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Decision Analysis

The document discusses different decision making approaches under conditions of risk and uncertainty including expected value, Bayesian probability, and maximax, minimax, maximin, and Laplace criteria. Examples are provided to illustrate how to apply each approach to make optimal decisions.

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30 views27 pages

Decision Analysis

The document discusses different decision making approaches under conditions of risk and uncertainty including expected value, Bayesian probability, and maximax, minimax, maximin, and Laplace criteria. Examples are provided to illustrate how to apply each approach to make optimal decisions.

Uploaded by

lp11223334444
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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Decision Analysis

Decision Analysis
• Decision theory is the distinction among three different states
of decisions : certainty, risk and uncertainty, the degree of
knowledge or information of decision-maker is the basis of
distinction.
• Certainty: A state in which the decision-maker possession
complete and perfect knowledge regarding the impact of all of
the available alternatives.
• the two terms 'risk' and 'uncertainty' Both imply 'a lack of
certainty'?
Risk: A state in which the decision-maker has only imperfect
knowledge and incomplete information but is still able to
assign probability estimates to the possible outcome of a
decision.
• Uncertainty: is a state in which the decision 'maker does not
have the information to make subjective probability
assessments.
These estimates may be subjective judgements, or they may
be derived mathematically from a probability distribution.
DECISION MAKING UNDER
CERTAINTY-
ANALYTIC HIERARCHY PROCESS
(AHP)
Martin Hans, a bright high school senior, has received full academic
scholarships from three institutions: U of A, U of B, and U of C. To
select a university, Martin specifies two main criteria: location and
academic reputation. Being the excellent student he is, he judges
academic reputation to be five times as important as location, giving a
weight of approximately 17% to location and 83% to reputation. The
following table ranks the two criteria for three universities –
Criteria U of A U of B U of C
Location 12.9 27.7 59.4
Reputation 54.5 27.3 18.2
Which university represents the best choice for Martin?
DECISION MAKING UNDER
RISK
DECISION MAKING UNDER RISK
• Under conditions of risk, the payoffs associated with each
decision alternative are represented by probability distributions,
and decision can be based on the expected value criterion—
maximization of expected profit or the minimization of expected
cost.

• Decision tree–Based expected Value Criterion :


Expected value criterion seeks the maximization of expected
(average) profit or the minimization of expected cost. The data
of the problem assumes that the payoff (or cost) associated
with each decision alternative is probabilistic.
Suppose that you want to invest $10,000 in the
stock market by buying shares in one of two
companies: A and B. Shares in Company A,
though risky, could yield a 50% return during the
next year. If the stock market conditions are not
favorable (i.e., a “bear” market), the stock may
lose 20% of its value. Company B provides safe
investments with a 15% return in a “bull” market
and only 5% in a “bear” market. All the publications
you have consulted (and there is always a flood of
them at the end of the year!) are predicting a 60%
chance for a “bull” market and 40% chance for a
“bear” market. How should you invest your money?
Draw Decision Tree of the situation
• Decision Problem can be summarized as follows –

Decision Alternative Bull Market (Return on $ 10,000) Bear Markert (Return/Loss on $


10,000)

Company A stock 50% of return = 0.5*10000 = 5000 Loss of 20% = 0.2 *10000= -2000

Company B stock 15% of return = 0.15*10000 = 1500 5% of return = 0.05*10000 = 500

Probability of Occurrence 0.6 0.4

For Stock A = 5000 x 0.6 + (-2000 x 0.4) = $ 2200

For Stock B = 1500 x 0.6 + 500 x 0.4 = $1100

Your Decision is to invest in Stock A


positive or negative payoff

A square represents a decision point, and a circle represents a chance event.


let's consider a scenario where you're deciding between two investment
options: investing in real estate properties or investing in government bonds.

Investment Option 1: Real Estate Properties


 In a favorable market, real estate properties could yield a 10% return
on investment annually.
 In an unfavorable market (e.g., economic recession), properties may
lose 5% of their value.
 Market predictions suggest a 70% chance of a favorable market and
a 30% chance of an unfavorable market.

Investment Option 2: Government Bonds

 Government bonds offer a safe investment with a guaranteed 3%


return annually.
 Regardless of market conditions, the return on government bonds
remains constant.
• Decision Problem can be summarized as follows –

Decision Alternative Favorable Market Unfavorable Market

Real Estate Property 10% of return = 0.1 Loss of 5% = -0.05

Government Bond 3% of return = 0.03 3% of return = 0.03

Probability of Occurrence (Market 0.7 0.3


Predictions)

For Real Estate Property = 0.1 x 0.7 + (-0.05 x 0.3) = 0.055 or 5.5%

For Government Bond = 0.03 * 0.7 + 0.03 x 0.3 = 0.03 = 3%

Your Decision is to invest in Real Estate Property


Variations of the expected Value
Criterion

Posterior (Baye’s) Probabilities


In previous example, the (prior) probabilities of .6
and .4 of a “bull” and a “bear” market are
determined from available financial publications.
Suppose that rather than relying solely on these
publications, you have decided to conduct a
more “personal” investigation by consulting a
friend who has done well in the stock market.
The friend quantifies a “for/ against” investment
recommendation in the following manner: In a
“bull” market, there is a 90% chance the
recommendation is “for.” It drops to 50% in a
“bear” market. How does the additional
v1 = “For” vote
v2 = “Against” vote
m1 = “Bull” market
m2 = “Bear” market
v1 = “For” vote v2 = “Against” vote m1 = “Bull” market m2 = “Bear” market

Step 1. Summarize the conditional probabilities


v1 = “For” vote v2 = “Against” vote
m1 = “Bull” market m2 = “Bear” market
“For” Recommendation
Stock A at node 4 = 5000 * .730 + ( -2000) * .270 =
$3110
Stock B at node 5 = 1500 * .730 + 500 * .270 = 1230
Decision. Invest in stock A.
“Against” Recommendation
Stock A at node 6 = 5000 * .231 + (-2000) * .769 = - $383
Stock B at node 7 = 1500 * .231 + 500 * .769 = $731
Decision. Invest in stock B
DECISION MAKING UNDER
UNCERTAINTY
The research department of Hindustan Lever Ltd. has recommended paying
the marketing department to launch a shampoo of three different types. The
marketing types of shampoo to be launched under the following estimated
pay-offs for various levels of sales.

Estimated Sales (in Units)


Types of Shampoo
Rs 15000 Rs 10000 Rs 5000

Egg Shampoo 30 10 10

Clinic Shampoo 40 15 5

Deluxe Shampoo 55 20 3

What will be the marketing manager’s decision if


(i) Maximin
(ii) Minimax
(iii) Maximax
(iv) Laplace
The research department of consumer products division has
recommended to the marketing department to launch a soap with
three different perfumes. The marketing manager has to decide
the type of perfume to launch under the following estimated pay-
off for the various levels of sales.

For each of the following decisions, state the optimal action and specify he
value leading to its selection
• maximax,
• minimax,
• maximin and
• Laplace criterion

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