QM Ch4-I

Chapter 4
Decision Analysis-I
February 23rd , 2014 Week 5
Chapter 4 Decision Analysis

Problem Formulation Decision Making without Probabilities Decision Making with Probabilities Risk Analysis and Sensitivity Analysis Decision Analysis with Sample Information Computing Branch Probabilities
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Problem Formulation
The first step in the decision analysis process is problem formulation. We begin with a verbal statement of the problem. Then we identify: the decision alternatives the states of nature (uncertain future events) the payoff (consequences) associated with each specific combination of: decision alternative state of nature
Formulation
Example: Burger Prince Restaurant Burger Prince Restaurant is considering opening a new restaurant on Main Street. The company has three different building designs (A, B, and C), each with a different seating capacity.
Burger Prince estimates that the

average number of customers arriving per hour will be 40, 60, or 80.
Formulation
Decision Alternatives d1 = use building design A d2 = use building design B d3 = use building design C States of Nature s1 = an average of 40 customers arriving per hour s2 = an average of 60 customers arriving per hour s3 = an average of 80 customers arriving per hour
Payoff Table
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.
Formulation
Payoff Table (Payoffs are Profit Per Week) Average Number of Customers Per Hour s1 = 40 s2 = 60 s3 = 80
Design A Design B Design C
$10,000 $15,000 $14,000 $ 8,000 $18,000 $12,000 $ 6,000 $16,000 $21,000
Formulation Decision Tree

Decision tree is a chronological representation of the decision problem. A decision tree has two types of nodes:
round nodes correspond to chance events square nodes correspond to decisions
Branches leaving a round node represent the different states of nature; branches leaving a square node represent the different decision alternatives. At the end of a limb of the tree is the payoff attained from the series of branches making up the limb.
Formulation
Decision Tree
40 customers per hour (s1)
Design A (d1)
10,000

15,000
14,000 8,000 18,000 12,000 6,000 16,000 21,000
Design B (d2)
60 customers per hour (s2) 80 customers per hour (s3) 40 customers per hour (s1)
Design C (d3)
60 customers per hour (s2) 80 customers per hour (s3)
Problem 1a
Decision Making without Probabilities

Criteria for Decision Making
Three commonly used criteria for decision making when probability information regarding the likelihood of the states of nature is unavailable are: the optimistic (maximax) approach the conservative (maximin) approach the minimax regret approach.
Optimistic (Maximax/Minimin) Approach The optimistic approach would be used by an optimistic decision maker. The decision with the overall largest payoff is chosen. If the payoff table is in terms of costs, the decision with the overall lowest cost will be chosen (hence, a minimin approach).
Decision Making without Probabilities

Optimistic (Maximax) Approach The decision that has the largest single value in the payoff table is chosen.
Decision
Maximax decision Alternative Design A d1 Design B d2 Design C d3
States of Nature (Customers Per Hour)

40 s1 60 s2 80 s3 Maximax payoff 10,000 15,000 14,000 8,000 18,000 12,000 6,000 16,000 21,000
Conservative (Maximin/Minimax) Approach The conservative approach would be used by a conservative decision maker. For each decision the minimum payoff is listed. The decision corresponding to the maximum of these minimum payoffs is selected. If payoffs are in terms of costs, the maximum costs will be determined for each decision and then the decision corresponding to the minimum of these maximum costs will be selected. (Hence, a minimax approach)
Conservative (Maximin) Approach

List the minimum payoff for each decision. Choose the decision with the maximum of these minimum payoffs.
Maximin decision
Decision
Alternative
Design A d1 Design B d2 Design C d3
Minimum
Payoff
10,000 8,000 6,000
Maximin payoff
Minimax Regret Approach
The minimax regret approach requires the construction of a regret table or an opportunity loss table. This is done by calculating for each state of nature the difference between each payoff and the largest payoff for that state of nature. Then, using this regret table, the maximum regret for each possible decision is listed. The decision corresponding to the minimum of the maximum regrets is chosen.
First compute a regret table by subtracting each payoff in a column from the largest payoff in that column. The resulting regret table is:
Decision
Alternative Design A d1 Design B d2 Design C d3
States of Nature (Customers Per Hour)

40 s1 60 s2 80 s3 0 3,000 7,000 2,000 0 9,000 4,000 2,000 0
For each decision list the maximum regret. Choose the decision with the minimum of these values.
Decision
Alternative
Maximum
Regret 7,000 9,000 4,000 Minimax regret
Minimax decision
Design A d1 Design B d2 Design C d3
Problem 1b
Decision Making with Probabilities

Assigning Probabilities
Once we have defined the decision alternatives and states of nature for the chance events, we focus on determining probabilities for the states of nature. The classical, relative frequency, or subjective method of assigning probabilities may be used. Because only one of the N states of nature can occur, the probabilities must satisfy two conditions:
P(sj) > 0 for all states of nature
P(s ) P(s ) P(s

j 1 j 1
P(sN ) 1
Expected Value Approach
We use the expected value approach to identify the best or recommended decision alternative. The expected value of each decision alternative is calculated (explained on the next slide). The decision alternative yielding the best expected value is chosen.
The expected value of a decision alternative is the sum of the weighted payoffs for the decision alternative. The expected value (EV) of decision alternative di is defined as
EV( d i ) P( s j )Vij
j 1 N
where:
N = the number of states of nature P(sj) = the probability of state of nature sj Vij = the payoff corresponding to decision alternative di and state of nature sj
the expected value (EV) for each decision. The decision tree on the next slide can assist in this calculation. Here d1, d2, d3 represent the decision alternatives of Designs A, B, and C. And s1, s2, s3 represent the states of nature of 40, 60, and 80 customers per hour. The decision alternative with the greatest EV is the optimal decision.
Calculate
Decision Tree
40 customers (s1) P(s1) = .4 Design A (d1)
10,000 15,000 14,000 8,000 18,000 12,000 6,000 16,000 21,000
60 customers (s2) P(s2) = .2 80 customers (s3) P(s3) = .4 40 customers (s1) P(s1) = .4
Design B (d2)
60 customers (s2) P(s2) = .2


Design C (d3)
Expected Value Approach

EV(d1) = .4(10,000) + .2(15,000) + .4(14,000) = $12,600
Design A d1
Design B d2
EV(d2) = .4(8,000) + .2(18,000) + .4(12,000) = $11,600
Design C d3
EV(d3) = .4(6,000) + .2(16,000) + .4(21,000) = $14,000
Choose the decision alternative with the largest EV: Design C

Problem 5
Expected Value of Perfect Information

Frequently information is available which can improve the probability estimates for the states of nature. The expected value of perfect information (EVPI) is the increase in the expected profit that would result if one knew with certainty which state of nature would occur. The EVPI provides an upper bound on the expected value of any sample or survey information.
Expected value of perfect information is defined as EVPI = |EVwPI EVwoPI| where: EVPI = expected value of perfect information EVwPI = expected value with perfect information about the states of nature EVwoPI = expected value without perfect information about the states of nature

EVPI Calculation
Step 1: Determine the optimal return corresponding to each state of nature. Step 2: Compute the expected value of these optimal returns. Step 3: Subtract the EV of the optimal decision from the amount determined in step (2).

EVPI Calculation Calculate the expected value for the optimum payoff for each state of nature and subtract the EV of the optimal decision.
EVPI= .4(10,000) + .2(18,000) + .4(21,000) - 14,000 = $2,000
Problem 14

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Chapter 4

Chapter 4 Decision Analysis

Burger Prince estimates that the

Design A Design B Design C

$10,000 $15,000 $14,000 $ 8,000 $18,000 $12,000 $ 6,000 $16,000 $21,000

Formulation Decision Tree

60 customers per hour (s2)

80 customers per hour (s3)

60 customers per hour (s2) 80 customers per hour (s3)

Decision Making without Probabilities

Decision Making without Probabilities

States of Nature (Customers Per Hour)

Conservative (Maximin) Approach

Minimax Regret Approach

States of Nature (Customers Per Hour)

Design A d1 Design B d2 Design C d3

Decision Making with Probabilities

P(s ) P(s ) P(s

Expected Value Approach

10,000 15,000 14,000 8,000 18,000 12,000 6,000 16,000 21,000

60 customers (s2) P(s2) = .2 80 customers (s3) P(s3) = .4 40 customers (s1) P(s1) = .4

60 customers (s2) P(s2) = .2

40 customers (s1) P(s1) = .4

60 customers (s2) P(s2) = .2

80 customers (s3) P(s3) = .4

Expected Value Approach

EV(d2) = .4(8,000) + .2(18,000) + .4(12,000) = $11,600

EV(d3) = .4(6,000) + .2(16,000) + .4(21,000) = $14,000

Choose the decision alternative with the largest EV: Design C

Expected Value of Perfect Information

Expected Value of Perfect Information

Expected Value of Perfect Information

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