QMT437 Operational Research

Pn. Paezah

TOPIC 2: DECISION THEORY

LEARNING OUTCOMES
Students will be able to:
list the steps of decision-making process
describe the decision-making environments
apply quantitative techniques to analyze decisions under risk environments.

I. INTRODUCTION
Definition: Decision theory is an analytic and systematic approach to the study
of decision making.
A good decision is based on logic, considers all available data and possible
alternatives, and applies an appropriate quantitative technique.

Decision Making Environments

There are three environments under which we make decisions.

1. Decision Making under Certainty

In making decision under certainty, the decision maker knows with certainty all of the
information in the decision problem, the consequence of every alternative or decision
choice.

2. Decision Making under Uncertainty (without Probabilities)

In decision making under uncertainty, there are several possible outcomes (state of
nature) for each alternative and the decision maker has no basis to estimate the
probability associated with the outcomes.

3. Decision Making under Risk (with Probabilities)

Under this decision making environment, there are several possible outcomes for
each alternative. Additionally, the decision maker is able to estimate a probability for
the occurrence of each of the possible states of nature that may occur.

Under certainty environment all of the data in a decision problem are known with
certainty and accurate. In most cases, we do not know what future yields or prices will
be, what rates of returns we will receive from investments, or how consumers will react
to a new product. Decision under certainty rarely occurs in real life.

Note: QMT437 course covers decision making under risk.

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 Decision analysis can be used to develop an optimal strategy when a decision
maker is faced with several decision alternatives and risky future events.

The 6 steps in decision making

Step 1: Clearly define the problem.
Step 2: List all possible decision alternatives/plans of actions.
Definition: A decision alternative is a course of action or a strategy that
may be chosen by a decision maker.
Step 3: Identify the possible states of nature (or outcomes) and, if available, their
associated probabilities.
Definition: A state of nature refers to the possible outcomes of a chance
event an outcome or occurrence over which the decision maker has little or
no control.
Step 4: Determine the payoffs or returns accruing to each decision under each state
of nature.
Step 5: Select one decision model and evaluate each alternative using the model.
Step 6: Make a decision, i.e. select the best alternative.

Information on the alternatives, states of nature and probabilities of the states of nature
can be summarized using a payoff table:

Decision State of Nature

alternatives S1 S2 ... Sm
Vij = the payoff if alternative di
d1 V11 V12 ... V1m
is chosen and state of
d2 V21 r21 ... V21 nature Sj occurs.
... ... ... ... ...
dn Vn1 Vn1 ... Vnm P(Sj) = the probability that state
of nature Sj will occur
Probabilities P(S1) P(S2) ... P(Sm)

Example 1:
Berjaya Construction has purchased a land for a future condominium complex. The
company plans to price the iondividual units between RM300,000 to RM1,400,000. The
company has commisioned preliminery archetectural drawings for three different-sized
projects: one with 30 codominiums, one with 60 condominiums, and one with 90
condominiums. The financial success of the project depends upon the size of the
condominium complex and the chance event concerning the demand for the
condominiums. The company anticipates that demand for the condominium will be
either strong or weak with probabilities of 0.6 and 0.4, respectively.

If the company builds a small complex (30 condominiums units), the payoffs are
estimated at RM8 million under strong demand, and RM7 million under weak demand.
The estimated profit for a medium complex (60 condominiums) are RM14 million under
strong demand and RM5 million under weak demand, respectively. For a large complex

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(90 condominiums), the estimated profits are RM20 million under strong demand and a
loss of RM9 million under weak demand, respectively.

Berjaya needs to select the size of the new luxury condominium project that will yield the
largest profit given the uncertainty concerning the demand for the condominiums.

i) State the decision alternatives and states of nature in Berjaya Constructions

decision problem.
ii) Develop a payoff table for the company.

III. DECISION MAKING UNDER RISK (with Probabilities)

Decision making under risk allows us to incorporate our best estimates of what the future
will hold into a decision problem. Based either on analysis of historical patterns or on
forecasts of future events, we can build a range of potential states of natures, or
outcomes, into a problem.

The assumption of decision making under risk is that the decision maker is able to
estimate a probability estimate for the occurrence of each of the possible states of
nature that may occur. Decision making under risk thus differs from decision making
under uncertainty in that, in the latter, no probabilities of occurrence can be attached to
the possible outcomes.

Decision Models under Risk:

1. Expected Monetary Value (EMV)
2. Expected Opportunity Loss (EOL)

The above models can be used to compare alternatives.

1. Expected Monetary Value (EMV) Approach

The EMV approach can be used to identify the best decision alternative when
assessments on the proabibilities of the states of nature are available.

Let
N = the number of states of nature
P(sj) = the probability of state of nature j

Hence, P(sj) 0 for all states of nature, and

N
P(sj) P(si ) P(s2 ) ... P(sN ) 1
j 1

The expected monetary value (EMV) of a decision alternative di is defined as follows:

N
EMV(di ) P( s j )Vij
j 1

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Example 2: Apply the expected monetary value approach to solve Berjaya
Constructions problem.

2. Expected Opportunity Loss (EOL) Approach

Alternatives in a decision problem can also be compared using the EOL approach.

Definition: An opportunity loss (regret) is the loss for not choosing the best
alternative.

The EOL technique

Step 1: Develop an opportunity loss table using information from a payoff table.
For each state of nature (column), choose the BIGGEST value.
The opportunity loss is obtained by subtracting every number from the biggest
number.

Step 2: Evaluate each alternative using the EOL approach using the formula:

EOL(alternative)
= (opportunity loss under state of nature)(probability of state of nature)

Step 3: Choose the alternative with the lowest EOL value.

Example 3: Solve Berjaya Construction companys problem using the EOL approach.
Comment on the decision made using each approach (EMV and EOL).

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3. Expected Value of Perfect Information (EVPI)
A perfect information is an information that is 100% correct.
An EVPI is the worth or value of perfect information.
It is the maximum amount to pay an expert for providing perfect information on an
uncertain future event.

How to determine the EVPI?

Method 1: Based on EMV approach

Expected Value of Perfect Information (EVPI)

= Expected return if you make Expected return in

the right decision under the absence of
each state of nature perfect forecast

= Expected Value Expected Value

with without
Perfect Information Perfect Information

EVPI = EVwithPI EVwithoutPI

best payoff
probability of
= under each maximum EMV
state of nature state of nature

Method 2: Based on EOL approach

EVPI = minimum EOL

Example 4: Determine the expected value of perfect information for Berjaya

Construction.

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Example 5:

Fresh Bloom Flower Kiosk must decide how many dozens of fresh roses to buy from the
supplier for next weekends supply. Purchase price is RM20/dozen and sale price will
be RM35/dozen. Past records indicate demand for fresh roses on weekends has been
either 6, 7, or 8 dozens. Fresh Blooms owner estimates the probability associated with
each of these quantities demanded is 0.5, 0.3, and 0.2, respectively. Unsold roses have
no resale value.

Complete the following payoff table to analyze your decision assuming the objective is to
maximize the expected profit.

Fresh Blooms Decision Analysis:

Per dozen
Selling Price RM35
Purchase Price RM20
Profit RM15

Payoff (RM)

States of Nature (Roses Demanded)

Decision Demand of Demand of Demand of
Alternatives 6 dozen 7 dozen 8 dozen

Stock 6 dozen

Stock 7 dozen

Stock 8 dozen

Probabilities

a) Complete the above payoff table for Fresh Bloom.

b) Apply the EMV approach to determine the best decision for Fresh Bloom.
c) Suppose that a customer is willing to buy all unsold roses at RM10 per dozen. What
is the best decision for Fresh Bloom?
d) Suppose that a customer is willing to buy all unsold roses at RM10 per dozen, and
any shortage is satisfied by buying the necessary roses from a nearby store at the
price of RM30 per dozen. What is the best strategy for Fresh Bloom?

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Exercises:
1. Salwa is considering opening a new fashion outlet. She is evaluating three sites:
Klang, Shah Alam and Subang Jaya. Salwa calculated the value (RM00) of a
successful and an unsuccessful store at these locations as follows:

Location Successful Unsuccessful

Klang 250 - 100
Subang Jaya 325 - 120
Shah Alam 360 - 200

She figures her chance of success to be 50% at Klang, 60% at Subang Jaya and
75% at Shah Alam.

Which location is best for Salwa to open the new fashion store?

2. The following table shows the payoff (RM000) under various alternatives and states
of nature.

States of Nature
Alternative S1 S2 S3
A -10 12 50
B 30 30 30
Probability 0.1 0.3 0.6

a) Use the Expected Opportunity Loss approach to determine the best alternative.
b) Determine the Expected Value of Perfect Information. Interpret.

3. The manager for a home appliance shop has to decide how many units of Model X
fan to order from the distributor at the beginning of each month. The demand for
Model X fan is projected to be either 10, 15, or 20 units per month with probability of
0.35, 0.40, and 0.25, respectively. Each unit costs RM200 and sells for RM350.
a) Construct a payoff table for this problem.
b) Use the Expected Monetary Value to determine the best quantity to order each
month.

4. Alia Design Sdn. Bhd. realized that orders for clothing from a particular manufacturer
for next years season must be placed now. The cost per unit of a particular dress is
RM55 while the anticipated selling price is RM90. Any clothing not sold during the
season can be sold for RM40 to a local discount store. Demand is projected to be
either 50, 60, or 70 units. There is a 40% chance that demand will be 50 units, a
50% chance that demand will be 60 units, and a 10% chance that demand will be 70
units.

a) Determine how many units Alia Design should order to maximize profit.
b) Calculate the Expected Value of Perfect Information. Interpret.