Quantitative Analysis for Management

Thirteenth Edition

Chapter 3
Decision Analysis

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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

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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 100,000 −20,000 100,000
plant
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 0 180,000 180,000
plant
Construct a small 100,000 20,000 100,000
plant
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)

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 100,000 −20,000 40,000
plant
Do nothing 0 0 0
With perfect 200,000 0 100,000
information
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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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
EVwPI = $925
TABLE 3.14 Expected Monetary Values and Expected
Values
Best with
EMVPerfect
withoutInformation for Business
perfect information Analytics
= $970
Department
Blank EVPI =20,000
10,000 970 − 925 = $45
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 (8 of 8)

• Opportunity loss criteria

TABLE 3.15 Opportunity Loss Table for Business

Analytics Department
Blank 10,000 20,000 30,000
COPIES PER COPIES PER COPIES 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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Using Software (1 of 2)

PROGRAM 3.1A QM for Windows Input for

Thompson umber Example

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Decision Trees

• Any problem that can be presented in a decision table can

be graphically represented in a decision tree

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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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