I.
6 steps in decision making
II. Types of decision-making environments
● Decision-making under certainty
● Decision-making under uncertainty
● Decision-making under risk
III. Decision making under uncertainty
1. Maximax (optimistic)
Find maximum in a row -> max
2. Maximin (pessimistic)
Find minimum in a row -> max
3. Criterion of realism (Hurwicz): weighted average
Select a coefficient of realism α, with 0 ≤ α ≤ 1
Weighted average = α(best in row) + (1−α)(worst in row)
-> choose the best alternative (max)
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
4. Equally likely (Laplace):
Find the average of each row -> max
5. Minimax regret
Subtract each payoff in the column from the best payoff -> choose min
IV. Decision making under risk
1. EMV (expected monetary value)
= 1st payoff x prob of 1st state + 2nd payoff x prob of 2nd state + … + last
payoff x prob of last state
-> choose max
—
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
2. EVPI (expected value of perfect in4)
● EVwPI = ∑(best payoff in state of nature i) (probability of state
of nature i)
= best payoff of 1st state x prob of 1st state + best payoff of
2nd state x prob of 2nd state + … + best payoff of last state x
prob of last state
● EVPI = EVwPI - best EMV
EVPI = EVwPI − Maximum EMV = $100,000 − $40,000 = $60,000 -> the maximum
should pay for the additional information
3. EOL (expected opportunity loss)
Min EOL = EVPI
EOL (large plant) = (0.50)($0) + (0.50)($180,000) = $90,000
EOL (small plant) = (0.50)($100,000) + (0.50)($20,000) = $60,000 -> choose min
EOL (do nothing) = (0.50)($200,000) + (0.50)($0) = $100,000
4. Sensitivity analysis
Point 1: EMV(do nothing) = EMV(small plant)
0 = $120,000P - $20,000 => P = 20,000/120,000 = 0.167
Point 2: EMV(small plant) = EMV(large plant)
$120,000P - $20,000 = $380,000P - $180,000 => P = 160,000/260,000 = 0.615
- Minimization example -
● Using Hurwicz criteria with 70% coefficient
Weighted average = 0.7(best payoff) + (1 − 0.7)(worst payoff)
For each machine:
- Machine A: 0.7(950) + 0.3(1,150) = 1,010
- Machine B: 0.7(850) + 0.3(1,350) = 1,000
- Machine C: 0.7(700) + 0.3(1,300) = 880
● Equally likely criteria
For each machine:
- Machine A: (950 + 1,050 + 1,150)÷3 = 1,050
- Machine B: (850 + 1,100 + 1,350)÷3 = 1,100
- Machine C: (700 + 1,000 ç + 1,300)÷3 = 1,000
● EMV criteria
● EVPI = best EMV - EVwPI = 970 - 925 = $45
● Opportunity loss criteria
V. Software & Payoff table
VI. Decision trees
1. Decision trees
a. 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
—
b. 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 survey)
= (0.27)($90,000) + (0.73)(−$30,000) = $2,400
● EMV for no plant = −$10,000
—
c. 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
—
d. Expected value no market survey
● 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
2. EVSI (expected value of sample in4)
EVSI = EV with SI + cost - EV without SI
=> EVSI = ($49,200 + $10,000) − $40,000 = $19,200
= node 1 + node 6 - node 7
3. Efficiency of sample in4
4. Sensitivity analysis
● EMV(node 1) = ($106,400)p +($2,400)(1−p)
= $104,000p + $2,400
● We are indifferent when the EMV of node 1 is the same as the
EMV of not conducting the survey
● $104,000p + $2,400 = $40,000 => $104,000p = $37,600
=> p = $37,600÷$104,000 = 0.36
If p < 0.36, do not conduct the survey
If p > 0.36, conduct the survey
VII. Bayesian analysis
1. 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
2. Prior probabilities
● P(FM) = 0.50
● P(UM) = 0.50
VIII. Utility theory
- The worst outcome a utility of 0
- The best outcome a utility of 1
● Expected utility of alternative 2 = Expected utility of alternative 1
● Utility of other outcome = (p)(utility of best outcome, which is 1) +
(1−p)(utility of the worst outcome, which is 0)
● Utility of other outcome = (p)(1) + (1−p)(0) = p
- Investment example -
- Construct a utility curve revealing preference for money between $0 and $10,000
- A utility curve plots the utility value versus the monetary value
● An investment in a bank will result in $5,000
● An investment in real estate will result in $0 or $10,000
● Unless there is an 80% chance of getting $10,000 from the real estate deal,
prefer to have her money in the bank
● If p = 0.80, Jane is indifferent between the bank or the real estate investment
