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Decision analysis

1. Introduction decision theory

2. The Six Steps in Decision Making
3. Types of Decision-Making Environments
4. Decision Making under Uncertainty
5. Decision Making under Risk

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Lecturer: Yusuf H. MoHaMed Handout subject: operationaL researcH

Introduction
Most people often make choices out of habit or tradition, without going through the decision-making
process steps systematically. Decisions may be made under social pressure or time constraints that
interfere with a careful consideration of the options and consequences.
Decision theory is the analytic and systematic approach for making the best decision
Decision making is the process of examining your possibilities options, comparing them, and choosing a
course of action.
Decision analysis: It is an analytical approach of comparing decision alternatives in terms of expected
outcomes
What is decision making
Decision making is the cognitive process leading to the selection of a course of action among
alternatives.
Every decision making process produces a final choice. It can be an action or an opinion.
It begins when we need to do something but we do not know what. Therefore, decision making is
a reasoning process which can be rational or irrational, and can be based on explicit assumptions
or tacit assumptions.
Six C's of Decision Making
Construct a clear picture of precisely what must be decided.
Compile a list of requirements that must be met.
Collect information on alternatives that meet the requirements
Compare alternatives that meet

the requirements.

Consider the "what might go wrong" factor with each alternative.

Commit to a decision and follow through with it.

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Lecturer: Yusuf H. MoHaMed Handout subject: operationaL researcH

WHY MUST DECISIONS BE MADE?

The essence of management is to make decisions that commit Resources in the pursuit of organizational
objectives. Resources are limited and wants and needs of human beings are unlimited and diversified and
each wants to satisfy his needs in an atmosphere, where resources are limited. Here the decision theory
helps to take a certain decision to have most satisfactory way of satisfying their needs. Decisions are
made to achieve these goals and objectives
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Lecturer: Yusuf H. MoHaMed Handout subject: operationaL researcH

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 or 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
Types of Decision-Making Environments
Type 1:

The decision maker knows with certainty the consequences of every alternative or
decision choice.

Type 2:

Decision making under uncertainty

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

Type 3:

Decision making under certainty

Decision making under risk

The decision maker knows the probabilities of the various outcomes.\

Decision Making Under Uncertainty

There are several criteria for making decisions under uncertainty:
1. Maximax (optimistic)
2. Maximin (pessimistic)
3. Criterion of realism (Hurwicz)
4. Equally likely (Laplace)
5. Minimax regret

Components of Decision Making

Alternatives of a decision

A list of choices, one of which will be selected as the decision by the decision maker.

States of Nature

Possible conditions that may actually occur in the future, which will affect the outcome of
your decision but are beyond your control.
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Lecturer: Yusuf H. MoHaMed Handout subject: operationaL researcH

Payoffs

A payoff is the outcome of a decision alternative under a state of nature. The larger the
payoff the better.

The decision alternatives, states of nature and payoffs are organized in a decision table.

Example payoff
A firm manufactures three types of products. The fixed and variable costs are given below:
Fixed cost
variable cost per unit
Product A :
25,000
12
Product B :
35,000
9
Product C :
53,000
7
The likely demand (units) of the products is given below:
Poor Demand
3,000
moderate demand 7,000
high demand
11,000
If the sale price of each type of product is $ 25, then prepare the payoff matrix
Let D1, D2 and D3 be the poor, moderate and high demand, respectively. The payoff is determined as
Payoff = Sales revenue Cost
The calculations for payoff (in 000) for each pair of alternative demand (course of action) and the types
of product (state of nature) are shown below
D1 A = 3 25 25 3 12
D1 B = 3 25 35 3 19
D1 C = 3 25 53 3 17
D3 A = 11 25 25 11 12
D3 B = 11 25 35 11 19
D3 C = 11 25 53 11 17

= 14
=13
=1
= 118
= 141
=145

D2 A = 7 25 25 7 12 = 66
D2 B = 7 25 35 7 19 = 77
D2 C = 7 25 53 7 17 = 73

Table 3.1 payoff values

Product Type
A
B
C

Alternative demand ( In 000)

D1
D2
D3
14
66
118
13
77
141
1
73
145

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Lecturer: Yusuf H. MoHaMed Handout subject: operationaL researcH

Example - Decision Making Under Uncertainty

A firm has two options for expanding production of a product: (1) construct a large plant; or (2)
construct a small plant. Whether or not the firm expands, the future market for the product will be either
favorable or unfavorable.
If a large plant is constructed and the market is favorable, then the result is a profit of $200,000. If
a large plant is constructed and the market is unfavorable, then the result is a loss of $180,000.
If a small plant is constructed and the market is favorable, then the result is a profit of $100,000. If
a small plant is constructed and the market is unfavorable, then the result is a loss of $20,000. Of course,
the firm may also choose to do nothing, which produces no profit or loss = 0.8.
Criterion 1: Maximax (Optimistic)

Step 1. Pick maximum payoff of each alternative.

Step 2. Pick maximum of those maximums in Step 1; its corresponding alternative is the decision.

Best of bests.
State of Nature

Decision
Alternatives

Favorable Market

Large Plant

200,000

(180,000) 200,000

Small Plant
100,000
do nothing
0
Max(Row maxs) = Max(200,000, 100,000, 0) = 200,000.

(20,000) 100,000
0

Unfavorable Market

Row Maximum

So, the decision is Large plant. For whom MaxiMax is an approach for: Risk taker who
tends not to give up attractive opportunities regardless of possible failures, or Optimistic
decision maker in whose eyes future is bright.

Criterion 2: Maximin (Pessimistic)

Step 1. Pick minimum payoff of each alternative

Step 2. Pick the maximum of those minimums in Step 1, its corresponding alternative is the
decision

Best of worsts

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Lecturer: Yusuf H. MoHaMed Handout subject: operationaL researcH

State of Nature
Decision
Alternatives

Favorable Market

Large Plant

200,000

(180,000) (180,000)

Small Plant

100,000

(20,000) (20,000)

Unfavorable Market

Row Minimum

do nothing
0
Max(Row Mins) = Max(180,000, 20,000, 0) = 0.

0 -

So, the decision is do nothing.

For Whom? MaxiMin is an approach for:

Risk averter who tends to avoid bad outcomes despite of some possible attractive
outcomes; or Pessimistic decision maker in whose eyes future is obscure.

Criterion 3: Hurwicz (Realism)

A weighted average compromise between optimistic and pessimistic
o Select a coefficient of realism
o Coefficient is between 0 and 1
o A value of 1 is 100% optimistic
o Compute the weighted averages for each alternative
o Select the alternative with the highest value
Hurwicz (Realism) Steps

Step 1. Calculate Hurwicz value for each alternative

Step 2. Pick the alternative of largest Hurwicz value as the decision.

Hurwicz Formula
= (row max)() + (row min)(1-)
where (01) is called coefficient of realism
State of Nature
Decision
Alternatives

Favorable Market

Large Plant

200,000

(180,000) 124,000

Small Plant

100,000

(20,000) 76,000

do nothing

Unfavorable Market

Hurwicz Value

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Lecturer: Yusuf H. MoHaMed Handout subject: operationaL researcH

Max(Hurwicz values) = Max(124,000,76,000,0) = 124,000.

So, the decision is large plant.

For Whom? Hurwicz method can be used by decision makers with different preferences on risks.

For a person who tends to take risk, a larger is used; For a person who tends to be
conservative, a smaller is used.

Criterion 4: Equally Likely

Step 1. Calculate the average payoff for each alternative.

Step 2. The alternative with highest average if the decision.

State of Nature

Decision
Alternatives

Favorable Market

Large Plant

200,000

(180,000) 10,000

Small Plant

100,000

(20,000) 40,000

do nothing

Unfavorable Market

Raw Average

0 -

Max(Row avgs) = Max(10,000, 40,000, 0) = 40,000.

So, the decision is small plant
For Whom? Equally Likely method is for the decision maker who does not have particular
preference on taking or avoiding risks.
Criterion 5: Minimax Regret

Step 1. Construct a regret table,

Step 2. Pick maximum regret of each row in regret table,

Step 3. Pick minimum of those maximums in Step 2, its corresponding alternative is the decision.
Regret

Regret is amount you give up due to not picking the best alternative in a given state of nature.

Regret = Opportunity cost = Opportunity loss

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Lecturer: Yusuf H. MoHaMed Handout subject: operationaL researcH

Opportunity Loss Tables

Decision
Alternatives
Large Plant
Small Plant
do nothing

Favorable
Market
200000-200000
200000-100000
200000-0

Colum max

2,000,000

Decision
Alternatives

Favorable
Market

Large Plant

Small Plant

100,000

Unfavorable
Market
0- (-180000)
0-(-20000)
0-0
0
Unfavorable Market

do nothing
200,000
Min (Row maxs) = Min{180,000, 100,000, 200,000} = 100,000.

Row
Maximum
180,000 180,000
20,000 100,000
- 200,000

So, the minimax regret decision is small plant

For Whom?

MiniMax Regret is an approach for the decision maker who hates the feeling of having regrets.

Decision Making under Risk

The outcome of a decision alternative is not known, but its probability is known
Decision Making under Risk
The outcome of a decision alternative is not known, but its probability is known.
Max EMV Approach

Step 1. Calculate EMV for each alternative.

Step 2. Pick the alternative with highest EMV as the decision.

EMV of an alternative is the expected value of possible payoffs of that alternative.

n

EMV= Xi * P( X i )
i 1

n=number of states of nature

P(Xi)=probability of the i-th state of nature
Xi=payoff of the alternative under the i-th state of nature

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Lecturer: Yusuf H. MoHaMed Handout subject: operationaL researcH

Decision
Alternatives

State of Nature
Unfavorable Market
Favorable Market

Row Maximum
0.5

0.5

Large Plant

200,000

(180,000) 10,000

Small Plant

100,000

(20,000) 40,000

do nothing
So the maximum decision is small plant

0 -

Expected Value of Perfect Information (EVPI)

It is value of additional information for better decision making.
It is an upper bound on how much to pay for the additional information.
EVPI is a Benchmark in Purchasing Additional Information EVPI is the maximum $ amount the
decision maker would pay to purchase the additional information about the states of nature (from a
consulting firm, for example).
What if Information Is Not Perfect?
In most cases, information about future is not perfect. We need to discount EVwPI properly in
those cases.

If you have 80% of confidence on the information, then

Expected Value of Additional Information = EVAI
= EVwPI * 80% - EVw/oPI

Expected Value of Perfect Information (EVPI)

EVPI places an upper bound on what you should pay for additional information
EVPI = EVwPI Maximum EMV

EVPI is the increase in EMV that results from having perfect information

EVwPI is the long run average return if we have perfect information before a decision is made

We compute the best payoff for each state of nature since we dont know, until after we
pay, what the research will tell us

EV w/o PI
EV w/o PI is the average payoff you expect to get based only on the information given in the
decision table without the help of additional information.
EVw/oPI = Max (EMV)
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Lecturer: Yusuf H. MoHaMed Handout subject: operationaL researcH

Calculating EVPI
= (Exp. payoff with perfect information)
(Exp. payoff without perfect information)
= EVwPI EVw/oPI
Expected Value of Perfect Information (EVPI)

EVPI for Thompson Lumber

1. Best alternative for favorable state of nature is build a large plant with a payoff of $200,000
Best alternative for unfavorable state of nature is to do nothing with a payoff of $0
EVwPI = ($200,000)(0.50) + ($0)(0.50) = $100,000
2. The maximum EMV without additional information is $40,000
EVPI = EVwPI Maximum EMV
= $100,000 - $40,000
= $60,000
Expected opportunity loss (EOL

Expected opportunity loss (EOL) is the cost of not picking the best solution

First 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

Minimum EOL Approach

Step 1. Generate the opportunity loss table.

Step 2. Calculate the expected value (EOL) for each alternative in the opportunity loss table.

Step 3. Pick up the alternative with the minimum EOL

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Lecturer: Yusuf H. MoHaMed Handout subject: operationaL researcH

Opportunity Loss Table

Decision
Alternatives
Large Plant
Small Plant
do nothing
colum max

Favorable Market
200000-200000
200000-100000
200000-0
2,000,000

Unfavorable Market

Decision
Alternatives

Favorable Market

Unfavorable Market

Large Plant

0- (-180000)
0-(-20000)
0-0
0

Small Plant

100,000

do nothing

200,000
0.5

Row Maximum
180,000 90,000
20,000 60,000
- 100,000
0.5

The minimum EOL is 60,000 the decision is Small plant

NB.
Minimum EOL will always result in the same decision as maximum EMV
Minimum EOL will always equal EVPI

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Lecturer: Yusuf H. MoHaMed Handout subject: operationaL researcH

Questions
1. Discuss the difference between decision-making under certainty, under uncertainty and under risk.
2. What techniques are used to solve decision-making problems under uncertainty? Which technique
results in an optimistic decision? Which technique results in a pessimistic decision?
3. Explain the various quantitative methods that are useful for decision-making under uncertainty.
4. What is a scientific decision-making process? Discuss the role of the statistical method in such a
process.
5. Give an example of a good decision that you made, which resulted in a bad outcome. Also give an
example of a good decision that you made and that had a good outcome. Why was each decision
good or bad?
6. Given the complete set of outcomes in a certain situation, how is the EMV determined for a
specific course of action? Explain in your own words.
7. Explain the difference between expected opportunity loss and expected value of perfect
information.
8. Indicate the difference between decision-making under risk, and uncertainty, in statistical decision
theory.
9. Briefly explain expected value of perfect information with examples.
10. Describe a business situation where a decision-maker faces a decision under uncertainty and
where a decision based on maximizing the expected monetary value cannot be made. How do you
think the decision maker should make the required decision?

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Lecturer: Yusuf H. MoHaMed Handout subject: operationaL researcH

Problems
Problem one

Coefficient of optimism

.4

.6

Find
1.
2.
3.
4.
5.

maximax
maximin
minimax
Hurwicz
equal likelihood

Problem two
Shakir Production (SP) is planning a new manufacturing facility for a new product. MBP is considering
three plant sizes, small, medium, and large. The demand for the product is not fully known, but SP
assumes two possibilities, 1. High demand and 2. Low demand. The profits (payoffs) associated with
each plant size and demand level is given in the table below.
Decision

State of Nature

Plant Size

High Demand (S1)

Low Demand (S2)

Large (d1)

$200 K

$-20 K

Medium (d2)

$150 K

$ 20 K

Small (d3)

$100 K

$ 60 K

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Lecturer: Yusuf H. MoHaMed Handout subject: operationaL researcH

Instruction
1. Analyze this decision using the maximax (optimistic) approach.
2. Analyze this decision using the maximin (conservative) approach.
3. Analyze this decision using the minimax regret criterion.[1]
4. Now assume the decision makers have probability information about the states of nature. Assume
that P(S1)=.3, and P(S2)=.7. Analyze the problem using the expected value criterion.[2]
5. How much would you be willing to pay in this example for perfect information about the actual
demand level? (EVPI)
6. Compute the expected opportunity loss (EOL) for this problem. Compare EOL and EVPI
Problem Three
Mr Sethi has 10,000 to invest in one of three options: A, B or C. The return on his investment depends on
whether the economy experiences inflation, recession, or no change at all. The possible returns under
each economic condition are given below:
State of Nature
Strategy Inflation Recession No Change
A
2,000
1,200
1,500
B
3,000
800
1,000
C
2,500
1,000
1,800
What should he decide, using the pessimistic criterion, optimistic criterion, equally likely criterion and
regret criterion?
Problem Four
In a toy manufacturing company, suppose the product acceptance probabilities are not known but the
following data is known:

Product Acceptance
Good
Fair
Poor

Anticipated First Year Profit (000 `)

Product Line
Full
Partial
Minimal
8
50
-25

70
45
-10

50
40
0

Determine the optimal decision under each of the Following decision criteria and show how you
arrived atit:
(a) Maximax, (b) Maximin, (c) Equal likelihood and (d) Minimax regret?

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Lecturer: Yusuf H. MoHaMed Handout subject: operationaL researcH

Problem Five
The following matrix gives the payoff of different strategies (alternatives) S1, S2 and S3 against
conditions (events) N1, N2, N3 and N4.

Strategy
S1
S2
S3

N1
4,000
20,000
20,000

State of nature
N2
N3
-100
6,000
5,000
400
15,000
-2,000

N4
18,000
0
1,000

Indicate the decision taken under the following approaches:

(i)
Pessimistic,
(ii)
Optimistic,
(iii)
Equal probability,
(iv)
Regret,
(v)
Hurwicz criterion, the degree of optimism being 0.7.
Problem Six
For the following payoff table, the probability of event 1 is 0.5, and the probability of event 2 is also 0.5:

A.
B.
C.
D.
E.

Determine the optimal action based on the maximax criterion.

Determine the optimal action based on the maximin criterion.
Compute the expected monetary value (EMV) for actions A and B.
Compute the expected opportunity loss (EOL) for actions A and B.
Explain the meaning of the expected value of perfect information (EVPI) in this problem.
F. Based on the results of (c) or (d), which action would you choose? Why?

Problem Seven
Investor has a certain amount of money available to invest now. Three alternative investments are available.
The estimated profits ($) of each investment under each economic condition are indicated in the following payoff table

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Lecturer: Yusuf H. MoHaMed Handout subject: operationaL researcH

Based on his own past experience, the investor assigns the following probabilities to each economic condition:
P (Economy declines) = 0.30
P (No change)
= 0.50
P (No change)
= 0.50
Instruction
1. Determine the optimal action based on the maximax criterion.
2. Determine the optimal action based on the maximin criterion.
3. Compute the expected monetary value (EMV) for each investment.
4. Compute the expected opportunity loss (EOL) for each investment.
5. Explain the meaning of the expected value of perfect information (EVPI ) in this problem.

6. Based on the results of (c) or (d), which investment would you choose? Why?
Problem Eight
A farmer wants to decide which of the three crops he should plant on his field. The produce depends upon the climate
situation during the harvest period, which can be excellent, normal or bad. His estimated profits for each state of nature are
given in the following table:

(i)
(ii)
(iii)
(iv)
(v)

Indicate the decision taken under the following approaches:

Pessimistic,
Optimistic,
Equal probability,
Regret,
Hurwicz criterion, the degree of optimism being 0.7

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Lecturer: Yusuf H. MoHaMed Handout subject: operationaL researcH