Chapter 3

Decision Analysis

To accompany
Quantitative Analysis for Management, Tenth Edition,
by Render, Stair, and Hanna © 2008 Prentice-Hall, Inc.
Power Point slides created by Jeff Heyl © 2009 Prentice-Hall, Inc.
 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

© 2009 Prentice-Hall, Inc. 3–5

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
© 2009 Prentice-Hall, Inc. 3–6
Thompson Lumber Company

Step 1 – Define the problem

 Expand by manufacturing and
marketing a new product, backyard
storage sheds
Step 2 – List alternatives
 Construct a large new plant
 A small plant
 No plant at all
Step 3 – Identify possible outcomes
 The market could be favorable or
unfavorable

© 2009 Prentice-Hall, Inc. 3–7

Thompson Lumber Company

Step 4 – List the payoffs

 Identify conditional values for the
profits for large, small, and no plants
for the two possible market conditions
Step 5 – Select the decision model
 Depends on the environment and
amount of risk and uncertainty
Step 6 – Apply the model to the data
 Solution and analysis used to help the
decision making

© 2009 Prentice-Hall, Inc. 3–8

 Thompson Lumber Company

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

Table 3.1

© 2009 Prentice-Hall, Inc. 3–9

 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

© 2009 Prentice-Hall, Inc. 3 – 10

 Decision Making Under
Uncertainty
There are several criteria for making decisions
under uncertainty

1. Maximax (optimistic)
2. Maximin (pessimistic)
3. Criterion of realism (Hurwicz)
4. Equally likely (Laplace)
5. Minimax regret

© 2009 Prentice-Hall, Inc. 3 – 11

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

Table 3.2
© 2009 Prentice-Hall, Inc. 3 – 12
 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
200,000 –180,000 –180,000
plant
Construct a small
100,000 –20,000 –20,000
plant
Do nothing 0 0 0
Maximin
Table 3.3
© 2009 Prentice-Hall, Inc. 3 – 13
 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)

© 2009 Prentice-Hall, Inc. 3 – 14

 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
200,000 –180,000 124,000
plant
Realism
Construct a small
100,000 –20,000 76,000
plant
Do nothing 0 0 0
Table 3.4
© 2009 Prentice-Hall, Inc. 3 – 15
 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
200,000 –180,000 10,000
plant
Construct a small
100,000 –20,000 40,000
plant
Equally likely
Do nothing 0 0 0
Table 3.5

© 2009 Prentice-Hall, Inc. 3 – 16

 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

© 2009 Prentice-Hall, Inc. 3 – 17

 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
Table 3.6

STATE OF NATURE
FAVORABLE UNFAVORABLE
ALTERNATIVE MARKET ($) MARKET ($)
Construct a large plant 0 180,000
Construct a small plant 100,000 20,000
Do nothing 200,000 0
Table 3.7
© 2009 Prentice-Hall, Inc. 3 – 18
 Minimax Regret
STATE OF NATURE
FAVORABLE UNFAVORABLE MAXIMUM IN
ALTERNATIVE MARKET ($) MARKET ($) A ROW ($)
Construct a large
0 180,000 180,000
plant
Construct a small
100,000 20,000 100,000
plant
Minimax
Do nothing 200,000 0 200,000

Table 3.8

© 2009 Prentice-Hall, Inc. 3 – 19

 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)

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)

© 2009 Prentice-Hall, Inc. 3 – 20

In a game involving a single die, the
following rules were suggested. I pay
P 2 for each roll. If 5 comes out, I
receive P2.5, if 6 comes out I receive
P4, if 4 comes out i receive P1.50. I
receive nothing if 1,2 and 3 comes
out. What is the mathematical
expectation of the game.

© 2009 Prentice-Hall, Inc. 3 – 21

 EMV for Thompson Lumber
 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

© 2009 Prentice-Hall, Inc. 3 – 22

 EMV for Thompson Lumber

STATE OF NATURE
FAVORABLE UNFAVORABLE
ALTERNATIVE MARKET ($) MARKET ($) EMV ($)
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
Probabilities 0.50 0.50

Table 3.9 Largest EMV

© 2009 Prentice-Hall, Inc. 3 – 23

 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
© 2009 Prentice-Hall, Inc. 3 – 37
 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

© 2009 Prentice-Hall, Inc. 3 – 38

 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

© 2009 Prentice-Hall, Inc. 3 – 39

 Thompson’s Decision Tree
A State-of-Nature Node
Favorable Market
A Decision Node
1
Unfavorable Market

Favorable Market
Construct
Small Plant
2
Unfavorable Market

Figure 3.2

© 2009 Prentice-Hall, Inc. 3 – 40

 Thompson’s 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)
–$180,000

Favorable Market (0.5)

$100,000
Construct
Small Plant
2
Unfavorable Market (0.5)
–$20,000

EMV for Node = (0.5)($100,000)

2 = $40,000 + (0.5)(–$20,000)
Figure 3.3
$0
© 2009 Prentice-Hall, Inc. 3 – 41
A canteen concessionaire has to decide whether to prepare a
bid or not for the canteen concession of a university. The cost
of preparing a bid P 2000. If the bid is submitted it has a 60-40
chance that the concession will be awarded to her. If she gets
the contract she may earn a monthlyincome of P52000 if it
succeeds (that is if the students patronize the canteen) or
incurs a monthly loss of P 13000 if it fails. The concessionaire
estimated the probability of successs to be 75%. Should she
bid or not?

© 2009 Prentice-Hall, Inc. 3 – 74

Dante Development Corporation is considering bidding on a contract for a
new office building complex. Figure 13.17 shows the decision tree
prepared by one of Dante’s analysts. At node 1, the company must decide
whether to bid on the contract. The cost of preparing the bid is $200,000.
The upper branch from node 2 shows that the company has a 0.8
probability of winning the contract if it submits a bid. If the company wins
the bid, it will have to pay $2,000,000 to become a partner in the project.
Node 3 shows that the company will then consider doing a market research
study to forecast demand for the office units prior to beginning
construction. The cost of this study is $150,000. Node 4 is a chance node
showing the possible outcomes of the market research study. Nodes 5, 6,
and 7 are similar in that they are the decision nodes for Dante to either
build the office complex or sell the rights in the project to another
developer. The decision to build the complex will result in an income of
$5,000,000 if demand is high and $3,000,000 if demand is moderate. If
Dante chooses to sell its rights in the project to another developer, income
from the sale is estimated to be $3,500,000. The probabilities shown at
nodes 4, 8, and 9 are based on the projected outcomes of the market
research study.

© 2009 Prentice-Hall, Inc. 3 – 75

© 2009 Prentice-Hall, Inc. 3 – 76