetary value
(EMV) for each alternative.
• Computed as weighted average of all possible payoffs for
alternative, where weights are probabilities of different states
of nature:
EMV (alternative 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)
Expected Monetary Value
•If the probability of high is 30%, of medium 50%, and of low
is 20%. Using EMV, what option should be chosen and what is
that optimal expected value? This value is called expected
value without perfect information = EWoPI
Thompson Lumber
0.20 0.50 0.30 Probability
0 0 0 0 No Plant
48,000 -20,000 50,000 90,000 Small Plant
86,000 -120,000 100,000 200,000 Large Plant
EMV Low Mod High Alternatives
E.g. (0.3*200,000)+(0.5*100,000)+(0.3*-120,000) = 86,000
Decision Large Plant. EMV = 86,000.
Expected Value of Perfect Information
• Expected value with perfect information is expected or average
return, if one has perfect information before decision has to be
made.
• Choose best alternative for each state of nature and multiply its
payoff times probability of occurrence of that state of nature:
Expected value with perfect information (EV with PI) =
(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)
(1) EVPI = EV with PI - EWoPI
(2) EVPI = MINIMUM Expected Regret.

EV with PI and EVPI
• Best outcome for state of nature “high” is “Large Plant” with a
payoff of 200,000; Best outcome for state of nature “Moderate”
is “Large Plant” with payoff of 100,000 and best outcome for
state of nature “low” is “no plant” with a payoff of 0.
• Expected value with perfect information
(EV with PI) = (200,000)(0.3) + (100,000)(0.5) + (0)(0.2)
= 110,000. This is called EWPI
• If one had perfect information, an average payoff of 110,000 if
decision could be repeated many times.
• Maximum EMV or expected value without perfect information,
is 86,000. This is called EWoPI
• EVPI = EWPI – EWoPI = 110,000 – 86,000 = 24,000.
EVPI From Regrets
•Calculate Expected Value for all Decision Alternatives.
•Identify Minimum Expected Regret (Opportunity Loss)
•This is EVPI = 24,000
Thompson Lumber
Alternatives
Outcomes (Demand)
High
Moderate
Low
Large plant 0 0 120,000
Small plant 110,000 50,000 20,000
No plant 200,000 100,000 0
EOL
24,000
62,000
110,000
Probability 0.3 0.5 0.2
Decision Trees
• Any problem presented in decision table can be
graphically illustrated in decision tree.
• All decision trees are similar in that they contain
decision nodes (or points) and state of nature nodes
(or points).
• These nodes are represented using following symbols:
= A decision node.
Arcs (lines) originating from decision node denote all
decision alternatives available at that node.
О = A state of nature (or chance) node.
Arcs (lines) originating from a chance node denote all
states of nature that could occur at that node.
8.6 Solving Decision Trees
• Draw (grow) decision trees from LEFT to RIGHT .
• Solve Decision trees from RIGHT to LEFT.
– Operate at NODES only (Please number all nodes)
– Calculate (only) expected values at state of nature nodes
– Make decisions at decision nodes
– Fold back optimal expected values. That is, at every decision
node, write optimal value obtained from that decision.
– Prune (using double slash), the INFERIOR decisions
• State optimal decision from LEFT to RIGHT.
– Follow UNPRUNED decisions
– At state of nature points say “IF”
• Report the Optimal Expected value of Node 1.
Smith Manufacturing
• The Smith Manufacturing Company must decide whether it
should purchase a component part from a supplier or make the
part itself at its St. Lucia plant. Figures are \$0,000.
• If demand turns out to be high (H), the net profits from purchase
is \$70 and from manufacture is \$100. If demand turns out to be
medium (M), the net profits from purchase is \$45 and from
manufacture is \$40. If demand turns out to be low (L), the net
profits from purchase is \$10 and from manufacture is - \$20
(loss). The probabilities are high: 0.3; medium: 0.35; low: 0.35
• Smith may have a test market study done by a market research
company. The response will be either favourable (probability
0.35) or unfavourable. This test costs \$2.5. If the test is done,
then the probabilities would be revised. P(H|F) = 0.5; P(M|F) =
0.4; P(L|F) = 0.1; P(H|U) = 0.2; P(M|U) = 0.32; P(L|U) = 0.48
Smith Manufacturing
• Requirements (for all decision trees).
• Draw a decision tree in logical order.
– Decision alternatives
– States of nature
– Payoffs (net)
– Probability values
• Solve the decision tree by folding back method
• State optimal decision and optimal EMV
• What is the Expected Value of Sample Information
(EVSI) which is the most that should be paid for the test?
• What is the EVPI?
• What is the Efficiency of Sample Information?
Smith Manufacturing Solution
 In all decision trees there is a logical order of events. A
tree cannot be put together arbitrarily. Even if all the
components are right but they are in the wrong places,
the tree is wrong!! Bear these points in mind.
 Certain outcomes follow certain decisions only. You must
identify all the decisions and their respective outcomes. The
outcomes must immediately follow their decisions.
 In the event that there is sample or survey information that may
be collected (it is an option), this cannot be done after the main
decision(s); it must be done before.
 The decision maker who chooses to collect sample information,
must await the outcome of the sample information before
proceeding o his or her main decision
 Irrespective of the outcome of sample information, the main
decision(s) are always available to the decision maker
Decision Tree
Tree usually begins with decision node.
Since there is the option of a test market study, then
Smith should choose whether to do it or not, before
deciding between the make or buy (main) decisions.
Smith Manufacturing
Two decision alternatives
Decision point
Decision Tree
Following the option to test the market we immediately
put its outcomes and NEVER nowhere else. Also write
the probabilities if known.
State of nature point
Two states of nature (their
probabilities must sum to 1)
Decision Tree
Following the test market results, or the decision not to test,
Smith must now decide between make or buy (or do nothing).
The do nothing option must always be considered if it is better
than an existing option (to prevent a loss when it can be avoided)
Following
the make or
buy decision
in ALL
CASES the
outcomes
that follow
are demand
high,
medium or
low.
1
2
5
4
3
6
7
10
9
8
11
P(M) = 0.35
P(M) = 0.35
P(M|F) = 0.4
P(M|F) = 0.4
P(M|U) = 0.32
97.5
37.5
-22.5
67.5
42.5
7.5
100
40
-20
70
45
10
7.5
42.5
67.5
-22.5
37.5
97.5
Complete the tree
by including the
NET payoffs.
Since the test costs
2.5, all payoffs
that follow must
go down by 2.5
Folding Back a Decision Tree
 In folding back decision tree, use following two rules:
 At each state of nature node, compute expected value using
probabilities of all possible outcomes at that node and payoffs
associated with outcomes.
 At each decision node, select alternative that yields better
expected value or payoff.
 EV (6) = (0.3*100)+ (0.35*40)+(0.35*-20) = 37
 EV (7) = (0.3*70)+ (0.35*45)+(0.35*10) = 40.25
 EV (8) = (0.5*97.5)+ (0.4*37.5)+(0.1*-22.5) = 61.5
 EV (9) = (0.5*67.5)+ (0.4*42.5)+(0.1*7.5) = 51.5
 EV (10) = (0.20*97.5)+ (0.32*37.5)+(0.48*-22.5) = 20.7
 EV (11) = (0.20*67.5)+ (0.32*42.5)+(0.48*7.5) = 30.7
Write the values at the nodes!!
1
2
5
4
3
6
7
10
9
8
11
P(M) = 0.35
P(M) = 0.35
P(M|F) = 0.4
P(M|F) = 0.4
P(M|U) = 0.32
97.5
37.5
-22.5
67.5
42.5
7.5
100
40
-20
70
45
10
7.5
42.5
67.5
-22.5
37.5
97.5
40.25
61.5
51.5
20.7
30.7
37
Expected values
written at nodes, now
make decision at 3, 4
and 5
Choose between
make or buy at each
point, based on best
value
1
2
5
4
3
6
7
10
9
8
11
P(M) = 0.35
P(M) = 0.35
P(M|F) = 0.4
P(M|F) = 0.4
P(M|U) = 0.32
97.5
37.5
-22.5
67.5
42.5
7.5
100
40
-20
70
45
10
7.5
42.5
67.5
-22.5
37.5
97.5
40.25
61.5
51.5
20.7
30.7
37
•At 4, choose make
•At 5, choose buy
•At 3, choose buy
1
2
5
4
3
6
7
10
9
8
11
P(M) = 0.35
P(M) = 0.35
P(M|F) = 0.4
P(M|F) = 0.4
P(M|U) = 0.32
97.5
37.5
-22.5
67.5
42.5
7.5
100
40
-20
70
45
10
7.5
42.5
67.5
-22.5
37.5
97.5
40.25
61.5
51.5
20.7
30.7
37
40.25
61.5
30.7
Folding back the
optimal values,
pruning the inferior
decisions
Pruning
Now Calculate
EV at node 2
EV(2) = 0.35*61.5+0.65*30.7 = 41.48
1
2
5
4
3
6
7
10
9
8
11
P(M) = 0.35
P(M) = 0.35
P(M|F) = 0.4
P(M|F) = 0.4
P(M|U) = 0.32
97.5
37.5
-22.5
67.5
42.5
7.5
100
40
-20
70
45
10
7.5
42.5
67.5
-22.5
37.5
97.5
40.25
61.5
51.5
20.7
30.7
37
40.25
61.5
30.7
41.48
41.48
Write EV at 2, and make
decision at node 1
Bring back optimal EV to
node 1.
Stating Decision, EVSI, EVPI, Efficiency
•Decision: Do the market test, if favourable MAKE
(manufacture) the part but if unfavourable, Buy the part
•Optimal EV is 41.48
•EVSI: One way of measuring value of market
information is to compute the expected value of sample
information (EVSI), as follows:
•EVSI = EWSI – EWoSI (Profits)
•EVSI = EWoSI – EWSI (Costs)
Expected Value of Sample Information
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EVSI with Cost Minimisation
•When dealing with costs: EVSI = EWoSI – EWSI
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EVPI
•EVPI is obtained from NO TEST SIDE ONLY!!
•EVPI = EWPI – EWoPI (Profits)
•This is expected value of perfect information,
uncontaminated by sample information.
•EWoPI = optimal EV at No Test Decision = 40.25
•EWPI = 0.3*100 + 0.35*45 + 0.35*10 = 49.25
•EVPI = 49.25 – 40.25 = 9.00
100 is best expected value if we knew demand was going
to be high; 45 is best if we knew it was medium and 10 is
best if we knew demand was going to be low.
Efficiency of Sample Information
How close does the sample information come to
perfect information?

Efficiency of sample information
= EVSI | EVPI
Efficiency = EVSI/EVPI % = 3.73/9 = 41.44%
Expanded Thompson
Lumber Example
Suppose they will first decide whether to pay
\$4000 to conduct a market survey
Survey results will be imperfect
Then they will decide whether to build a large
plant, small plant, or no plant
Then they will find out what the outcome and
payoff are
Marketing Reliability of Research Firm
The marketing research firm provided the following
probabilities based on its track record of survey
accuracy:
P(V|H) = 0.967 P(N|H) = 0.033
P(V|M) = 0.533 P(N|M) = 0.467
P(V|L) = 0.067 P(N|L) = 0.933
That is, for example, in the past, when demand
was high, it reported positive 96.7% of the time
and negative 3.3% of the time
Here V = the event the survey result is positive and
N = the event the result is negative N = V’
Questions
What should Thompson Lumber do now?
Use a decision tree this time.
You have to revise probabilities using law of Total
Probability and Bayes Theorem.
What is the optimal decision and optimal EMV?
What is EVSI?
What is EVPI?
What is the efficiency of sample information?
Shamrock Oil (Same Questions)
• Shamrock Oil owns a parcel of land that has the
potential to be an underground oil field. It will
cost \$500,000 to drill for the oil. If oil does exist
on the land, Shamrock will realize a payoff of
\$4,000,000 (not including drilling costs). With
current information, Shamrock estimates that there
is a 20% probability that oil is present on the site.
• Shamrock also has the option of selling the land as
is for \$400,000 without further information about
the likelihood of oil being present.
Shamrock Oil continued
• A firm can perform geological tests at the site,
which would cost \$100,000. Shamrock Oil has
some information concerning the accuracy of the
geological test probabilities. According to this
information, the probability that the test will be
positive given that oil is present in the ground is
85%. The probability that the test will be negative
given that oil is not present is 75%. If the test
results are positive Shamrock can sell the land for
\$650,000 or continue to drill. If the test results are
negative, Shamrock can sell the land for \$50,000 or
drill the land for oil.
Decision Theory 2. Bob’s Bike Shop
Bob’s Bike Shop is considering three options for his
facility next year. He can expand his current shop, move
to a larger facility, or make no change. With a
favourable market, the annual payoff would be \$56000 if
he expands, \$70000 if he moves, and \$30000 if he does
nothing. With an average market, his payoff will be
\$21000, \$35000, and \$10000 respectively. With an
unfavourable market, his payoff will be \$-29000, \$-
45000, and \$5000 respectively.
Bob’s Payoff Table
Payoffs are Profits
States of Nature (Market)
Decision
Alternatives Favourable Average Unfavourable
Expand \$56,000 \$21,000 –\$29,000
Move \$70,000 \$35,000 –\$45,000
No Change \$30,000 \$10,000 \$5,000
Bob’s Bike Shop
Decision Theory 3. Tees R Us
Tees R Us manufactures and sells tee shirts for
sporting events. They are providing tee shirts for an
upcoming event with the following financial data.
Each tee shirt that is MADE will cost \$10
Each tee shirt that is SOLD will generate \$16 revenue
Each tee shirt that was made but NOT SOLD will be
salvaged for \$5 (this is revenue)
There is no cost for lost sales (demand greater than
amount made)
Tees R Us
Tees R Us believes that demand will be 1,000,
2,000, 3,000 or 4,000 tee shirts. They need to
decide whether to produce 1,000, 2,000, 3,000 or
4,000 tee shirts.
Create a payoff table that shows the quantity made
(in row) and possible demand - states of nature (in
column) where payoffs = profits.
Answer the questions that follow
Questions
• Complete the payoff table for Tees R Us (TRU)
• Using maximax, what quantity should Tees R Us make?
• Using maximin, what quantity should Tees R Us make?
• For a LaPlace decision maker, what quantity should TRU make?
• Using Hurwicz, what quantity should TRU make α = 0.7?
• Using a minmax regret approach, which option would you
choose?
• If the demand probabilities are 0.15, 0.25, 0.30 and 0.30,
respectively which quantity will maximise expected profit?
What is the expected profit associated with that
recommendation?
• What is the most the firm should be willing to pay to obtain
further (perfect) information (EVPI) concerning the actual
demand?
Decision Theory 4. Data Processing (Costs)
•A firm is considering three options for managing its data
processing operation: continuing with its own staff, hiring an
outside vendor to do the managing (referred to as outsourcing), or
a combination of its own staff and outside vendor. The cost of
the operation depends on future demand. The annual cost of each
decision alternative and state of nature (in thousands of dollars) is
as follows: (Objective is to MINIMISE costs)
States of Nature (Demand)
Alternative High Medium Low
Own staff 650 650 600
Vendor 900 600 300
Combination 800 650 500
Questions – Data Processing
• Using maximax, what option should the firm choose?
• Using maximin, what option should the firm choose?
• For a LaPlace, what option should the firm choose?
• Using Hurwicz, what option should be chosen? Make α =
0.7?
• Using a minmax regret approach, which option would you
choose?
• If the demand probabilities are 0.3, 0.3, and 0.4, respectively
which option will minimise expected cost? What is the
expected cost associated with that recommendation?
• What is the most the firm should be willing to pay to obtain
further (perfect) information (EVPI) concerning the actual
demand?
Maximax Criterion (Costs)
•Maximax criterion selects alternative which minimises
minimum (best) payoff over all alternatives.
•First locate minimum payoff for each alternative.
•Select alternative with minimum number.
•Decision criterion locates alternative with lowest
possible cost.
Alternatives Minimum
Own Staff 600
Vendor 300
Combination 500
Decision: Since
Vendor carries the
minimum of 300,
the decision is to
use Vendor
Data Processing question
Maximin Criterion (Costs)
•Maximin criterion finds alternative which minimises
worst (maximum in costs) payoff over all alternatives.
•First locate worst (highest) cost for each alternative.
•Select alternative with minimum (best) number.
•Criterion locates alternative that has lowest of max cost.
•Called pessimistic criterion.
Alternatives Max (worst)
Own Staff 650
Vendor 900
Combination 800
Decision: Since Own
Staff carries the minimum
of the maximum costs =
600, the decision is to use
Own Staff
Data Processing Operation

Learning Objectives
• List steps of decision making process. • Describe different types of decision making environments. • Make decisions under uncertainty when probabilities are not known. • Make decisions under risk when probabilities are known. • Use Excel for problems involving decision tables. • Develop accurate and useful decision trees. • Revise probability estimates using Bayesian analysis

8.1 Introduction
• Decision theory is analytic and systematic approach to study of decision-making. • What makes difference between good and bad decisions? • Good decisions may be defined as:
– – – – Based on logic, Considered all possible decision alternatives, Examined all available information about future, and Applied decision modeling approach.

• Bad decision may be defined as:
– – – – Not based on logic, Did not use all available information, Did not consider all alternatives, and Did not employ appropriate decision modeling techniques.

8.2 Five Steps of Decision Making
1. Clearly define problem at hand. 2. List all possible decision alternatives. 3. Identify possible future outcomes for each decision alternative. 4. Identify payoff (usually, profit or cost) for each combination of alternatives and outcomes.

5. Select one of decision theory modeling techniques,
apply decision model, and make decision.

Thompson Lumber Co. Example
Decision: Whether or not to make and sell storage sheds Alternatives: Build a large plant Build a small plant Do nothing Outcomes: Demand for sheds will be high, moderate, or low

000 50.Thompson Lumber Co Payoff Table Outcomes (Demand) Alternatives Large plant Small plant No plant High 200.000 0 Low -120.000 -20.000 0 .000 90.000 0 Moderate 100.

presenting the payoffs from different decisions given the various states of nature. • A payoff table is a means of organising a decision situation.Components of Decision Making • A state of nature is an actual event that may occur in the future. Payoff Table .

.3 Types Of Decision Making Environments Type 1: Decision Making under Certainty. Examples: • Probability of being dealt club from deck of cards is 1/4. Decision maker knows with certainty consequence of every decision alternative. • Probability of rolling 5 on die is 1/6. Type 2: Decision Making under Uncertainty. Type 3: Decision Making under Risk. Decision maker has some knowledge regarding probability of occurrence of each outcome or state of nature.8. Decision maker has no information about various outcomes.

Maximin. Maximax. 1. 3. 2. .4 Decision Making Under Uncertainty • Criteria for making decisions under uncertainty. • Fifth minmax regret criterion requires use of opportunity loss (regret) table. Minimax (or minmax) regret. Equally likely (LaPlace).8. • First four criteria calculated directly from decision payoff table. 4. 5. Criterion of realism (Hurwicz).

•First locate maximum (best) payoff for each alternative. •Criterion locates alternative with highest possible gain.000 90. the decision is to build Large Plant .000 0 Decision: Since Large Plant carries the maximum of 200.•Maximax criterion selects alternative maximises maximum (best) payoff over all alternatives.000. •Select alternative with maximum (best) number. •Called optimistic criterion. Thompson Lumber Maximax Criterion (Profits) Alternatives Large plant Small plant No plant Maximum 200.

Maximin Criterion (Profits) •Maximin criterion finds alternative which maximises minimum payoff over all alternatives. •Criterion locates alternative that has least possible loss. •Select alternative with maximum (best) number. Alternatives Large plant Small plant No plant Minimum -120. the decision is No Plant . •Called pessimistic criterion.000 0 Thompson Lumber Decision: Since No Plant carries the maximum of min (best of the worst) 0. •First locate minimum (worst) payoff for each alternative.000 -20.

000 No plant (0 + 0 + 0)/3 = 0 Decision: Large plant .20. •Calculate average payoff for every alternative. •Pick alternative with maximum average payoff.000 . Thompson Lumber Choices Average Large plant (200. lowest average payoff (costs).000-120.Equally Likely (LaPlace) Criterion •Equally likely.000)/3 = 60.000 Small plant (90.000)/3 = 40.000+100. •Assumes all probabilities of occurrence for states of nature are equal.000 + 50. also called LaPlace. criterion finds decision alternative with highest average payoff (profits).

• Select coefficient of realism. decision maker is pessimistic about future. with value between 0 and 1. the criterion of realism (or Hurwicz) decision criterion is a compromise between optimistic and pessimistic decision. a. – When a is close to 1. .Criterion of Realism (Hurwicz) • Often called weighted average. – When a is close to 0. decision maker is optimistic about future.

45* 90.000 + 0.45. So 1.45*0+0.55*0 = 0 Decision: Small plant Not that when applied to the Costs.a ) to the WORST For Hurwicz in PROFITS = a*(max) + (1-a)*(min) Assume coefficient of realism a = 0.55 Choices Large plant Small plant No plant Average 0.Hurwicz Criterion Thompson Lumber Apply a to the BEST payoff and (1.000 0.a = 0.55 * (-20. α goes with the LOWEST .55*(-120.000) = 24.500 0.000) = 29.45*200.000 + 0.

also called regret. • Develop opportunity loss (regret) table. • Determine opportunity loss of not choosing best alternative for each state of nature. or any column. is calculated by subtracting each outcome in column from best outcome in same column.Minimax Regret Criterion • Final decision criterion is based on opportunity loss. PROFITS • Opportunity loss for any state of nature. • Opportunity loss. or any column. is difference between optimal payoff and actual payoff received. • Opportunity loss for any state of nature. is calculated by subtracting best outcome in same column from each outcome in column: COSTS .

000 – 50.000 – 0 100.000 Small Plant 200.Calculating Regrets Payoffs are Profits States of Nature (Market) High Moderate Low 0 – –120. . We cannot have negative regrets.000 100. If the payoffs were cost. then the best is the LOWEST and it is SUBTRACTED FROM all the rest in that state of nature.000 – 200.000 – 100.000 – 90.000 Decision Large Plant 200.000 No Plant 200. we find the best (highest) payoff and FROM it we subtract all the rest.000 – 0 0–0 Note that for each STATE OF NATURE.000 100.000 0 – – 20.

Choose Small Plant for it has the minimum of the max regrets.Minimax Regret Criterion Thompson Lumber Regrets States of Nature (Market) Alternatives High Moderate Low Maximum Large Plant Small Plant No Plant 0 110.000 110.000 100.000 0 120.000 20. but find the maximum. .000 0 50.000 Decision.000 120. Note that we do not ADD regrets.000 200.000 200.

expert opinions. • When probability of occurrence of each state of nature can be assessed. problem environment is called decision making under risk. • Probabilities may be based on decision maker’s personal opinions about future events. or on data obtained from market surveys.5 Decision Making Under Risk • Common for decision maker to have some idea about probabilities of occurrence of different outcomes or states of nature.8. . etc.

Expected Monetary Value • Given decision table with conditional values (payoffs) and probability assessments. . where weights are probabilities of different states of nature: EMV (alternative 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) + . • Computed as weighted average of all possible payoffs for alternative. + (payoff of last state of nature) x (probability of last state of nature) . . determine expected monetary value (EMV) for each alternative.

.000 0 0.000)+(0.000 0 0.000 50.000 0 0. EMV = 86. and of low is 20%. what option should be chosen and what is that optimal expected value? This value is called expected value without perfect information = EWoPI Alternatives Large Plant Small Plant No Plant Probability High 200.50 Low -120.000)+(0. Using EMV.g.3*200.000.5*100.30 Mod 100.000 -20.000) = 86. of medium 50%.Thompson Lumber Expected Monetary Value •If the probability of high is 30%.3*-120.000 90.000 0 E.000 48.000 Decision Large Plant. (0.20 EMV 86.

if one has perfect information before decision has to be made. + (best payoff for last state of nature) x (probability of last state of nature) (1) EVPI = EV with PI . . .EWoPI (2) EVPI = MINIMUM Expected Regret.Expected Value of Perfect Information • Expected value with perfect information is expected or average return. . • Choose best alternative for each state of nature and multiply its payoff times probability of occurrence of that state of nature: Expected value with perfect information (EV with PI) = (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) + .

000. • Maximum EMV or expected value without perfect information.2) = 110.000. This is called EWoPI • EVPI = EWPI – EWoPI = 110.EV with PI and EVPI • Best outcome for state of nature “high” is “Large Plant” with a payoff of 200.000 if decision could be repeated many times. is 86.5) + (0)(0.3) + (100.000 = 24. • Expected value with perfect information (EV with PI) = (200.000)(0.000)(0.000 and best outcome for state of nature “low” is “no plant” with a payoff of 0. .000. an average payoff of 110. Best outcome for state of nature “Moderate” is “Large Plant” with payoff of 100.000.000 – 86. This is called EWPI • If one had perfect information.

EVPI From Regrets •This is EVPI = 24.000 0 50.000 0.000 No plant Probability 200.000 20.000 EOL 24.000 62. •Identify Minimum Expected Regret (Opportunity Loss) Moderate Low Large plant Small plant 0 110.000 Outcomes (Demand) Alternatives High Thompson Lumber •Calculate Expected Value for all Decision Alternatives.3 100.5 0.000 120.000 110.2 0 .000 0.

• All decision trees are similar in that they contain decision nodes (or points) and state of nature nodes (or points). О = A state of nature (or chance) node. • These nodes are represented using following symbols:  = A decision node. Arcs (lines) originating from decision node denote all decision alternatives available at that node.Decision Trees • Any problem presented in decision table can be graphically illustrated in decision tree. . Arcs (lines) originating from a chance node denote all states of nature that could occur at that node.

6 Solving Decision Trees • Draw (grow) decision trees from LEFT to RIGHT . at every decision node. – Follow UNPRUNED decisions – At state of nature points say “IF” • Report the Optimal Expected value of Node 1. – – – – Operate at NODES only (Please number all nodes) Calculate (only) expected values at state of nature nodes Make decisions at decision nodes Fold back optimal expected values. – Prune (using double slash). That is.8. • Solve Decision trees from RIGHT to LEFT. write optimal value obtained from that decision. the INFERIOR decisions • State optimal decision from LEFT to RIGHT. .

35. If demand turns out to be low (L). Figures are \$0.35 • Smith may have a test market study done by a market research company.5.5. then the probabilities would be revised. the net profits from purchase is \$70 and from manufacture is \$100.2.32. P(M|U) = 0.\$20 (loss). P(M|F) = 0. If the test is done.000. • If demand turns out to be high (H).Smith Manufacturing • The Smith Manufacturing Company must decide whether it should purchase a component part from a supplier or make the part itself at its St. The response will be either favourable (probability 0. P(L|F) = 0.3. The probabilities are high: 0.48 . If demand turns out to be medium (M). Lucia plant.35) or unfavourable.1. P(H|U) = 0. low: 0. P(H|F) = 0. the net profits from purchase is \$10 and from manufacture is . P(L|U) = 0. the net profits from purchase is \$45 and from manufacture is \$40. medium: 0. This test costs \$2.4.

Smith Manufacturing • Requirements (for all decision trees). • Draw a decision tree in logical order. – – – – Decision alternatives States of nature Payoffs (net) Probability values • Solve the decision tree by folding back method • State optimal decision and optimal EMV • What is the Expected Value of Sample Information (EVSI) which is the most that should be paid for the test? • What is the EVPI? • What is the Efficiency of Sample Information? .

the main decision(s) are always available to the decision maker . The outcomes must immediately follow their decisions. it must be done before. A tree cannot be put together arbitrarily.  Certain outcomes follow certain decisions only.  The decision maker who chooses to collect sample information.Smith Manufacturing Solution  In all decision trees there is a logical order of events.  In the event that there is sample or survey information that may be collected (it is an option). Even if all the components are right but they are in the wrong places. the tree is wrong!! Bear these points in mind. this cannot be done after the main decision(s). must await the outcome of the sample information before proceeding o his or her main decision  Irrespective of the outcome of sample information. You must identify all the decisions and their respective outcomes.

Decision point Two decision alternatives .Smith Manufacturing Tree Decision Tree usually begins with decision node. before deciding between the make or buy (main) decisions. then Smith should choose whether to do it or not. Since there is the option of a test market study.

Also write the probabilities if known.Decision Tree Following the option to test the market we immediately put its outcomes and NEVER nowhere else. State of nature point Two states of nature (their probabilities must sum to 1) .

The do nothing option must always be considered if it is better than an existing option (to prevent a loss when it can be avoided) . or the decision not to test. Smith must now decide between make or buy (or do nothing).Decision Tree Following the test market results.

Following the make or buy decision in ALL CASES the outcomes that follow are demand high. medium or low. .

5 10 1 5 11 37.35 40 -20 70 42.5 67. 2 8 4 9 P(M|F) = 0.5 P(M|F) = 0.97.4 37.35 45 10 Since the test costs 2.4 42.32 6 3 P(M) = 0.5 67.5.5 -22.5 Complete the tree by including the NET payoffs.5 7.5 7 P(M) = 0.5 -22.5 100 P(M|U) = 0. all payoffs that follow must go down by 2.5 97.5 .5 7.

5)+ (0.5)+ (0.7 Write the values at the nodes!! .5)+(0.3*70)+ (0.5) = 30.5)+ (0.5*67.5) = 20.5)+(0.35*-20) = 37 EV (7) = (0.5)+ (0.3*100)+ (0.5)+(0. EV (6) = (0.32*37.4*42.5)+(0.35*40)+(0.1*7.25 EV (8) = (0.4*37.20*67.35*45)+(0.32*42.5) = 51. compute expected value using probabilities of all possible outcomes at that node and payoffs associated with outcomes.Folding Back a Decision Tree        In folding back decision tree.1*-22.7 EV (11) = (0. select alternative that yields better expected value or payoff.5*97.35*10) = 40.  At each decision node.20*97.48*7.5 EV (10) = (0. use following two rules:  At each state of nature node.5 EV (9) = (0.48*-22.5) = 61.

5 37.5 -22.35 45 10 Choose between make or buy at each point.7 P(M|F) = 0.25 P(M) = 0. 4 and 5 2 97.5 P(M|U) = 0.35 40 -20 42.5 -22.5 70 7 P(M) = 0. based on best value .61.4 8 4 51.5 10 1 37 37.5 Expected values written at nodes.5 97. now make decision at 3.5 P(M|F) = 0.5 7.5 67.4 42.7 100 11 6 3 40.5 9 20.5 67.5 7.32 5 30.

4 42.7 100 11 6 3 40.5 67.5 -22.32 5 30.5 7.5 -22.5 97.5 9 20.7 P(M|F) = 0.5 97.35 40 -20 42. choose buy •At 3.5 P(M|F) = 0.5 7.25 P(M) = 0.5 P(M|U) = 0.•At 4.5 10 1 37 37. choose make •At 5.4 8 4 51. choose buy 2 61.5 37.5 67.35 45 10 .5 70 7 P(M) = 0.

7 = 41.5 67.4 9 20.32 5 30.5 Folding back the optimal values.5 37.4 97.25 6 3 40.35*61.7 11 40.5+0.5 70 Pruning 7 P(M) = 0. pruning the inferior decisions 2 61.5 -22.65*30.7 42.35 45 10 Now Calculate EV at node 2 EV(2) = 0.5 37.5 67.48 .5 P(M|F) = 0.61.5 7.5 100 P(M|U) = 0.7 10 1 37 97.35 40 -20 42.5 -22.5 8 4 51.5 P(M|F) = 0.5 7.5 30.25 P(M) = 0.

5 67.4 9 20.5 70 7 P(M) = 0.25 6 3 40.5 37.4 97.7 42.5 8 4 51.5 P(M|F) = 0.25 P(M) = 0.7 100 37. .61.35 40 -20 42.5 7.7 41.5 -22. and make decision at node 1 41.5 7.5 67.5 10 5 30.5 30.48 1 37 97.35 45 10 Bring back optimal EV to node 1.5 Write EV at 2.5 P(M|F) = 0.5 -22.5 P(M|U) = 0.48 2 61.32 11 40.

EVPI. EVSI.48 •EVSI: One way of measuring value of market information is to compute the expected value of sample information (EVSI).Stating Decision. as follows: •EVSI = EWSI – EWoSI (Profits) •EVSI = EWoSI – EWSI (Costs) . Efficiency •Decision: Do the market test. if favourable MAKE (manufacture) the part but if unfavourable. Buy the part •Optimal EV is 41.

 assuming no   cost togather it    Expected value     of best decision   without    sample   information                 Add BACK the costs subtracted first EVSI = EWSI –EWoSI = 41.73 .25 = 3.Expected Value of Sample Information  Expected value   of best decision  with sample EVSI =   information.48 + 2.5 – 40.

 assuming no        cost togather it      Subtract the costs added earlier .EVSI with Cost Minimisation •When dealing with costs: EVSI = EWoSI – EWSI Expected value  Expected value  of best decision  of best decision      without  with sample      EVSI =     sample  information  information.

25 = 9.EVPI •EVPI is obtained from NO TEST SIDE ONLY!! •EVPI = EWPI – EWoPI (Profits) •This is expected value of perfect information.3*100 + 0. uncontaminated by sample information.35*45 + 0. .25 – 40. 45 is best if we knew it was medium and 10 is best if we knew demand was going to be low. •EWoPI = optimal EV at No Test Decision = 40.00 100 is best expected value if we knew demand was going to be high.35*10 = 49.25 •EWPI = 0.25 •EVPI = 49.

Efficiency of Sample Information How close does the sample information come to perfect information? Efficiency of sample information = EVSI | EVPI Efficiency = EVSI/EVPI % = 3.44% .73/9 = 41.

Expanded Thompson Lumber Example  Suppose they will first decide whether to pay \$4000 to conduct a market survey  Survey results will be imperfect  Then they will decide whether to build a large plant. small plant. or no plant  Then they will find out what the outcome and payoff are .

when demand was high.Marketing Reliability of Research Firm The marketing research firm provided the following probabilities based on its track record of survey accuracy: P(V|H) = 0.967 P(N|H) = 0.933 That is.7% of the time and negative 3. in the past.467 P(V|L) = 0.033 P(V|M) = 0.3% of the time Here V = the event the survey result is positive and N = the event the result is negative N = V’ . it reported positive 96.067 P(N|L) = 0. for example.533 P(N|M) = 0.

Questions What Use should Thompson Lumber do now? a decision tree this time. What is the optimal decision and optimal EMV? What is EVSI? What is EVPI? What is the efficiency of sample information? . You have to revise probabilities using law of Total Probability and Bayes Theorem.

000 (not including drilling costs).Shamrock Oil (Same Questions) • Shamrock Oil owns a parcel of land that has the potential to be an underground oil field. . • Shamrock also has the option of selling the land as is for \$400. It will cost \$500.000 to drill for the oil. Shamrock will realize a payoff of \$4.000 without further information about the likelihood of oil being present. With current information. If oil does exist on the land.000. Shamrock estimates that there is a 20% probability that oil is present on the site.

which would cost \$100. If the test results are negative. According to this information. Shamrock Oil has some information concerning the accuracy of the geological test probabilities.Shamrock Oil continued • A firm can perform geological tests at the site.000. Shamrock can sell the land for \$50. the probability that the test will be positive given that oil is present in the ground is 85%. The probability that the test will be negative given that oil is not present is 75%.000 or continue to drill. If the test results are positive Shamrock can sell the land for \$650. .000 or drill the land for oil.

his payoff will be \$21000. his payoff will be \$-29000. the annual payoff would be \$56000 if he expands. With a favourable market.Decision Theory 2. With an average market. or make no change. move to a larger facility. Bob’s Bike Shop Bob’s Bike Shop is considering three options for his facility next year. . and \$10000 respectively. and \$5000 respectively. and \$30000 if he does nothing. He can expand his current shop. \$70000 if he moves. \$35000. With an unfavourable market. \$45000.

000 \$70.000 \$21.000 .000 \$5.Bob’s Payoff Table Bob’s Bike Shop Payoffs are Profits States of Nature (Market) Decision Alternatives Expand Move No Change Favourable Average \$56.000 \$10.000 Unfavourable –\$29.000 \$35.000 –\$45.000 \$30.

Each tee shirt that is MADE will cost \$10 Each tee shirt that is SOLD will generate \$16 revenue Each tee shirt that was made but NOT SOLD will be salvaged for \$5 (this is revenue) There is no cost for lost sales (demand greater than amount made) .Decision Theory 3. Tees R Us Tees R Us manufactures and sells tee shirts for sporting events. They are providing tee shirts for an upcoming event with the following financial data.

They need to decide whether to produce 1. Create a payoff table that shows the quantity made (in row) and possible demand . 2. 3. 3.000 or 4.Tees R Us Tees R Us believes that demand will be 1.000 tee shirts.000.000.000.000. Answer the questions that follow .000 or 4.states of nature (in column) where payoffs = profits. 2.000 tee shirts.

what quantity should Tees R Us make? For a LaPlace decision maker. what quantity should Tees R Us make? Using maximin.25. which option would you choose? • If the demand probabilities are 0.Questions • • • • • • Complete the payoff table for Tees R Us (TRU) Using maximax.7? Using a minmax regret approach.15. what quantity should TRU make? Using Hurwicz. what quantity should TRU make α = 0. 0.30 and 0. 0.30. respectively which quantity will maximise expected profit? What is the expected profit associated with that recommendation? • What is the most the firm should be willing to pay to obtain further (perfect) information (EVPI) concerning the actual demand? .

or a combination of its own staff and outside vendor.Decision Theory 4. The cost of the operation depends on future demand. The annual cost of each decision alternative and state of nature (in thousands of dollars) is as follows: (Objective is to MINIMISE costs) Alternative Own staff Vendor Combination States of Nature (Demand) High Medium Low 650 900 800 650 600 650 600 300 500 . Data Processing (Costs) •A firm is considering three options for managing its data processing operation: continuing with its own staff. hiring an outside vendor to do the managing (referred to as outsourcing).

3. what option should the firm choose? Using Hurwicz. what option should the firm choose? Using maximin. respectively which option will minimise expected cost? What is the expected cost associated with that recommendation? • What is the most the firm should be willing to pay to obtain further (perfect) information (EVPI) concerning the actual demand? .4. what option should be chosen? Make α = 0.3. what option should the firm choose? For a LaPlace. 0. which option would you choose? • If the demand probabilities are 0. and 0.Questions – Data Processing • • • • Using maximax.7? • Using a minmax regret approach.

the decision is to use Vendor . Data Processing question Alternatives Own Staff Vendor Combination Minimum 600 300 500 Decision: Since Vendor carries the minimum of 300.Maximax Criterion (Costs) •Maximax criterion selects alternative which minimises minimum (best) payoff over all alternatives. •Select alternative with minimum number. •First locate minimum payoff for each alternative. •Decision criterion locates alternative with lowest possible cost.

•Select alternative with minimum (best) number. •Called pessimistic criterion. Data Processing Operation Alternatives Own Staff Vendor Combination Max (worst) 650 900 800 Decision: Since Own Staff carries the minimum of the maximum costs = 600. •Criterion locates alternative that has lowest of max cost.Maximin Criterion (Costs) •Maximin criterion finds alternative which minimises worst (maximum in costs) payoff over all alternatives. the decision is to use Own Staff . •First locate worst (highest) cost for each alternative.

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