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Decision Analysis: Quantitative Techniques

The document discusses decision analysis techniques for determining an optimal strategy when faced with uncertain future events and multiple decision alternatives. It covers formulating the decision problem, constructing decision trees, and approaches for decision-making both with and without probabilistic information about potential outcomes. An example problem is presented about determining the optimal size for a new condominium development project given uncertainty in housing demand.

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DennisBriones
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91 views

Decision Analysis: Quantitative Techniques

The document discusses decision analysis techniques for determining an optimal strategy when faced with uncertain future events and multiple decision alternatives. It covers formulating the decision problem, constructing decision trees, and approaches for decision-making both with and without probabilistic information about potential outcomes. An example problem is presented about determining the optimal size for a new condominium development project given uncertainty in housing demand.

Uploaded by

DennisBriones
Copyright
© © All Rights Reserved
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
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DECISION ANALYSIS

Quantitative Techniques

Dennis Rayn Briones


Decision analysis can be used to determine an optimal strategy when a decision
maker is faced with several decision alternatives and an uncertain or riskfilled pattern of future events.

Problem Formulation
A decision problem is characterized by decision alternatives, states of
nature, and resulting payoffs.
The decision alternatives are the different possible strategies the
decision maker can employ.
The states of nature refer to future events, not under the control of
the decision maker, which may occur. The states of nature are defined so
that one and only one of the possible states of nature will occur.

Example Problem
Pittsburgh Development Corporation (PDC) purchased land that will be the site of a new
luxury condominium complex. PDC commissioned preliminary architectural drawings for
three different projects: one with 6floors 30units, one with 12 floors 60units, and
one with 18 floors 90 units condominiums.
The financial success of the project depends upon the size of the condominium
complex and the chance event concerning the demand for the condominiums. The statement
of the PDC decision problem is to select the size of the new luxury condominium
project that will lead to the largest profit given the uncertainty concerning the
demand for the condominiums.

Decision Alternatives
d1 = a small condominium units 6 floors 30 units
d2 = a medium condo units 12 floors 60 units
d3 = a large condo complex 18 floors 90 units

States of Nature
s1 = high market acceptance, high demand
s2 = low market acceptance, limited demand

Payoff Table
The consequence resulting from a specific combination of a decision
alternative and a state of nature is a payoff.
A table showing payoffs for all combinations of decision alternatives
and states of nature is a payoff table.
Payoffs can be expressed in terms of profit, cost, time, distance or any
other appropriate measure.
Payoff table

Decision Tree
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 attained from the
series of branches making up that limb.

Decision Making without Probabilities


Three commonly used criteria for decision making when probability
information regarding the likelihood of the states of nature is
unavailable are:
o the optimistic approach
o the conservative approach
o the minimax regret approach

Optimistic Approach
The optimistic approach would be used by an optimistic decision maker.
The decision with the largest possible payoff is chosen. If the payoff table
was in terms of costs, the decision with the lowest cost would be chosen.

Conservative Approach
The conservative approach would be used by a conservative decision
maker. For each decision the minimum payoff is listed and then the decision
corresponding to the maximum of these minimum payoffs is selected.
(Hence,
the minimum possible payoff is maximized.)If the payoff was in terms of costs,
the maximum 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.)

Minimax Regret Approach


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 largest payoff for that
state of nature. Then, using this regret table, the maximum regret for each
possible decision is listed. The decision chosen is the one corresponding to
the minimum of the maximum regrets.
For the minimax regret approach, first compute a regret table by subtracting each payoff in a
column from the largest payoff in that column. In this example, in the first column subtract 8,
14, and 20 from 20; etc. The resulting regret table is:

For each decision list the maximum regret.

Choose the decision with the minimum of these values.

Decision Making with Probabilities

Expected Value Approach


o If probabilistic information regarding the states of nature is
available, one may use the expected value (EV) approach.
o 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.
o The decision yielding the best expected return is chosen.
Calculate the expected value for each decision. The decision tree on the next
slide can assist in this calculation. Here d1, d2, and d3 represent the
decision alternatives of building a small, medium, and large complex, while s1
and s2 represent the states of nature of strong demand and weak demand.
EV(d1) 0.8(8) + 0.2(7) 7.8
EV(d2) 0.8(14) + 0.2(5) 12.2
EV(d3) 0.8(20) + 0.2(9) 14.2

Expected Value of Perfect Information


Frequently information is available which can improve the probability
estimates for the states of nature. The expected value of perfect
information (EVPI) is the increase in the expected profit that would result
if one knew with certainty which state of nature would occur. The EVPI
provides an upper bound on the expected value of any sample or survey
information.
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).
Expected Value with Perfect Information (EVwPI)
EVwPI = .8(20 mil) + .2(7 mil) = $17.4 mil
Expected Value without Perfect Information (EVwoPI)
EVwoPI = .8(20 mil) + .2(-9 mil) = $14.2 mil
Expected Value of Perfect Information (EVPI)
EVPI = |EVwPI EVwoPI| = |17.4 14.2| = $3.2 mil

Decision Analysis with Sample Information

Frequently, decision makers have preliminary or prior probability assessments


for the states of nature that are the best probability values available at
that time. To make the best possible decision, the decision maker may want to
seek additional information about the states of nature. This new information,
often obtained through sampling, can be used to revise the prior probabilities
so that the final decision is based on more accurate probabilities for the
states of nature. These revised probabilities are called posterior
probabilities.
Let us return to the PDC problem and assume that management is considering a 6month market research study designed to learn more about potential market acceptance
of the PDC condominium project. Management anticipates that the market research study
will provide one of the following two results:
1.Favorable report: A significant number of the individuals contacted express
interest in purchasing a PDC condominium.
2.Unfavorable report: Very few of the individuals contacted express interest in
purchasing a PDC condominium.

Decision
Strategy

A decision
strategy
is
a
sequence
of
decisions and chance outcomes where the decisions chosen depend on the yet-tobe-determined outcomes of chance events. The approach used to determine the
optimal decision strategy is based on a backward pass through the decision
tree using the following steps:
At chance nodes, compute the expected value by multiplying the payoff at the
end of each branch by the corresponding branch probabilities.
At decision nodes, select the decision branch that leads to the best expected
value. This expected value becomes the expected value at the decision node.

PDCs optimal decision strategy is:


Conduct the market research study.
If the market research report is favorable, construct the large condominium
complex.
If the market research report is unfavorable, construct the medium condominium
complex.

Expected Value of Sample information


The expected value of sample information (EVSI) is the additional expected
profit possible through knowledge of the sample or survey information.
The expected value associated with the market research study is $15.93.
The best expected value if the market research study is not undertaken is
$14.20.
We can conclude that the difference, $15.93 $14.20 = $1.73, is the expected
value of sample information.
Conducting the market research study adds $1.73 million to the PDC expected
value.

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