What is Quantitative Analysis?

Quantitative analysis is a scientific approach

to managerial decision making in which raw
data are processed and manipulated to
produce meaningful information.

Quantitative Meaningful
Raw Data Analysis Information
Decision theory is an
analytic and systematic
approach to the study of
decision making.
■ Decision theory problems are
generally represented as one
of the following:
■ Payoff Table
■ Decision Tree

Decision Theory Models

 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
will ultimately affect decision results.
 Payoff Tables
■ 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.
Thompson Lumber Company

Step 1 – Define the problem.

■ The company is considering
expanding by manufacturing and
marketing a new product – backyard
storage sheds.
Step 2 – List alternatives.
■ Construct a large new plant.
■ Construct a small new plant.
■ Do not develop the new product line
at all.
Step 3 – Identify possible outcomes.
■ The market could be favorable or
unfavorable.
Thompson Lumber Company

Step 4 – List the payoffs.

■ Identify conditional values for the
profits for large plant, small plant, and
no development for the two possible
market conditions.
Step 5 – Select the decision model.
■ This depends on the environment and
amount of risk and uncertainty.
Step 6 – Apply the model to the data.
■ Solution and analysis are then used to
aid in decision-making.
 Thompson Lumber Company

Decision Table with Conditional Values for

Thompson Lumber

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
 Types of Decision-Making
Environments

Type 1: Decision making under certainty

■ The 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.
 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
 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 ($)
Construct a large
200,000 –180,000 200,000
plant
Maximax
Construct a small
100,000 –20,000 100,000
plant
Do nothing 0 0 0
 Maximin
Used to find the alternative that maximizes
the minimum payoff.
■ Locate the minimum payoff for each alternative.
■ Select the alternative with the maximum
number.
STATE OF NATURE
FAVORABLE UNFAVORABLE MINIMUM IN
ALTERNATIVE MARKET ($) 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
 Criterion of Realism (Hurwicz)
This is a weighted average compromise
between optimism and pessimism.
■ Select a coefficient of realism α, with 0≤α≤1.
■ A value of 1 is perfectly optimistic, while a
value of 0 is perfectly pessimistic.
■ Compute the weighted averages for each
alternative.
■ Select the alternative with the highest value.

Weighted average = α(maximum in row)

+ (1 – α)(minimum in row)
 Criterion of Realism (Hurwicz)
■ For the large plant alternative using α = 0.8:
(0.8)(200,000) + (1 – 0.8)(–180,000) = 124,000
■ For the small plant alternative using α = 0.8:
(0.8)(100,000) + (1 – 0.8)(–20,000) = 76,000
STATE OF NATURE
CRITERION
FAVORABLE UNFAVORABLE OF REALISM
ALTERNATIVE MARKET ($) MARKET ($) (α = 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
 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
 Minimax Regret
Based on opportunity loss or regret, this is
the difference between the optimal profit and
actual payoff for a decision.
■ Create an opportunity loss table by determining
the opportunity loss from 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.
 Minimax Regret
Determining Opportunity Losses for Thompson Lumber
STATE OF NATURE

FAVORABLE MARKET ($) UNFAVORABLE MARKET ($)

200,000 – 200,000 0 – (–180,000)

200,000 – 100,000 0 – (–20,000)

200,000 – 0 0–0
 Minimax Regret
Opportunity Loss Table for Thompson Lumber

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
 Minimax Regret

Thompson’s Minimax Decision Using Opportunity Loss

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
 Decision Making Under Risk
■ This is decision making when there are several
possible states of nature, and the probabilities
associated with each possible state are known.
■ The most popular method is to choose the
alternative with the highest expected monetary
value (EMV).
■ This is very similar to the expected value calculated in
the last chapter.

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)
 EMV for Thompson Lumber
■ Suppose each market outcome has a probability of
occurrence of 0.50.
■ Which alternative would give the highest EMV?
■ The calculations are:

EMV (large plant) = ($200,000)(0.5) + (–$180,000)(0.5)

= $10,000
EMV (small plant) = ($100,000)(0.5) + (–$20,000)(0.5)
= $40,000
EMV (do nothing) = ($0)(0.5) + ($0)(0.5)
= $0
 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

Largest EMV
 Expected Value of Perfect
Information (EVPI)
■ EVPI places an upper bound on what you should
pay for additional information.
EVPI = EVwPI – Maximum EMV

■ EVwPI is the long run average return if we have

perfect information before a decision is made.

EVwPI = (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)
 Expected Value of Perfect
Information (EVPI)

■ Suppose Scientific Marketing, Inc. offers

analysis that will provide certainty about
market conditions (favorable).
■ Additional information will cost $65,000.
■ Should Thompson Lumber purchase the
information?
 Expected Value of Perfect
Information (EVPI)
Decision Table with Perfect Information

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
With perfect
200,000 0 100,000
information
EVwPI
Probabilities 0.5 0.5
Table 3.10
 Expected Value of Perfect
Information (EVPI)
The maximum EMV without additional information is
$40,000.
EVPI = EVwPI – Maximum EMV
= $100,000 - $40,000
= $60,000

So the maximum Thompson

should pay for the additional
information is $60,000.
 Expected Value of Perfect
Information (EVPI)
The maximum EMV without additional information is
$40,000.
EVPI = EVwPI – Maximum EMV
= $100,000 - $40,000
= $60,000

So the maximum Thompson

should pay for the additional
information is $60,000.
Therefore, Thompson should not
pay $65,000 for this information.
 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, from which one of several alternatives
may be chosen.
■ All decision trees contain state-of-nature
points or nodes, out of which one state of
nature will occur.
 Five Steps of
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.
 Structure of Decision Trees
■ Trees start from left to right.
■ Trees 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.
 Thompson’s Decision Tree
A State-of-Nature Node

Favorable Market
A Decision Node
1
Unfavorable Market
uct nt
r
n st Pla
e
Co arg
L Favorable Market
Construct
Small Plant
2
Unfavorable Market
Do
No
th
in
g
 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)
ct nt –$180,000
r u
n st Pla
e
Co arg
L Favorable Market (0.5)
$100,000
Construct
Small Plant
2
Unfavorable Market (0.5)
–$20,000
Do
No
th EMV for Node = (0.5)($100,000)
in
g 2 = $40,000 + (0.5)(–$20,000)

$0
 Thompson’s Complex Decision Tree
First Decision Second Decision Payoffs
Point Point
Favorable Market (0.78)
$190,000
t 2 Unfavorable Market (0.22)
lan
g eP –$190,000
Lar Favorable Market (0.78)
$90,000
Small
5) 3 Unfavorable Market (0.22)
0.4 Plant –$30,000
(
e y ts l e
rv ul ab No Plant
Su es vor –$10,000
R a
1 Surv F Favorable Market (0.27)
$190,000
y

e
Re y (
ve

nt 4 Unfavorable Market (0.73)

Ne su 0.5 Pla
ur

–$190,000
5) ge
tS

g a l ts
ti v Lar Favorable Market (0.27)
$90,000
Small
ke

e 5 Unfavorable Market (0.73)

ar

Plant –$30,000
M
ct

No Plant
du

–$10,000
n
Co

Do Favorable Market (0.50)

Not $200,000
Con nt 6 Unfavorable Market (0.50)
d uct Pla –$180,000
ge
Sur
vey Lar Favorable Market (0.50)
$100,000
Small
Plant 7 Unfavorable Market (0.50)
–$20,000
No Plant
$0
 Thompson’s Complex Decision Tree

1. Given favorable survey results,

EMV(node 2) = EMV(large plant | positive
survey)
= (0.78)($190,000) + (0.22)(–$190,000) =
$106,400
EMV(node 3) = EMV(small plant | positive
survey)
= (0.78)($90,000) + (0.22)(–$30,000) =
$63,600
EMV for no plant = –$10,000
2. Given negative survey results,
EMV(node 4) = EMV(large plant | negative
survey)
= (0.27)($190,000) + (0.73)(–$190,000) = –
$87,400
EMV(node 5) = EMV(small plant | negative
 Thompson’s Complex Decision Tree

3. Compute the expected value of the

market survey,
EMV(node 1) = EMV(conduct survey)
= (0.45)($106,400) + (0.55)($2,400)
= $47,880 + $1,320 = $49,200
4. If the market survey is not conducted,
EMV(node 6) = EMV(large plant)
= (0.50)($200,000) + (0.50)(–$180,000) =
$10,000
EMV(node 7) = EMV(small plant)
= (0.50)($100,000) + (0.50)(–$20,000) =
$40,000
EMV for no plant = $0
5. The best choice is to seek marketing
information.
 Thompson’s Complex Decision Tree
First Decision Second Decision Payoffs
Point Point
$106,400 Favorable Market (0.78)
$190,000
nt Unfavorable Market (0.22)
e Pla –$190,000

$106,40
g
Lar Small$63,600 Favorable Market (0.78) $90,000
5) Unfavorable Market (0.22)

0
0.4 Plant –$30,000
(
e y ts l e
rv ul ab No Plant
Su es vor –$10,000
Su R Fa –$87,400 Favorable Market (0.27)
rv $190,000
y

e
Re y (
ve

nt Unfavorable Market (0.73)

Ne su 0.5 Pla
ur

e –$190,000
5) g
tS

g a l ts Lar $2,400 Favorable Market (0.27)

$2,400
ti v Small $90,000
ke

e Unfavorable Market (0.73)

ar

Plant –$30,000
M
ct

No Plant
du

–$10,000
on
$49,200
C

Do $10,000 Favorable Market (0.50)

Not $200,000
Con t Unfavorable Market (0.50)
d uct Plan –$180,000
ge
$40,000

Sur
vey Lar Small$40,000 Favorable Market (0.50)
$100,000
Plant Unfavorable Market (0.50)
–$20,000
No Plant
$0
Expected Value of Sample Information

■ Suppose Thompson wants to know the

actual value of doing the survey.
Expected value Expected value
with sample of best decision
EVSI = information, assuming – without sample
no cost to gather it information

= (EV with sample information + cost)

– (EV without sample information)

EVSI = ($49,200 + $10,000) – $40,000 = $19,200

 Bayesian Analysis
■ There are many ways of getting
probability data. It can be based on:
■ Management’s experience and intuition.
■ Historical data.
■ Computed from other data using Bayes’
theorem.
■ Bayes’ theorem incorporates initial
estimates and information about the
accuracy of the sources.
■ It also allows the revision of initial
estimates based on new information.
 Calculating Revised Probabilities

■ In the Thompson Lumber case we used these four

conditional probabilities:
P (favorable market(FM) | survey results positive) = 0.78
P (unfavorable market(UM) | survey results positive) = 0.22
P (favorable market(FM) | survey results negative) = 0.27
P (unfavorable market(UM) | survey results negative) = 0.73

■ But how were these calculated?

■ The prior probabilities of these markets are:

P (FM) = 0.50
P (UM) = 0.50
 Calculating Revised Probabilities
■ Through discussions with experts Thompson has
learned the information in the table below.
■ He can use this information and Bayes’ theorem
to calculate posterior probabilities.
STATE OF NATURE
RESULT OF FAVORABLE MARKET UNFAVORABLE MARKET
SURVEY (FM) (UM)

Positive (predicts P (survey positive | P (survey positive |

favorable market FM) UM)
for product) = 0.70 = 0.20

Negative (predicts P (survey negative P (survey negative

unfavorable | FM) | UM)
market for
product) = 0.30 = 0.80
 Calculating Revised Probabilities
■ P (FM | survey negative)

■ P (UM | survey negative)

 Calculating Revised Probabilities

Probability Revisions Given a Positive Survey

POSTERIOR PROBABILITY
CONDITIONAL
PROBABILITY P(STATE OF
P(SURVEY NATURE |
STATE OF POSITIVE | STATE PRIOR JOINT SURVEY
NATURE OF NATURE) PROBABILITY PROBABILITY POSITIVE)
FM 0.70 X 0.50 = 0.35 0.35/0.45 = 0.78
UM 0.20 X 0.50 = 0.10 0.10/0.45 = 0.22
P(survey results positive) = 0.45 1.00
 Calculating Revised Probabilities

Probability Revisions Given a Negative Survey

POSTERIOR PROBABILITY

CONDITIONAL
PROBABILITY P(STATE OF
P(SURVEY NATURE |
STATE OF NEGATIVE | STATE PRIOR JOINT SURVEY
NATURE OF NATURE) PROBABILITY PROBABILITY NEGATIVE)
FM 0.30 X 0.50 = 0.15 0.15/0.55 = 0.27

UM 0.80 X 0.50 = 0.40 0.40/0.55 = 0.73

P(survey results positive) = 0.55 1.00