September 29, 2015

Decision Analysis

Introduction

Decision

Analysis can be used to

determine the optimal strategies
when a decision-maker is faced with
several decision alternatives and an
uncertain future events.

Introduction
Possibilities
Certainty
Uncertainty
Risk

to consider

Mathematical Expectation
(ME) or Expected Value (EV)

It

is the product of the probability

that the event will occur and the
amount to be received upon such
occurrence.

Computation of EV
Let

P be the probability value and X

be the amount of money.
EV = P(X)

If

an event has several possible

outcomes with probability P1, P2, ...,
Pn and if X denotes a discrete
variable which can assume the
values X1, X2, ..., Xn then
EV = P1X1 + P2X2 +...+ PnXn

Example 1
A

fair coin is tossed. If the coin lands

heads, Chito will receive P6, and pay
P4 if it lands tails. Find the EV.

EV

= (0.50)(6) + (0.50)(-4) = P1

This

means that the game is fair for

Chito

Example 2
Consider

the

following

game

of

chance.
Mark pays P200 and roll a fair die. Then

he receives a payment according to the

following
schedule.
If
the
event
A={1,2,3} occurs, then he will receive
P100. If the event B={4,5} occurs, Mark
receives P200. If the event C = {6}
occurs, then he will receive P600. What
is the average profit he can make if he

Example 2 - Solution

If A occurs , then a profit will be

100-200=-100 (Mark will lose P100)

If B occurs, a profit will be

200-200=0

If C occurs, a profit will be 600-200=400

Therefore we may compute the average profit as follows:

ave.-profit = (3/6)(-100) + (2/5)(0) + (1/6)(400) = 50/3

That is , Mark can expect to make P16.67 on the average

every time he plays this game.

Example 3
The

ABC construction operations

manager has to decide whether to
accept a bid or not. If the manager
accepts the bid, the construction
company may gain p3.5 million if it
succeeds, or lose P2.5 million if it
fails. The probability that it will
succeed is 30%. Find the EV if the
company accepts the bid.

Example 3 - Solution
The

ABC construction operations manager has to

decide whether to accept a bid or not. If the manager
accepts the bid, the construction company may gain
p3.5 million if it succeeds, or lose P2.5 million if it fails.
The probability that it will succeed is 30%. Find the EV
if the company accepts the bid.

P1

= 30% X1 = 3.5
P2 = 70% X2 = -2.5

This

EV = -0.7

means that the company is expected to lose.

Decision-making Under
Certainty
The

decision-maker is to pick the alternative

with the best payof for the known event
Payof consequence resulting from a specific combination of a

decision alternative and a state of nature

Best

alternative

Highest payoff if the payoffs are expressed in

profits
Lowest payoff if the payoffs are expressed as

costs.

Example

Consider the payoff table which illustrates a capacity planning

problem. It is helpful in selecting among alternatives because
they facilitate comparison of alternatives
Possible Future Demand
Alternative

Low

High

Small Capacity

300

370

Large Capacity

180

900

Present values in thousand pesos

The payoffs are the present values of future revenues minus

the costs for each alternative in each event.
What is the best choice if future demand will be low?

Example
The

best choice is the one with

highest payoff.

P300,000

facility)

(leads to building small

Decision-making Under Uncertainty

(Decision-making without probabilities)
Assumption:

Managers

can list the possible

events but cannot estimate their
probabilities.

Decision-making Under
Uncertainty
Conditions

that will be used in decision

rules:

1.

Pessimistic Approach
Choose the alternative that is the best of the worst.
It takes into account only the worst possible outcome
for each alternative.
Maximization : maximin
Minimization : minimax

Maximin
Example: Refer to the previous table
Alternative
Small facility
Large facility
P300,000

Worst Payoff
300
180

is the worst member, the

pessimist will build a small facility.

Decision-making Under
Uncertainty
Conditions

that will be used in decision rules:

2. Optimistic
best of the best
go for it strategy that has high expectations
Maximization : maximax
Minimization : minimin

Since P900,000 is the best member, the optimistic would

build a large facility.

Decision-making Under
Uncertainty
Conditions
3.

that will be used in decision rules:

Laplace

Choose the alternative with the best weighted payoff

Treats the state of nature as equally likely to each event

Alternative Weighted Payof

Small facility 0.50(300) + 0.50(370) = 335
Large facility 0.50(180) + 0.50(900)=540
Since P540,000 is the best weighted payoff, the realist
would build a large facility.

Decision-making Under
Uncertainty
4. Minimax Regret
Choose the alternative with the best worst
regret.
It seeks to minimize the difference between
the given payoff and the best payoff for each
state of nature.
For profit: Regret Value = Highest column
entry-every column entry
For cost: Regret Value=Entry every columnlowest column entry

MINIMAX REGRET

Regret
Alternative

Low
Demand

High
Demand

Maximum
Regret

Small
facility

300-300=0

900370=530

530

Large
facility

300180=120

900-900=0

120

Pick

a large facility to minimize the

maximum regret.

Decision-making Under Risk

(Decision-making with probabilities)
The

manager has less information

than with decision-making under
certainty but more information than
with
decision-making
under
uncertainty.

widely used approach under such

circumstances is the EV

Expected Value (EV)

EV

is the sum of the payoffs for an

alternative where each payoff is
weighted by the probability for the
relevant state of nature.
state of nature possible outcomes for a

chance event

EV - Example
Which

is the best alternative if the

probability of low demand is
estimated to be 0.40 and the
probability of high demand is
Demand
estimatedPossible
to beFuture
0.60?
Alternative

Low

High

EV

Small Facility

300

370

0.4(300)+0.6(370)
=342

Large Facility

180

900

0.4(180)+0.6(900)
=612

The

large facility has higher EV

Decision Tree
A

schematic model of alternative

available to the decision maker
along wit their possible
consequences

Composed

of a number of nodes that

have branches emanating from it.

Decision Tree
Two

types of nodes

a square
a circle

The

represents a decision point

stands for a chance event.

branches of the tree having

square nodes represent alternatives
and branches having circular nodes
represent chance events.

Decision Tree - Example

The manager of the company has to

decide whether to prepare a bid or not. It
costs P5,000 to prepare the bid. If the bid
is submitted, the probability that the
contract will be awarded is 60%. If the
company is awarded the contract, it may
earn an income of P60,000 if it succeeds
or pay a fine of P15,000 if it fails. The
probability of success is estimated to be
70%. Should the owner prepare the bid?

Decision Tree

P = 0.70

P = 0.60

success

60,000-5000

contract awarded

prepare

failure

-15,000-5,000

not awarded
0.30

not prepare

P = 0.40 -5,000

P=

Decision Tree
Compute

the EV backward from

position.
EV

= 0.70(55,000) + 0.30(-20,000)
= 32,500

EV = 0.60(32,500)

= 17,500

+ 0.40(-5,000)

Decision Tree

55,000

32,50
P=0.60
0

contract awarded

P17,50
0

success P=0.70

prepare
failure

P=0.30

-20,000
not awarded
P=0.40 -5,000

not prepare

Expected Value of Perfect

Information (EVPI)

Once

a manager knows which

decision to make, the payoff
increases and is now a certainty, not
a probability.

Expected Value of Perfect

Information (EVPI)

EVPI

= expected payoff under

certainty
expected payoff
under risk.

EVPI - Example

Compute for the expected payoff under certainty. The

best payoff for the small capacity and large capacity
are P370 and P900 respectively. Then combine by
weighing each payoff by the probability of that state
of nature and add the amounts.

The expected payoff under certainty is

0.40(370)+0.60(900) = P688

The expected payoff under risk, as computed

P612.

EVPI = P688-P612=P76

is

Engrande Lechon

Mr. X is planning to open up a new branch of Engrande Lechon

at a new location in Pasig or expand the existing branch located
in Marikina City. Demand on the new location is expected to be
60% high and 40% low. Fixed cost will reach the amount
P150,000. If the demand becomes high, he expects to have a
revenue of P250,000, however if the demand becomes low, he
could only expect a revenue of P200,000. Upon analyzing the
situation in his existing branch, he believes that by introducing
new recipes the sales will reach the amount P120,000 if the
demand becomes high. However, if the demand becomes low,
he could only expect P80,000 revenue. Projection on high
demand in the existing branch tends to be 55% and upon
computing the fixed cost it would reach the amount of P50,000.

If you were the consultant of Mr. X, what would you advise?

Exercises

Ruth has to decide whether or not to open a

small dress shop near the U-belt, a few blocks
away from her. 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 are 0.20 for a
good market, 0.50 for an average, and 0.30 for a
bad market. The no profit loss for the mediumsized or small shops for the various market
conditions are given in the table. Building no
shops at all yields no loss and no gain. What do
you recommend?

Ruth Dress Shop

Alternatives

Good Market
(PhP)

Ave. Market
(PhP)

Bad Market
(PhP)

Small Shop

85,000

20,000

-30,000

Medium-sized
shop

120,000

45,000

-70,000

No shop

Probabilities

0.20

0.50

0.30