2IntroductionDecision analysis provides a framework and methodology for rational decision making when the outcomes are uncertain.Example: A company plans to determine the best location to startup a new plant from a choice of several locations. Each location offers a different cost scenario. Decision Analysis techniques can be used to determine the best decision.
3Payoff TableStates of Nature refer to future events which may occur and the values in a Payoff Table refer to either Profit or Cost. Example: s1, s2 & s3 could refer to possible scenarios (i.e. Moderate, Strong & Weak market demand)States of Natures s s3dDecisions dd
4Simple Decision Making without Probabilities Three commonly used criteria for decision making when probability information regarding the likelihood of the states of nature is unavailable are:the Optimistic approach (Maximax or Minimin)the Conservative approach (Maximin or Minimax)the Minimax Regret approach.
5Optimistic ApproachThe optimistic approach would be used by an optimistic decision maker.The decision with the largest possible payoff is chosen.If the payoff table was in terms of costs, the decision with the lowest cost would be chosen.
6Example: Optimistic Approach Consider the following problem with three decision alternatives and three states of nature with the following payoff table representing profits:States of Natures s s3dDecisions dd
7Example: Optimistic Approach The Optimistic Approach is to make decision based on the maximum of the largest profits. For each decision, d, the largest profits are identified (i.e. 4, -1 & 5)Formula Spreadsheet
9Conservative Approach The conservative approach would be used by a conservative decision maker.For each decision the minimum payoff is listed and then the decision corresponding to the maximum of these minimum payoffs is selected.If the payoff was in terms of costs, the maximum costs would be determined for each decision and then the decision corresponding to the minimum of these maximum costs is selected.
10Example: Conservative Approach Based on the same table with three decision alternatives and three states of nature with the following payoff table representing profits:States of Natures s s3dDecisions dd
11Example: Conservative Approach Formula Spreadsheet
13Minimax Regret Approach The minimax regret approach requires the construction of a regret table or an opportunity loss table.This is done by calculating for each state of nature the difference between each payoff and the largest payoff for that state of nature.Then, using this regret table, the maximum regret for each possible decision is listed.The decision chosen is the one corresponding to the minimum of the maximum regrets.
14Example: Minimax Regret Approach Compute a regret table by subtracting each payoff in a column from the largest payoff in that column. Add a Max Regret Col and make decision based on the Minimum of Maximum Regret. Example: 4, 0, 1 is subtracted by 4 giving OL 0, 4, 3, etc.s1 OL s2 OL s3 OL Max Regretddd
15Example: Minimax Regret Approach Formula Spreadsheet
17Decision Making with Probabilities Expected Value ApproachIf probabilities regarding the states of nature is available, we may use the expected value (EV) approach. Decision is based on maximising EV.The expected value (EV) of decision alternative di is defined as:where: N = the number of states of natureP(sj ) = the probability of state of nature sjVij = the payoff corresponding to decision alternative di and state of nature sj
18Example: Expected Value Approach ABC RestaurantAverage Number of Customers Per Hours1 = s2 = s3 = 120Model A $10, $15, $14,000Model B $ 8, $18, $12,000Model C $ 6, $16, $21,000ProbabilityGiven s1, s2 & s3 have the probabilities: 0.4, 0.2 & 0.4
19Example: Expected Value Approach Formula Spreadsheet
20Example: Expected Value Approach Solution Spreadsheet
21Expected Value of Perfect Information The expected value of perfect information (EVPI) is the increase in the expected profit that would result if one knew with certainty which state of nature would occur.EVPI = EVwPI – Max EV where EVwPI = ∑ Pi * Max Vi where Vi is the payoffs and EVwPI = Expected Value with Perfect Information
22Expected Value of Perfect Information Spreadsheet
23Decision Tree Payoffs 10,000 2 15,000 d1 14,000 8,000 d2 1 3 18,000 d3 Average Number of Customers Per Hours1 = s2 = s3 = 120Model A $10, $15, $14,000Model B $ 8, $18, $12,000Model C $ 6, $16, $21,000ProbabilitiesPayoffss1.410,000s2.2215,000s3.4d114,000.4s18,000d213s2.218,000d3s3.412,000s1.46,0004s2.216,000s3.421,000
24Decision Tree d1 2 Model A Model B d2 Choose the model with largest EV, Model C.EMV = .4(10,000) + .2(15,000) + .4(14,000)= $12,600d12Model AEMV = .4(8,000) + .2(18,000) + .4(12,000)= $11,600Model Bd213d3EMV = .4(6,000) + .2(16,000) + .4(21,000)= $14,000Model C4
25Decision Tree with Tree Plan Open ‘tree164e.xla’ and enable Macro first.
29TOM BROWN INVESTMENT DECISION Tom Brown has inherited $1000.He has to decide how to invest the money for one year.A broker has suggested five potential investments.GoldJunk BondGrowth StockCertificate of DepositStock Option Hedge
30TOM BROWNThe return on each investment depends on the (uncertain) market behavior during the year.Tom would build a payoff table to help make the investment decision
31The Payoff Table DJA is down more than 800 points DJA moves within[-300,+300]DJA is up[+300,+1000]DJA is up more than1000 points
32Task Evaluate each investment alternative using: Maximax approach Maximin approachMinimax Regret approachEV approachAnd construct Decision Tree for EV approachCalculate EVPI
34Review Questions:1. What is meant by ‘decision-making under uncertainty’? 2. Why should sequential decisions be considered differently from a series of separate decisions? 3. How can you identify the best decisions in a decision tree?