To accompany Quantitative Analysis for Management, 9e by Render/Stair/Hanna 16-1 © 2006 by Prentice Hall, Inc. Upper Saddle River, NJ Chapter 16 Markov Analysis Prepared by Lee Revere and John Large

To accompany Quantitative Analysis for Management, 9e by Render/Stair/Hanna 16-2 © 2006 by Prentice Hall, Inc. Upper Saddle River, NJ Learning Objectives Students will be able to: Determine future states or conditions using Markov analysis. Compute long-term or steady-state conditions using only the matrix of transition. Understand the use of absorbing state analysis in predicting future conditions.

To accompany Quantitative Analysis for Management, 9e by Render/Stair/Hanna 16-3 © 2006 by Prentice Hall, Inc. Upper Saddle River, NJ Chapter Outline Introduction States and State Probabilities Matrix of Transition Probabilities Predicting Future Market Share Markov Analysis of Machine Operations Equilibrium Conditions Absorbing States and the Fundamental Matrix: Accounts Receivable Applications

To accompany Quantitative Analysis for Management, 9e by Render/Stair/Hanna 16-4 © 2006 by Prentice Hall, Inc. Upper Saddle River, NJ Introduction Markov Analysis A technique dealing with probabilities of future occurrences with currently known probabilities Numerous applications in Business (e.g., market share analysis), Bad debt prediction University enrollment predictions Machine breakdown prediction

To accompany Quantitative Analysis for Management, 9e by Render/Stair/Hanna 16-5 © 2006 by Prentice Hall, Inc. Upper Saddle River, NJ Markov Analysis Matrix of Transition Probabilities  Shows the likelihood that the system will change from one time period to the next Markov Process.  This is the Markov Process. It enables the prediction of future states or conditions.

To accompany Quantitative Analysis for Management, 9e by Render/Stair/Hanna 16-6 © 2006 by Prentice Hall, Inc. Upper Saddle River, NJ States and State Probabilities States are used to identify all possible conditions of a process or system A system can exist in only one state at a time. Examples include: Working and broken states of a machine Three shops in town, with a customer able to patronize one at a time Courses in a student schedule with the student able to occupy only one class at a time

To accompany Quantitative Analysis for Management, 9e by Render/Stair/Hanna 16-7 © 2006 by Prentice Hall, Inc. Upper Saddle River, NJ Assumptions of Markov Analysis 1. 1.A finite number of possible states 2. 2.Probability of changing states remains the same over time 3. 3.Future state predictable from previous state and the transition matrix Size and states of the system remain the same during analysis States are collectively exhaustive All possible states have been identified States are mutually exclusive Only one state at a time is possible

To accompany Quantitative Analysis for Management, 9e by Render/Stair/Hanna 16-8 © 2006 by Prentice Hall, Inc. Upper Saddle River, NJ States and State Probabilities continued 1.Identify all states. 2.Determine the probability that the system is in this state. This information is placed into a vector of state probabilities.  (i) = vector of state probabilities for period i = (        …  n ) where n = number of states      …  n = P (being in state 1, 2, …, state n)

To accompany Quantitative Analysis for Management, 9e by Render/Stair/Hanna 16-9 © 2006 by Prentice Hall, Inc. Upper Saddle River, NJ States and State Probabilities continued For example: If dealing with only 1 machine, it may be known that it is currently functioning correctly. The vector of states can then be shown.  (1) = (1,0) where  (1) = vector of states for the machine in period 1    = 1 = P (being in state 1) = P (machine working)    = 0 = P (being in state 2) = P (machine broken) Most of the time, problems deal with more than one item!Most of the time, problems deal with more than one item!

To accompany Quantitative Analysis for Management, 9e by Render/Stair/Hanna © 2006 by Prentice Hall, Inc. Upper Saddle River, NJ States and State Probabilities continued Three Grocery Store example: 100,000 customers monthly for the 3 grocery stores State 1 = store 1 = 40,000/100,000 = 40% State 2 = store 2 = 30,000/100,000 = 30% State 3 = store 3 = 30,000/100,000 = 30% vector of state probabilities:  (1) = (0.4,0.3,0.3) where  (1) = vector of state probabilities in period 1    = 0.4 = P (of a person being in store 1)    = 0.3 = P (of a person being in store 2)    = 0.3 = P (of a person being in store 3)

To accompany Quantitative Analysis for Management, 9e by Render/Stair/Hanna © 2006 by Prentice Hall, Inc. Upper Saddle River, NJ States and State Probabilities continued Three Grocery Store example, continued: Probabilities in the vector of states for the stores represent market share for the first period. In period 1, the market shares are Store 1: 40% Store 2: 30% Store 3: 30% But, every month, customers who frequent one store have a likelihood of visiting another store. Customers from each store have different probabilities for visiting other stores.

To accompany Quantitative Analysis for Management, 9e by Render/Stair/Hanna © 2006 by Prentice Hall, Inc. Upper Saddle River, NJ States and State Probabilities continued Three Grocery Store example, continued: Store-specific customer probabilities for visiting a store in the next month: Store 1:Store 2: Return to Store 1 = 80%Visit Store 1 = 10% Visit Store 2 = 10%Return to Store 2 = 70% Visit Store 3 = 10%Visit Store 3 = 20% Store 3: Visit Store 1 = 20% Visit Store 2 = 20% Return to Store 3 = 60%

To accompany Quantitative Analysis for Management, 9e by Render/Stair/Hanna © 2006 by Prentice Hall, Inc. Upper Saddle River, NJ States and State Probabilities continued Three Grocery Store example, continued: Combining the starting market share with the customer probabilities for visiting a store next period yields the market shares in the next period: Initial ShareP(1)P(2)P(3) Store 1: Store 1:40%80%10%10% 32%4%4% Next Period:32% 4% 4% Store 2: Store 2:30%10%70%20% 3%21%6% Next Period: 3%21% 6% Store 3: Store 3:30%20%20%60% 6%6%18% Next Period: 6% 6%18% 41%31%28% New Shares:41%31%28% = 100%

To accompany Quantitative Analysis for Management, 9e by Render/Stair/Hanna © 2006 by Prentice Hall, Inc. Upper Saddle River, NJ Matrix of Transition Probabilities To calculate periodic changes, it is much more convenient to use a matrix of transition probabilities. a matrix of conditional probabilities of being in a future state given a current state. Let P ij = conditional probability of being in state j in the future given the current state of i, P (state j at time = 1 | state i at time = 0) For example For example, P 12 is the probability of being in state 2 in the future given the event was in state 1 in the prior period

To accompany Quantitative Analysis for Management, 9e by Render/Stair/Hanna © 2006 by Prentice Hall, Inc. Upper Saddle River, NJ Matrix of Transition Probabilities continued Let P = matrix of transition probabilities P 11 P 12 P 13 ***** P 1n P 21 P 22 P 23 ***** P 2n P = P m1 ****** P mnImportant: Each row must sum to 1. NOT But, the columns do NOT necessarily sum to 1. ******** ******** Row Sum 1 1 1

To accompany Quantitative Analysis for Management, 9e by Render/Stair/Hanna © 2006 by Prentice Hall, Inc. Upper Saddle River, NJ Matrix of Transition Probabilities continued Three Grocery Stores, revisited The previously identified transitional probabilities for each of the stores can now be put into a matrix: P = Row 1 interpretation: 0.8 = P 11 = P (in state 1 after being in state 1) 0.1 = P 12 = P (in state 2 after being in state 1) 0.1 = P 13 = P (in state 3 after being in state 1)

To accompany Quantitative Analysis for Management, 9e by Render/Stair/Hanna © 2006 by Prentice Hall, Inc. Upper Saddle River, NJ Predicting Future Market Shares Grocery Store example A purpose of Markov analysis is to predict the future Given the 1.vector of state probabilities and 2.matrix of transitional probabilities. It is easy to find the state probabilities in the future. This type of analysis allows the computation of the probability that a person will be at one of the grocery stores in the future. Since this probability is equal to market share, it is possible to determine the future market shares of the grocery store.

To accompany Quantitative Analysis for Management, 9e by Render/Stair/Hanna © 2006 by Prentice Hall, Inc. Upper Saddle River, NJ Predicting Future Market Shares continued Grocery Store example When the current period is 0, finding the state probabilities for the next period (1) can be found using:  (1) =  (0)P Generally, in any period n, the state probabilities for period n+1 can be computed as:  (n+1) =  (n)P

To accompany Quantitative Analysis for Management, 9e by Render/Stair/Hanna © 2006 by Prentice Hall, Inc. Upper Saddle River, NJ Predicting Future States continued [ ] )1( (0)  (0) = state probabilities π                           (1)   P P  (1) =  (.4*.8 +.3*.1 +.3*.2) + (.4*.1 +.3*.7 +.3*.2) + (.4*.1 +.3*.2 +.3*.6) (1)  = [ ]

To accompany Quantitative Analysis for Management, 9e by Render/Stair/Hanna © 2006 by Prentice Hall, Inc. Upper Saddle River, NJ Predicting Future Market Shares continued In general,  (n) =  (0)P n Therefore, the state probabilities n periods in the future can be obtained from the current state probabilities and the matrix of transition probabilities.

To accompany Quantitative Analysis for Management, 9e by Render/Stair/Hanna © 2006 by Prentice Hall, Inc. Upper Saddle River, NJ Markov Analysis of Machine Operations where P 11 = 0.8 = probability of machine working this period if working last period P 12 = 0.2 = probability of machine not working this period if working last P 21 = 0.1 = probability of machine working this period if not working last P 22 = 0.9 = probability machine not working this period if not working last P =

To accompany Quantitative Analysis for Management, 9e by Render/Stair/Hanna © 2006 by Prentice Hall, Inc. Upper Saddle River, NJ Markov Analysis of Machine Operations continued What is the probability the machine will be working next month?   (1) =  (0)P = (1,0) = [(1)(0.8)+(0)(0.1), (1)(0.2)+(0)(0.9)] = (0.8, 0.2) If the machine works this month, then there is an 80% chance that it will be working next month and a 20% chance it will be broken.

To accompany Quantitative Analysis for Management, 9e by Render/Stair/Hanna © 2006 by Prentice Hall, Inc. Upper Saddle River, NJ Markov Analysis of Machine Operations continued What is the probability the machine will be working in two months?   (2) =  (1)P = (0.8, 0.2) = [(0.8)(0.8)+(0.2)(0.1), (0.8)(0.2)+(0.2)(0.9)] = (0.66, 0.34) If the machine works next month, then in two months there is a 66% chance that it will be working and a 34% chance it will be broken.

To accompany Quantitative Analysis for Management, 9e by Render/Stair/Hanna © 2006 by Prentice Hall, Inc. Upper Saddle River, NJ Equilibrium Conditions Equilibrium state probabilities are the long-run average probabilities for being in each state. Equilibrium conditions exist if state probabilities do not change after a large number of periods. At equilibrium, state probabilities for the next period equal the state probabilities for current period.

To accompany Quantitative Analysis for Management, 9e by Render/Stair/Hanna © 2006 by Prentice Hall, Inc. Upper Saddle River, NJ Equilibrium Conditions continued One way to compute the equilibrium share of the market is to use Markov analysis for a large number of periods and see if the future amounts approach stable values. On the next slide, the Markov analysis is repeated for 15 periods for the machine example. By the 15 th period, the share of time the machine spends working and broken is around 66% and 34%, respectively.

To accompany Quantitative Analysis for Management, 9e by Render/Stair/Hanna © 2006 by Prentice Hall, Inc. Upper Saddle River, NJ Machine Example: Periods to Reach Equilibrium Period State State 2

To accompany Quantitative Analysis for Management, 9e by Render/Stair/Hanna © 2006 by Prentice Hall, Inc. Upper Saddle River, NJ The Markov Process  (n)  P   (n+1) Equilibrium Conditions Matrix of Transition New State Current State

To accompany Quantitative Analysis for Management, 9e by Render/Stair/Hanna © 2006 by Prentice Hall, Inc. Upper Saddle River, NJ Equilibrium Equations   1 and 1 :or Then: P, (i) Assume: )()1( , p p p p Therefore: PPPP PPPP pp pp Pii                      

To accompany Quantitative Analysis for Management, 9e by Render/Stair/Hanna © 2006 by Prentice Hall, Inc. Upper Saddle River, NJ Equilibrium Equations continued It is always true that  (next period) =  (this period) P  (n+1) =  (n) P or At Equilibrium:  (n+1) =  (n) =  (n) P *  (n) =  (n) P *  =  P Dropping the n term:

To accompany Quantitative Analysis for Management, 9e by Render/Stair/Hanna © 2006 by Prentice Hall, Inc. Upper Saddle River, NJ Equilibrium Equations continued Machine Breakdown example (  1,  2 ) = (  1,  2 ) At Equilibrium:  =  P Applying matrix multiplication: (  1,  2 ) = [(  1 )(0.8) + (  2 )(0.1), (  1 )(0.2) + (  2 )(0.9) Multiplying through yields:  1 = 0.8   2  2 = 0.2   2

To accompany Quantitative Analysis for Management, 9e by Render/Stair/Hanna © 2006 by Prentice Hall, Inc. Upper Saddle River, NJ Equilibrium Equations continued Machine Breakdown example The state probabilities must sum to 1, therefore:  ’s = 1 In this example, then:  1 +  2 = 1 In a Markov analysis, there are always n state equilibrium equations and 1 equation of state probabilities summing to 1.

To accompany Quantitative Analysis for Management, 9e by Render/Stair/Hanna © 2006 by Prentice Hall, Inc. Upper Saddle River, NJ Equilibrium Equations continued Machine Breakdown Example Summarizing the equilibrium equations:  1 = 0.8   2  2 = 0.2   2  1 +  2 = 1 Solving by simultaneous equations:  1 =  2 = Therefore, in the long-run, the machine will be functioning 33.33% of the time and broken down 66.67% of the time.

To accompany Quantitative Analysis for Management, 9e by Render/Stair/Hanna © 2006 by Prentice Hall, Inc. Upper Saddle River, NJ Absorbing States absorbing state.Any state that does not have a probability of moving to another state is called an absorbing state. If an entity is in an absorbing state now, the probability of being in an absorbing state in the future is 100%. An example of such a process is accounts receivable. Bills are either paid, delinquent, or written off as bad debt. Once paid or written off, the debt stays paid or written off.

To accompany Quantitative Analysis for Management, 9e by Render/Stair/Hanna © 2006 by Prentice Hall, Inc. Upper Saddle River, NJ Absorbing States Accounts Receivable example The possible states are Paid Bad debt Less than 1 month old 1 to 3 months old A transition matrix for this would look similar to: Paid Bad <1 1-3 Paid Bad <

To accompany Quantitative Analysis for Management, 9e by Render/Stair/Hanna © 2006 by Prentice Hall, Inc. Upper Saddle River, NJ Markov Process Fundamental Matrix P = I 0 A B Partition the probability matrix into 4 quadrants to make 4 new sub-matrices: I, 0, A, and B

To accompany Quantitative Analysis for Management, 9e by Render/Stair/Hanna © 2006 by Prentice Hall, Inc. Upper Saddle River, NJ Markov Process Fundamental Matrix continued Where I = Identity matrix, and 0 = Null matrix Then The FA indicates the probability that an amount in one of the non-absorbing states will end up in one of the absorbing states. Once F is found, multiply by the A matrix: FA

To accompany Quantitative Analysis for Management, 9e by Render/Stair/Hanna © 2006 by Prentice Hall, Inc. Upper Saddle River, NJ Markov Process Fundamental Matrix continued Once the FA matrix is found, multiply by the M vector, which is the starting values for the non-absorbing states, MFA, where M = (M 1, M 2, M 3, … M n ) The resulting vector will indicate how many observations end up in the first non- absorbing state and the second non- absorbing state, respectively.