Chapter 5: Decision-making

Concepts
Quantitative Decision Making with
Spreadsheet Applications 7th ed.
By Lapin and Whisler
Sec 5.5 : Other Decision Criteria
Sec 5.6: Opportunity Loss and the
Expected Value of Perfect Information
 The Maximin Payoff
Criterion
The maximin payoff criterion is a
procedure that guarantees that the
decision maker can do no worse than
achieve the best of the poorest
outcomes.
 Example: Tippi-Toes Payoff
Table
Event Act (choice of movement)
(level of
demand) Gears and Spring Weights and
Levers Action Pulleys

Light $25,000 -$10,000 -$125,000

Moderate $400,000 $440,000 $400,000

Heavy $650,000 $740,000 $750,000

 Example
Goal: Ensure a favorable outcome no
matter what happens.
Determine the worst outcome for each act
regardless of the event.
Gears Light $25,000
and demand
Levers
Spring Light -$10,000
Action demand
Weights Light -
and demand $125,00
Pulleys 0
 Example
Choose an act with the largest lowest
payoff. This guarantees a minimum
return that is the best of the poorest
outcomes possible.
Gears and Levers will guarantee the
toy manufacturer a payoff of at least
$25,000.
Gears and Levers is the maximin
payoff act.
 Example: Tippi-Toes Payoff
Table
Event Act (choice of movement)
(level of
Gears and Spring Weights and
demand)
Levers Action Pulleys

Light $25,000 -$10,000 -$125,000

Moderate $400,000 $440,000 $400,000

Heavy $650,000 $740,000 $750,000

Column $25,000 -$10,000 -$125,000

Minimum
s
 Risk vs. Reward
Event Act Event Act

A1 A2 B1 B2

E1 $0 -$1 E1 $1 $10,00
0
E2 1 10,00 E2 -1 -
0 10,000
Column $0 -$1 Column -$1 -$10,000
Minimums Minimums
Deficiencies of Maximin Payoff
Criterion
It is an extremely conservative
decision criterion and may lead to
some bad decisions.
It is primarily suited to decision
problems with unknown probabilities
that cannot be reasonably assessed.
 The Maximum Likelihood
Criterion
The maximum likelihood criterion
focuses on the most likely event to
the exclusion of all others.
 Maximum Likelihood Act

Act (Choice of Movement)

Event Probabilit Gears & Spring Action Weights &
(level of y Levers Pulleys
demand)

Light .10 $25,000 -$10,000 -$125,000

Moderat .70 400,000 440,000 400,000
e
Heavy .20 650,000 740,000 750,000
 Maximum Likelihood
Criterion
Ignores most of other possible
outcomes.
Prevalent decision-making behavior.
 The Criterion of Insufficient
Reason
Used when decision maker has no
information about the event
probabilities.
Assumes each event has a probability
of 1/(number of events) of occuring.
Some knowledge of the probability of
an event is almost always available.
 The Bayes Decision Rule
The Bayes decision rule chooses the
act maximizing expected payoff.
It makes the greatest use of all
available information.
Its major deficiency occurs when
alternatives involve different
magnitudes of risk.
Event Probabili Act C1 Act C2
ty
Payoff Payoff Payoff Payoff
x Prob x Prob
E1 .5 - - $250,00 $125,00
$1,000,00 $500,00 0 0
0 0
E2 .5 2,000,00 1,000,00 750,000 375,000
0 0
Expected $500,00 $500,00
Payoff 0 0
 Opportunity Loss
Opportunity loss is the amount of
payoff that is forgone by not selecting
the act that has the greatest payoff
for the event that actually occurs.
To calculate opportunity losses the
maximum payoff for each row is
determined and its then subtracted
from its respective row maximum.
Event Payoff Row
(level of Gears & Spring Weights & Maximum
demand) Levers Action Pulleys

Light $25,000 -$10,000 -$125,000 $25,000

Moderate 400,000 440,000 400,000 440,000
Heavy 650,000 740,000 750,000 750,000
Row maximum-Payoff = Opportunity
Loss
(in thousands of dollars)
Light 25-25=0 25-(- 25-(-
125)=150
10)=35
Moderate 440- 440-440=0 440-
400=40 400=40
Heavy 750- 750- 750-750=0
650=100
 Opportunity Loss Table
Event Act (choice of movement)
(level of
demand) Gears & Spring Action Weights &
Levers Pulleys

Light $0 $35,000 150,000

Moderate 40,000 0 40,000

Heavy 100,000 10,000 0

 The Bayes Decision Rule and
Opportunity Loss
The Bayes decision rule is to select
the act that has the maximum
expected payoff or the minimum
expected opportunity loss.
Event Probabilit Act (choice of movement)
y
(level of
demand) Gears & Levers Spring Action Weights &
Pulleys
Loss Loss x Loss Loss x Loss Loss x
Prob Prob Prob

Light .10 $0 $0 $35,00 $3,50 $150,00 $15,00

0 0 0
0
Moderat .70 40,00 28,00 0 0 40,00 28,00
e
0 0 0 0
Heavy .20 100,00 20,00 10,00 2,000 0 0
0 0 0
Expected $48,00 $5,50 $43,00
Opportunity Loss 0 0
0
 The Expected Value of Perfect
Information
When the decision maker can acquire
perfect information the decision will be
made under certainty. Then the decision
maker can guarantee the best decision.
We want to investigate the worth of such
information before it is obtained, so we will
determine the expected payoff once
perfect information is obtained.
This quantity is called the expected payoff
under certainty.
 Calculating Expected Payoff
Under Certainty
1. Determine the highest payoff for
each event.
2. Multiply the maximum payoffs with
their respective event probabilities.
Then sum these amounts.
3. Determine the worth of perfect
information to the decision maker.
 Example: Highest Payoff for
each Event
Event( Proba Act Under Certainty
level bility Gears Spring Weight Maxim Chose Payoff
of & Action s& um n Act x Prob
dema Levers Pulleys Payoff
nd)

Light .10 $25,00 - - $25,00 G&L $2,500

$10,000 $125,000
0 0
Moderat .70 400,00 440,00 400,00 440,00 SA 308,00
e 0 0 0 0 0
Heavy .20 650,00 740,00 750,00 750,00 W&P 150,00
0 0 0 0 0
Expected 460,50
Payoff under 0
certainty
 Expected Value of Perfect
Information (EVPI)
EVPI = Expected payoff under certainty
- Maximum expected payoff.
Our example:
EVPI = $460,500-$455,000 = $5,500.
This is the greatest amount of money
the decision maker would be willing to
pay to obtain perfect information about
what demand will be.