Decision Analysis

• Decision analysis was created to incorporate the uncertainty

into the decision making.

• What is the problem to solve?

• What are the alternatives available?
• Which uncertain events are relevant, and what are their
outcomes?
• What are the possible consequences from decisions and
uncertain events, and which do you prefer?
 Example
• Cricket Match in Delhi
o May get cancelled in case of rain.
o Should you go or not?
• Decision Alternative:
o Go
o Don't Go
• States of Nature:
o Rain
o No Rain
• Payoff Table:
Outcomes
Alternatives Rain No Rain
Go -100 500
Don’t Go 0 0
 Thompson Lumber Co. Example
• Problem:
o Whether or not to make and sell storage sheds
• Decision Alternatives:
o Build a large plant
o Build a small plant
o Do nothing
• States of Nature:
o Demand for sheds will be high, moderate, or low

Outcomes (Demand)
Alternatives High Moderate Low
Large plant 200,000 100,000 -120,000
Small plant 90,000 50,000 -20,000
No plant 0 0 0
 Five Steps in Decision Making

1. Clearly define the problem

2. List all possible alternatives
o Decision variable
3. Identify all possible outcomes for each alternative
o Chance variable
• A particular event that is relevant to the decision but is beyond our
control.
• Event may have several (finite) possible outcomes.
• Outcomes are called states of nature.
4. Identify the payoff for each alternative & outcome
combination
o Payoff function
5. Use a decision modeling technique to choose an
alternative
How to decide which decision alternative to
select ?

✓ Decision Making under uncertainty

 Decision Making Under Uncertainty

• Probabilities of the possible outcomes are not known

• Probabilities of outcomes are available

How to decide which decision alternative to

select ?
• Several Ways to decide
• Depends on the outlook of decision maker
• No universal right decision
• Pessimistic vs. Optimistic vs. Rationalistic
• Several criteria for decision making are possible
• Several strategies are available for decision making
 Decision making without probabilities

• Maximin Payoff Criterion

• Maximax Payoff Criterion
• Equally Likely Criterion
• Criteria of Realism
• Minimax Regret Criterion
 The Maximin payoff criterion

• Best guaranteed outcome

• Picks the decision alternative whose minimum
payoff gives the maximum.

Outcomes (Demand)
Alternatives High Moderate Low
Large plant 200,000 100,000 -120,000
Small plant 90,000 50,000 -20,000
No plant 0 0 0

• Choose no plant (best payoff)

 The Maximax payoff criterion

• Decision alternative which maximizes the maximum

return
• Optimistic Approach
Outcomes (Demand)
Alternatives High Moderate Low
Large plant 200,000 100,000 -120,000
Small plant 90,000 50,000 -20,000
No plant 0 0 0

• Choose the Large Plant (Best Payoff)

 Equally Likely Criterion

• Assume all outcomes are equally likely

• Choose the alternative which maximizes the average
payoff

Outcomes (Demand) Average

Alternatives High Moderate Low Payoff
Large plant 200,000 100,000 -120,000 60,000
Small plant 90,000 50,000 -20,000 40,000
No plant 0 0 0 0

• Choose Large Plant

 Criterion of Realism

• Middle ground between the extremes posed by the

optimist and pessimist criteria
• Use the coefficient of realism (α) to estimate the
decision maker’s optimism
• 0<α<1
• Realism payoff for alternative =
➢ α x (max payoff for alternative) + (1- α) x (min payoff for alternative)
• Choose the alternative with Maximum Realism
payoff
 Criterion of Realism

• Suppose α = 0.45

Outcomes (Demand) Realism

Alternatives High Moderate Low Payoff
Large plant 200,000 100,000 -120,000 24,000
Small plant 90,000 50,000 -20,000 29,500
No plant 0 0 0 0

• Choose Small Plant

 Minimax Regret Criterion
• Decision alternative which minimizes the maximum regret
• Regret =
(payoff for the best decision for that state of nature) – (payoff for that decision)

Outcomes Regret Table Max

Alternatives Rain No Rain Rain No Rain Regret
Go -100 500 100 0 100
Don’t Go 0 0 0 500 500

• The alternative selected is to Go

 Minimax Regret Criterion
Outcomes (Demand)
Alternatives High Moderate Low
Large plant 200,000 100,000 -120,000
Small plant 90,000 50,000 -20,000
No plant 0 0 0

Regret Table Max

Alternatives High Moderate Low Payoff
Large plant 0 0 120,000 120,000
Small plant 110,000 50,000 20,000 110,000
No plant 200,000 100,000 0 200,000

• Choose Small Plant

 Need for Probabilities

• For better decision making, knowledge of

probabilities is required.
• Probability: Quantitative measure of chance
• EMV (Expected Monetary Value) Criterion
 EMV Criterion

• Expected Monetary Value (EMV) or Expected Payoff uses the probabilities

to calculate the weighted average payoff for each alternative
– EMV(di) = Σj r(di,cj)pj
• Selects a decision that maximizes the EMV

Outcomes (Demand) r(di,cj)

Alternatives High (c1) Moderate (c2) Low (c3) EMV
Large plant (d1) 200,000 100,000 -120,000 86,000
Small plant (d2) 90,000 50,000 -20,000 48,000
No plant (d3) 0 0 0 0
p1= 0.3 p2= 0.5 p3= 0.2

Choose Large Plant

 EOL Criterion

• Expected Opportunity Loss (EOL) uses the probabilities to

calculate the weighted average regret for each alternative
– EOL(di) = Σj l(di,cj)pj
• Selects a decision that minimizes the EOL

Regret Table
Alternatives Rain (c1) No Rain (c2) EOL
Go (d1) 100 0 = 0.75 × 100 + 0.25 × 0 = 75
l(di,cj)
Don’t Go (d2) 0 500 = 0.75 × 0 + 0.25 × 500 = 125
p1= 0.75 p2= 0.25

• The alternative selected is to GO

 EOL Criterion

Regret Table
Alternatives High Moderate Low EOL
Large plant 0 0 120,000 24,000
Small plant 110,000 50,000 20,000 62,000
No plant 200,000 100,000 0 110,000
p1= 0.3 p2= 0.5 p3= 0.2

• Choose Large Plant

 Relationship between EMV and EOL

• Both decision criteria (EMV and EOL) pointed to the same

action alternative
• Will this always be the case?
– Yes
• Suppose Perfect Information (forecast) is available.
– Perfect Information would tell us with certainty which outcome
is going to occur
– Having perfect information before making a decision would
allow choosing the best payoff for the outcome
• Perfect Forecaster would predict
– High 30% of the time
– Medium 50% of the time
– Low 20% of the time
 Relationship between EMV and EOL

Outcomes (Demand)
Alternatives High Moderate Low
Large plant 200,000 100,000 -120,000
Small plant 90,000 50,000 -20,000
No plant 0 0 0
p1= 0.3 p2= 0.5 p3= 0.2

• Make the decision with Highest possible payoffs under the

different market-demand conditions
• Taking the expected value of these best-possible payoffs:
EV|PI = 0.3 x 200,000 + 0.5 x 100,000 + 0.2 x 0 = 110,000
• Perfect forecasting EV|PI (Max EMV)
 Relationship between EMV and EOL

• Note that this idealized expected payoff (or expected

payoff given perfect forecasts) arises because the
corresponding expected opportunity loss is zero.
– Clearly, Max EMV can only be obtained with Min EOL. Thus,
both criteria must point to the same decision alternative
• Now, any expected opportunity loss that is incurred
must come out of forgone expected payoffs.
• EMV + EOL = 110,000
• EMV + EOL = Expected Payoff given Perfect Forecasts
• EV|PI (EVwPI)
= ∑ (probability of outcome) x ( best payoff of outcome)
 The minimum EOL

Regret Table
Alternatives High Moderate Low
Large plant 0 0 120,000
Small plant 110,000 50,000 20,000
No plant 200,000 100,000 0
p1= 0.3 p2= 0.5 p3= 0.2

• Make the decision with zero opportunity loss under the

different market-demand conditions
• Taking the expected value of these best-possible payoffs:
EOL* = EOL(d*) = 0.3 x 0 + 0.5 x 0 + 0.2 x 0 = 0
• Perfect forecasting Zero EOL (EOL*)
 Worth of perfect information

Expected Value of Perfect Information (EVPI)

• The amount by which perfect information would
increase our expected payoff
• Provides an upper bound on what to pay for
additional information
EVPI = EV|PI – EMV
EV|PI = Expected value given perfect information
EMV = the best EMV without perfect information
 Expected Value of Perfect Information

EVPI = EV|PI – EMV

= $110,000 - $86,000 = $24,000 = EOL

• EOL = Best (min) EOL without perfect information

• The “perfect information” increases the expected
value by $24,000
• Would it be worth $30,000 to obtain this perfect
information for demand?
 Decision Tree

• Visual/pictorial display of the problem

• Can be used instead of a table to show alternatives,
outcomes, and payoffs
• Chronologically depicts the sequence of actions and
outcomes as they unfold
• Helpful when sequence of decisions are to be made
 Constructing the Decision Tree

• Decision node:
– A decision to be made at that point
– represented by a square

• Event (Chance) node:

– A random event occurs
at that point
– represented by a circle
Example

Representation of a decision problem

in the form of a tree
 Doing the Calculations

Rain
-$100
$50 (0.75)

No rain
$500
$50 (0.25)
a

Rain
$0
$0 (0.75)

No rain
$0
(0.25)

Node b: 0.75 × -100 + 0.25 × 500 = 50

Node c: 0.75 × 0 + 0.25 × 0 = 0
 Folding Back a Decision Tree

• For identifying the best decision in the tree

• Work from right to left
• Calculate the expected payoff at each event
node
• Choose the best alternative at each decision
node (based on expected payoff)
 Decision Tree for Thompson Lumber
High Demand (0.30)
$200,000
$86,000
Moderate Demand (0.50)
b $100,000

Low Demand (0.20) -$120,000

High Demand (0.30) $90,000

$86,000 $48,000
Small Plant Moderate Demand (0.50)
a c $50,000

Low Demand (0.20) -$20,000

$0
All Demands
d $0

Node b: 200000 × 0.3 + 100000 × 0.5 - 120000 × 0.2 = $86000

Node c: 90000 × 0.3 + 50000 × 0.5 - 20000 × 0.2 = $48000
 Power Generator

• The management of First American Bank was concerned

about the potential loss of $100 million that might occur
in the event of a physical catastrophe such as a power
failure or fire.
• Bank is considering the installation of an emergency
power generator costing $800K to ensure no losses from
this type of incident will be incurred.
• If the generator is not installed, there is a 10% chance
that a power outage will occur during the next year.
• If there is an outage, there is a .05 probability that the resulting
losses will be very large, or approximately $80 million in lost
earnings.
• Alternatively, it is estimated that there is a 0.95 probability of
only slight losses of around $1 million.
• Determine whether the bank should install the new
power generator.
 Power Generator
Large Loss -80,000

(0.05)
Power
c -4950
Outage (0.95)
(0.10) Slight Loss
-1000
b -495

(0.90)
No
-495 Don’t Outage 0
Install
a

Install

-800