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

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*

*A decision problem is characterized by decision

strategies the decision maker can employ. alternatives, states of nature, and resulting payoffs.

*The decision alternatives are the different possible *The states of nature refer to future events, not under

the control of the decision maker, which will ultimately affect decision results. States of nature should be defined so that they are mutually exclusive and contain all possible future events that could affect the results of all potential decisions.

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*Decision theory problems are *Influence Diagram * Payoff Table *Decision Tree

generally represented as one of the following:

*

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***An influence diagram is a graphical device
**

showing the relationships among the decisions, the chance events, and the consequences.

*Squares or rectangles depict decision nodes. *Circles or ovals depict chance nodes. *Diamonds depict consequence nodes. *Lines or arcs connecting the nodes show the

direction of influence.

*

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*The consequence resulting from a specific

combination of a decision alternative and a state of nature is a payoff. of decision alternatives and states of nature is a payoff table. cost, time, distance or any other appropriate measure.

*A table showing payoffs for all combinations *Payoffs can be expressed in terms of profit,

*

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*

*A decision tree is a chronological representation of

the decision problem.

*Each decision tree has two types of nodes;

round nodes correspond to the states of nature while square nodes correspond to the decision alternatives.

*The branches leaving each round node represent the

different states of nature while the branches leaving each square node represent the different decision alternatives.

***At the end of each limb of a tree are the payoffs
**

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attained from the series of branches making up that limb.

A developer must decide how large a luxury condominium complex to build ² small, medium, or large. The profitability of this complex depends upon the future level of demand for the complex·s condominiums.

*

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* * *

States of nature: The states of nature could be defined as low demand and high demand.

Alternatives: CAL could decide to build a small, medium, or large condominium complex.

Payoffs: The profit for each alternative under each potential state of nature is going to be determined.

*

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*

THIS IS A PROFIT PAYOFF TABLE States of Nature Alternatives Low High Small 8 8 Medium 5 15 Large -11 22 (payoffs in millions of dollars)

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*

8 8 5 Medium Complex 15

-11

22

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*

*Three commonly used criteria for

decision making when probability information regarding the likelihood of the states of nature is unavailable are:

***the optimistic approach *the conservative approach *the minimax regret approach.
**

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***The optimistic approach would be used by an
**

optimistic decision maker. chosen.

*

*The decision with the best possible payoff is *If the payoff table was in terms of costs, the

decision with the lowest cost would be chosen.

***If the payoff table was in terms of profits,
**

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the decision with the highest profit would be chosen.

*

*For each decision the worst payoff is listed and then

the decision corresponding to the best of these worst payoffs is selected. (Hence, the worst possible payoff is maximized.) costs would be determined for each decision and then the decision corresponding to the minimum of these maximum costs is selected. (Hence, the maximum possible cost is minimized.) profits would be determined for each decision and then the decision corresponding to the maximum of these minimum profits is 13 selected. (Hence, the minimum possible profit is maximized.)

*If the payoff was in terms of costs, the maximum

*If the payoff was in terms of profits, the minimum

*

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

*** If the optimistic approach is selected:
**

STATES OF NATURE BEST Alternatives PROFIT Small Medium Large

Maximax decision

Low 8 5 -11

High 8 15 22 8 15 22

Maximax payoff

*

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*** If the conservative approach is selected:
**

STATES OF NATURE WORST Alternatives PROFIT Small Medium Large Low 8 5 -11 High 8 15 22 8 5 -11

Maximin payoff

Maximin decision

The decision with the best profit from the column of worst profits is selected.

*

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*** If the minimax regret approach is selected:
**

Step 1: Determine the best payoff for each state of nature and create a regret table.

STATES OF NATURE Alternatives Small Medium Large Low 8 5 -11 High 8 15 22

Best Profit for Low 8

Best Profit for High 22

*

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*** If the minimax regret approach is selected:
**

Step 1: Create a regret table (continued).

*

**STATES OF NATURE Alternatives Small Medium Large Low 0 3 19 High 14 7 0
**

For a profit payoff table, entries in the regret table represent profits that could have been earned.

If they knew in advanced that the demand would be low, they would have built a small complex. Without this ³psychic insight´, if they decided to build a medium facility and the demand turned out to be low, they would regret building a medium complex because they only made 5 million dollars instead of 8 million had they built a small facility instead. They regret their decision by 3 million dollars.

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*** If the minimax regret approach is selected:
**

Step 2: Create a regret table (continued). Step 3: Determine the maximum regret for each decision.

STATES OF NATURE Max Alternatives Regret Small Medium Large Low 0 3 19 High 14 7 0 14 7 19

*

**Regret not getting a profit of 19 more than not making a profit of 0.
**

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*** If the minimax regret approach is selected:
**

Step 4: Select the decision with the minimum value from the column of max regrets.

**STATES OF NATURE Max Alternatives Regret Small
**

Minimax Regret decision

Low 0 3 19

High 14 7 0 14 7

Minimax Regret payoff

Medium Large

19

*

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*

*Expected Value Approach

***If probabilistic information regarding the states of
**

nature is available, one may use the expected value (EV) approach.

***Here the expected return for each decision is
**

calculated by summing the products of the payoff under each state of nature and the probability of the respective state of nature occurring.

***The decision yielding the best expected return is
**

chosen.

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*

* The expected value of a decision alternative is the sum of

weighted payoffs for the decision alternative. defined as:

* The expected value (EV) of decision alternative di

is

EV( di ) ! § P( s j )Vij

j !1

N

where:

N = the number of states of nature P(sj ) = the probability of state of nature sj Vij = the payoff corresponding to decision alternative di and state of nature sj

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

*

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*

* Payoff Table

Average Number of Customers Per Hour s1 = 80 Model A Model B Model C $10,000 $ 8,000 $ 6,000 s2 = 100 $15,000 $18,000 $16,000 s3 = 120 $14,000 $12,000 $21,000

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***Expected Value Approach
**

Calculate the expected value for each decision. Here d1, d2, d3 represent the decision alternatives of models A, B, C, and s1, s2, s3 represent the states of nature of 80, 100, and 120. Suppose that optimism leads to an initial subjective probability assessment of .4, .2 & .4 respectively.

*

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* Decision Tree

*Example:

2

s1 s2 s3 s1 s2 s3 s1 s2 s3

**Burger Prince Payoffs
**

.4 .2 .4 .4 .2 .4 .4 .2 .4

10,000 15,000 14,000 8,000 18,000 12,000 6,000 16,000 21,000

d1 1 d2 d3 3

4

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**Example: Burger Prince
**

Expected Value For Each Decision d1 2

EMV = .4(10,000) + .2(15,000) + .4(14,000) = $12,600

Model A

1

Model B d2

3

EMV = .4(8,000) + .2(18,000) + .4(12,000) = $11,600

Model C

d3

4

EMV = .4(6,000) + .2(16,000) + .4(21,000) = $14,000

**Choose the model with largest EV, Model C.
**

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*Suppose market research was

conducted in the community where the complex will be built. This research allowed the company to estimate that the probability of low demand will be 0.35, and the probability of high demand will be 0.65. Which decision alternative should they select.

*

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STATES OF NATURE Alternatives Small Medium Large Low (0.35) 8 5 -11 High (0.65) 8 15 22

*

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*

STATES OF NATURE Alternatives (0.35) value (EV) Small 8 8(0.65) = 8 Medium 5 15(0.65) = 11.5 Large -11 22(0.65) = 10.45 8 15 22 8(0.35) + 5(0.35) + -11(0.35) + Low (0.65) High Expected

Recall that this is a profit payoff table. Thus since the decision to build a medium complex has the highest expected profit, this is our best decision.

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*

*Frequently information is available which can *The expected value of perfect information

improve the probability estimates for the states of nature.

(EVPI) is the increase in the expected profit that would result if one knew with certainty which state of nature would occur. expected value of any sample or survey information.

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*The EVPI provides an upper bound on the

*

*EVPI Calculation

*Step 1:

Determine the optimal return corresponding to each state of nature.

*Step 2:

Compute the expected value of these optimal returns.

*Step 3:

Subtract the EV of the optimal decision from the amount determined in step (2). 32

***Expected Value of Perfect Information
**

Calculate the expected value for the optimum payoff for each state of nature and subtract the EV of the optimal decision. EVPI= .4(10,000) + .2(18,000) + .4(21,000) 14,000 = $2,000

*

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*Some of the quantities in a decision analysis,

particularly the probabilities, are often intelligent guesses at best. *It is important to accompany any decision analysis with a sensitivity analysis. *Sensitivity analysis can be used to determine how changes to the following inputs affect the recommended decision alternative:

*probabilities for the states of nature *values of the payoffs

*

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***If a small change in the value of one of the
**

inputs causes a change in the recommended decision alternative, extra effort and care should be taken in estimating the input value.

*One approach to sensitivity analysis is to

arbitrarily assign different values to the probabilities of the states of nature and/or the payoffs and resolve the problem. If the recommended decision changes, then you know that the solution is sensitive to the changes

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***For the special case of two states of nature, a
**

graphical technique can be used to determine how sensitive the solution is to the probabilities associated with the states of nature. Previously, we stated that CAL Condominiums estimated that the probability of future low demand is 0.35 and 0.65 is the probability of high demand. These probabilities yielded the recommended decision to build the medium complex.

*This problem has two states of nature.

*

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*

*In order to see how sensitive this

recommendation is to changing probability values, we will let p equal the probability of low demand. Thus (1-p) is the probability of high demand. Therefore EV( small) = 8*p + 8*(1-p)= 8 EV( medium) = 5*p + 15*(1-p) = 15 ² 10p EV( large) = -11*p + 22*(1-p) = 22 ² 33p 37

***Next we will plot the expected value
**

lines for each decision by plotting p on the x axis and EV on the y axis. EV( medium) = 15 ² 10p EV( large) = 22 ² 33p

*EV( small) = 8

*

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25

20

15

10

EV( small)

5

*

0 0 .2 0 .4

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0 0 .6 0 .8 1

*Since CAL condominiums list

payoffs are in terms of profits, we know that the highest profits is desirable.

***Look over the entire range of p
**

(p=0 to p=1) and determine the range over which each decision yields the highest profits.

*

40

25

20

15

10

EV( small)

5

*

0 0 .2 0 .4 0 .6

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0 0 .8 1

B1

B2

* Do not estimate the values of B1 or B2 (the points where the

intersection of lines occur). Determine the exact intersection points. ( medium) line:

*** B1 is the point where the EV( large) line intersects with the EV
**

To find this point set these two lines equal to each other and solve for p. 22-33p= 15-10p 7= 23p p=7/23= 0.3403

So B1 equals 0.3403

*** B2 is the point where the EV( medium) line intersects with the
**

EV( small) line: 15-10p = 8 7 = 10p p = 0.7

So B2 equals 0.7

*

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25

20

15

10

EV( small)

5

*

0 0 .2 0 .4 0 .6 0 .8 1

0

0.3403

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0.7

***From the graph we see that if the probability
**

of low demand (p) is between 0 and 0.3403, we recommend building a large complex.

*From the graph we see that if the probability *From the graph we see that if the probability

of low demand (p) is between 0.7 and 1, we recommend building a large complex.

of low demand (p) is between 0.3403 and 0.7, we recommend building a medium complex.

*

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*

See your textbook for more examples and detailed explanations of all topics discussed in these notes.

45

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