Quantitative Analysis for Management

Thirteenth Edition

Chapter 3
Decision Analysis

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Learning Objectives
After completing this chapter, students will be able to:
3.1 List the steps of the decision-making process.
3.2 Describe the types of decision-making environments.
3.3 Make decisions under uncertainty.
3.4 Use probability values to make decisions under risk.
3.5 Use computers to solve basic decision-making
problems.
3.6 Develop accurate and useful decision trees.
3.7 Revise probabilities using Bayesian analysis.
3.8 Understand the importance and use of utility theory in
decision making.
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Chapter Outline
3.1 The Six Steps in Decision Making
3.2 Types of Decision-Making Environments
3.3 Decision Making Under Uncertainty
3.4 Decision Making Under Risk
3.5 Using Software for Payoff Table Problems
3.6 Decision Trees
3.7 How Probability Values Are Estimated by Bayesian
Analysis
3.8 Utility Theory

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Introduction
• What is involved in making a good decision?

• Decision theory is an analytic and systematic approach to

the study of decision making

• A good decision is one that is based on logic, considers all

available data and possible alternatives, and applies a
quantitative approach

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The Six Steps in Decision Making
1. Clearly define the problem at hand

2. List the possible alternatives

3. Identify the possible outcomes or states of nature

4. List the payoff (typically profit) of each combination of

alternatives and outcomes

5. Select one of the mathematical decision theory models

6. Apply the model and make your decision

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Thompson Lumber Company (1 of 3)
• Step 1 – Define the problem
• Consider 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
• Step 3 – Identify possible outcomes, states of nature
• The market could be favorable or unfavorable

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Thompson Lumber Company (2 of 3)
• 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

• Depends on the environment and amount of
risk and uncertainty

• Step 6 – Apply the model to the data

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Thompson Lumber Company (3 of 3)
TABLE 3.1 Decision Table with Conditional Values for
Thompson Lumber

STATE OF NATURE
Blank FAVORABLE UNFAVORABLE
MARKET MARKET
ALTERNATIVE ($) ($)
Construct a large plant 200,000 −180,000
Construct a small plant 100,000 −20,000
Do nothing 0 0

Note: It is important to include all alternatives, including “do

nothing.”

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Types of Decision-Making Environments
• Decision making under certainty
– The decision maker knows with certainty the
consequences of every alternative or decision choice

• Decision making under uncertainty

– The decision maker does not know the probabilities of
the various outcomes

• Decision making under risk

– The decision maker knows the probabilities of the
various outcomes

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Decision Making Under Uncertainty
• Criteria for making decisions under uncertainty

1. Maximax (optimistic)
2. Maximin (pessimistic)
3. Criterion of realism (Hurwicz)
4. Equally likely (Laplace)
5. Minimax regret

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Optimistic
• Used to find the alternative that maximizes the maximum
payoff – maximax criterion
– Locate the maximum payoff for each alternative
– Select the alternative with the maximum number
TABLE 3.2 Thompson’s Maximax Decision
STATE OF NATURE
Blank FAVORABLE UNFAVORABLE MAXIMUM IN
Blank MARKET MARKET A ROW
ALTERNATIVE ($) ($) ($)
Construct a large plant 200,000 −180,000 200,000
Blank Blank Blank Maximax
Construct a small plant 100,000 −20,000 100,000
Do nothing 0 0 0

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Pessimistic
• Used to find the alternative that maximizes the minimum
payoff – maximin criterion
– Locate the minimum payoff for each alternative
– Select the alternative with the maximum number
TABLE 3.3 Thompson’s Maximin Decision
STATE OF NATURE
Blank FAVORABLE UNFAVORABLE MAXIMUM IN
Blank MARKET MARKET A ROW
ALTERNATIVE ($) ($) ($)
Construct a large plant 200,000 −180,000 −180,000
Construct a small plant 100,000 −20,000 −20,000
Do nothing 0 0 0
Blank Blank Blank Maximin

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Criterion of Realism (Hurwicz) (1 of 2)
• Often called weighted average
– Compromise between optimism and pessimism
– Select a coefficient of realism α, with 0 ≤ α ≤ 1
α = 1 is perfectly optimistic
α = 0 is perfectly pessimistic
– Compute the weighted averages for each alternative
– Select the alternative with the highest value

Weighted average = α(best in row)

+ (1−α)(worst in row)

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Criterion of Realism (Hurwicz) (2 of 2)
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
TABLE 3.4 Thompson’s Criterion of Realism Decision
STATE OF NATURE
Blank FAVORABLE UNFAVORABLE CRITERION OF REALISM
Blank MARKET MARKET OR WEIGHTED AVERAGE
ALTERNATIVE ($) ($) (α = 0.8) ($)
Construct a large plant 200,000 −180,000 124,000
Blank Blank Blank Realism
Construct a small plant 100,000 −20,000 76,000
Do nothing 0 0 0

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Equally Likely (Laplace)
• Considers all the payoffs for each alternative
– Find the average payoff for each alternative
– Select the alternative with the highest average

TABLE 3.5 Thompson’s Equally Likely Decision

STATE OF NATURE
Blank FAVORABLE UNFAVORABLE Blank
Blank MARKET MARKET ROW AVERAGE
ALTERNATIVE ($) ($) ($)
Construct a large plant 200,000 −180,000 10,000
Construct a small plant 100,000 −20,000 40,000
Blank Blank Blank Equally likely
Do nothing 0 0 0

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Minimax Regret (1 of 4)
• Based on opportunity loss or regret
– The difference between the optimal profit and actual
payoff for a decision
1. Create an opportunity loss table by determining the
opportunity loss from not choosing the best
alternative
2. Calculate opportunity loss by subtracting each
payoff in the column from the best payoff in the
column
3. Find the maximum opportunity loss for each
alternative and pick the alternative with the
minimum number
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Minimax Regret (2 of 4)
TABLE 3.6 Determining Opportunity Losses for Thompson
Lumber

STATE OF NATURE
FAVORABLE UNFAVORABLE
MARKET MARKET
($) ($)
200,000 − 200,000 0 − (−180,000)
200,000 − 100,000 0 − (−20,000)
200,000 − 0 0−0

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Minimax Regret (3 of 4)
TABLE 3.7 Opportunity Loss Table for Thompson Lumber

STATE OF NATURE
Blank FAVORABLE UNFAVORABLE
Blank MARKET MARKET
ALTERNATIVE ($) ($)
Construct a large plant 0 180,000
Construct a small plant 100,000 20,000
Do nothing 200,000 0

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Minimax Regret (4 of 4)
TABLE 3.8 Thompson’s Minimax Decision Using
Opportunity Loss

STATE OF NATURE
Blank FAVORABLE UNFAVORABLE MAXIMUM IN
Blank MARKET MARKET A ROW
ALTERNATIVE ($) ($) ($)
Construct a large plant 0 180,000 180,000
Construct a small plant 100,000 20,000 100,000
Blank Blank Blank Minimax
Do nothing 200,000 0 200,000

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Decision Making Under Risk (1 of 2)
• When there are several possible states of nature and the
probabilities associated with each possible state are
known
– Most popular method – choose the alternative with the
highest expected monetary value (EMV)
EMV  alternative  =  X i P  X i 
where
Xi = payoff for the alternative in state of nature i
P(Xi) =probability of achieving payoff Xi (i.e., probability of
state of nature i)
∑ = summation symbol
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Decision Making Under Risk (2 of 2)
• Expanding the equation

EMV (alternative i) = (payoff of first state of nature)

×(probability of first state of nature)
+ (payoff of second state of nature)

×(probability of second state of

nature)
+ … + (payoff of last state of
nature)
×(probability of last state of nature)
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EMV for Thompson Lumber (1 of 2)
• Each market outcome has a probability of occurrence of
0.50
• Which alternative would give the highest EMV?

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

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EMV for Thompson Lumber (2 of 2)
TABLE 3.9 Decision Table with Probabilities and EMVs for
Thompson Lumber
STATE OF NATURE
Blank FAVORABLE UNFAVORABLE Blank
Blank MARKET MARKET Blank
ALTERNATIVE ($) ($) EMV ($)
Construct a large plant 200,000 −180,000 10,000
Construct a small plant 100,000 −20,000 40,000
Blank Blank Blank Best EMV
Do nothing 0 0 0
Probabilities 0.50 0.50 Blank

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Expected Value of Perfect Information
(EVPI) (1 of 6)
• EVPI places an upper bound on what you should pay for
additional information
• EVwPI is the long run average return if we have perfect
information before a decision is made
EVwPI = ∑(best payoff in state of nature i)
(probability of state of nature i)

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Expected Value of Perfect Information
(EVPI) (2 of 6)
• Expanded EVwPI becomes
EVwPI = (best payoff for first state of nature)
× (probability of first state of nature)
+ (best payoff for second state of nature)
× (probability of second state of nature)
+ … + (best payoff for last state of nature)
× (probability of last state of nature)

And
EVPI = EVwPI − Best EMV

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Expected Value of Perfect Information
(EVPI) (3 of 6)
• 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?

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Expected Value of Perfect Information
(EVPI) (4 of 6)
TABLE 3.10 Decision Table with Perfect Information

STATE OF NATURE
Blank FAVORABLE UNFAVORABLE Blank
Blank MARKET MARKET Blank
ALTERNATIVE ($) ($) EMV ($)
Construct a large plant 200,000 −180,000 10,000
Construct a small plant 100,000 −20,000 40,000
Do nothing 0 0 0
With perfect information 200,000 0 100,000
Blank Blank Blank EVwPI
Probabilities 0.50 0.50 Blank

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Expected Value of Perfect Information
(EVPI) (5 of 6)
• The maximum EMV without additional information is
$40,000
– Therefore

EVPI = EVwPI − Maximum EMV

= $100,000 − $40,000
= $60,000

So the maximum Thompson should pay for the

additional information is $60,000

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Expected Value of Perfect Information
(EVPI) (6 of 6)
• The maximum EMV without additional information is
$40,000
– Therefore Thompson should not pay $65,000
for this information

EVPI = EVwPI − Maximum EMV

= $100,000 − $40,000
= $60,000

So the maximum Thompson should pay for the

additional information is $60,000

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Expected Opportunity Loss (1 of 2)
• Expected opportunity loss (EOL) is the cost of not picking
the best solution
– Construct an opportunity loss table
– For each alternative, multiply the opportunity loss by
the probability of that loss for each possible outcome
and add these together
– Minimum EOL will always result in the same decision
as maximum EMV
– Minimum EOL will always equal EVPI

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Expected Opportunity Loss (2 of 2)
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
EOL (do nothing) = (0.50)($200,000) + (0.50)($0) = $100,000
TABLE 3.11 EOL Table for Thompson Lumber
STATE OF NATURE
Blank FAVORABLE UNFAVORABLE Blank
Blank MARKET MARKET Blank
ALTERNATIVE ($) ($) EOL ($)
Construct a large plant 0 180,000 90,000
Construct a small plant 100,000 20,000 60,000
Blank Blank Blank Best EOL
Do nothing 200,000 0 100,000
Probabilities 0.50 0.50 Blank

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A Minimization Example (1 of 8)
• Three year lease for a copy machine
– Which machine should be selected?

TABLE 3.12 Payoff Table with Monthly Copy Costs for

Business Analytics Department

Blank 10,000 20,000 30,000

COPIES PER COPIES PER COPIES PER
MONTH MONTH MONTH
Machine A 950 1,050 1,150
Machine B 850 1,100 1,350
Machine C 700 1,000 1,300

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A Minimization Example (2 of 8)
• Three year lease for a copy machine
– Which machine should be selected?

TABLE 3.13 Best and Worst Payoffs (Costs) for Business

Analytics Department

Blank 10,000 20,000 30,000 BEST WORST

COPIES PER COPIES PER COPIES PER PAYOFF PAYOFF
MONTH MONTH MONTH (MINIMUM) (MAXIMUM)
Machine A 950 1,050 1,150 950 1,150

Machine B 850 1,100 1,350 850 1,350

Machine C 700 1,000 1,300 700 1,300

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A Minimization Example (3 of 8)
• 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

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A Minimization Example (4 of 8)
• For 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

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A Minimization Example (5 of 8)
• For EMV criteria

USAGE PROBABILITY
10,000 0.40
20,000 0.30
30,000 0.30

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A Minimization Example (6 of 8)
• For EMV criteria

TABLE 3.14 Expected Monetary Values and Expected

Values with Perfect Information for Business Analytics
Department
Blank 10,000 20,000 30,000
COPIES PER COPIES PER COPIES PER
MONTH MONTH MONTH EMV
Machine A 950 1,050 1,150 1,040
Machine B 850 1,100 1,350 1,075
Machine C 700 1,000 1,300 970
With perfect information 700 1,000 1,150 925
Probability 0.4 0.3 0.3 Blank

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A Minimization Example (7 of 8)
• For EVPI

TABLE 3.14 Expected Monetary Values and Expected

Values with Perfect Information EVwPI = $925
for Business Analytics
Department
Best EMV without perfect information = $970
Blank 10,000 20,000 30,000
EVPI
COPIES =
PER 970 − 925
COPIES PER= $45
COPIES PER
MONTH MONTH MONTH EMV
Machine A 950 1,050 1,150 1,040
Machine B 850 1,100 1,350 1,075
Machine C 700 1,000 1,300 970
With perfect information 700 1,000 1,150 925
Probability 0.4 0.3 0.3 Blank

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A Minimization Example (8 of 8)
• Opportunity loss criteria

TABLE 3.15 Opportunity Loss Table for Business Analytics

Department

Blank 20,000 30,000

10,000 COPIES
COPIES PER COPIES PER
PER MONTH
MONTH MONTH MAXIMUM EOL
Machine A 250 50 0 250 115
Machine B 150 100 200 200 150
Machine C 0 0 150 150 45
Probability 0.4 0.3 0.3 Blank Blank

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Decision Trees
• Any problem that can be presented in a decision table can
be graphically represented in a decision tree
– Most beneficial when a sequence of decisions must be
made
– All decision trees contain decision points/nodes and
state-of-nature points/nodes
– At decision nodes one of several alternatives may be
chosen
– At state-of-nature nodes one state of nature will occur

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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

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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

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Thompson’s Decision Tree (1 of 2)
FIGURE 3.2 Thompson’s Decision Tree

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Thompson’s Decision Tree (2 of 2)
FIGURE 3.3 Completed and Solved Decision Tree for
Thompson Lumber

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Thompson’s Complex Decision Tree (1 of 5)
FIGURE 3.4 Larger Decision Tree with Payoffs and
Probabilities for Thompson Lumber

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Thompson’s Complex Decision Tree (2 of 5)
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

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Thompson’s Complex Decision Tree (3 of 5)
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 survey)
= (0.27)($90,000) + (0.73)(−$30,000)
= $2,400
EMV for no plant= −$10,000

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Thompson’s
The best Complex Decision
choice is to seek Tree
marketing information
(4 of 5)

3. 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. 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
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Thompson’s Complex Decision Tree (5 of 5)
FIGURE 3.5 Thompson’s Decision Tree with EMVs Shown

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Copyright

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