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Decision Making

Sound decision making is at the core of all

Decision Analysis managerial functions and successful enterprises.
Complex organizations require efficient processes
to gain stakeholder consensus while making
informed decisions within constrained time
frames and budgets.
Poor decision making often lead to undesirable
outcomes. It can be costly in both time and
money.

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Decision Theory The Six Steps in Decision Making

What is involved in making a good decision? 1. Clearly define the problem at hand.
Decision theory is an analytic and systematic 2. List the possible alternatives.
approach to the study of decision making. 3. Identify the possible outcomes or states of
A good decision is one that is based on logic, nature.
considers all available data and possible 4. List the payoff (typically profit) of each
alternatives, and the quantitative approach combination of alternatives and outcomes.
described here.
5. Select one of the mathematical decision theory
models.
6. Apply the model and make your decision.
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Thompson Lumber Company Thompson Lumber Company

Step 1 – Define the problem. Step 4 – List the payoffs.
n The company is considering expanding n Identify conditional values for the
by manufacturing and marketing a new profits for large plant, small plant, and
product – backyard storage sheds.
no development for the two possible
Step 2 – List alternatives. market conditions.
n Construct a large new plant. Step 5 – Select the decision model.
n Construct a small new plant.
n This depends on the environment and
n Do not develop the new product line at amount of risk and uncertainty.
all.
Step 3 – Identify possible outcomes.
Step 6 – Apply the model to the data.
n Solution and analysis are then used to
n The market could be favorable or
unfavorable. aid in decision-making.

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Thompson Lumber Company Types of Decision-Making Environments

Decision Table with Conditional Values for Type 1: Decision making under certainty
Thompson Lumber ◦ The decision maker knows with certainty the
consequences of every alternative or decision
STATE OF NATURE choice.
FAVORABLE UNFAVORABLE Type 2: Decision making under uncertainty
ALTERNATIVE MARKET ($) MARKET ($)
◦ The decision maker does not know the
Construct a large plant 200,000 –180,000 probabilities of the various outcomes.
Construct a small plant 100,000 –20,000 Type 3: Decision making under risk
◦ The decision maker knows the probabilities of
Do nothing 0 0
the various outcomes.
Table 3.1

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Decision Making Under Uncertainty Maximax

There are several criteria for making decisions Used to find the alternative that maximizes the
under uncertainty: maximum payoff.
1. Maximax (optimistic) n Locate the maximum payoff for each alternative.
n Select the alternative with the maximum number.
2. Maximin (pessimistic)
STATE OF NATURE
3. Criterion of realism (Hurwicz) FAVORABLE UNFAVORABLE MAXIMUM IN
ALTERNATIVE MARKET ($) MARKET ($) A ROW ($)
4. Equally likely (Laplace) Construct a large
plant 200,000 –180,000 200,000
5. Minimax regret Construct a small
Maximax
100,000 –20,000 100,000
plant
Do nothing 0 0 0
Table 3.2
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Maximin Criterion of Realism (Hurwicz)

Used to find the alternative that maximizes This is a weighted average compromise
the minimum payoff. between optimism and pessimism.
n Locate the minimum payoff for each alternative. n Select a coefficient of realism a, with 0≤α≤1.
n Select the alternative with the maximum n A value of 1 is perfectly optimistic, while a
number. value of 0 is perfectly pessimistic.
STATE OF NATURE
n Compute the weighted averages for each
FAVORABLE UNFAVORABLE MINIMUM IN
ALTERNATIVE MARKET ($) MARKET ($) A ROW ($) alternative.
Construct a large n Select the alternative with the highest value.
plant 200,000 –180,000 –180,000
Weighted average = a(maximum in row)
Construct a small
plant
100,000 –20,000 –20,000 + (1 – a)(minimum in row)
Do nothing 0 0 0
Table 3.3 Maximin
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Criterion of Realism (Hurwicz) Equally Likely (Laplace)

n For the large plant alternative using a = 0.8: Considers all the payoffs for each alternative
(0.8)(200,000) + (1 – 0.8)(–180,000) = 124,000 n Find the average payoff for each alternative.
n For the small plant alternative using a = 0.8: n Select the alternative with the highest average.
(0.8)(100,000) + (1 – 0.8)(–20,000) = 76,000
STATE OF NATURE STATE OF NATURE
CRITERION FAVORABLE UNFAVORABLE ROW
FAVORABLE UNFAVORABLE OF REALISM ALTERNATIVE MARKET ($) MARKET ($) AVERAGE ($)
ALTERNATIVE MARKET ($) MARKET ($) (a = 0.8) $ Construct a large
plant 200,000 –180,000 10,000
Construct a large
plant 200,000 –180,000 124,000
Realism Construct a small 100,000 –20,000 40,000
Construct a small plant
plant 100,000 –20,000 76,000 Equally likely
Do nothing 0 0 0
Do nothing 0 0 0
Table 3.5
Table 3.4
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Minimax Regret Minimax Regret

Determining Opportunity Losses for Thompson Lumber
Based on opportunity loss or regret, this is the
STATE OF NATURE
difference between the optimal profit and actual
payoff for a decision. FAVORABLE MARKET ($) UNFAVORABLE MARKET ($)
◦ Create an opportunity loss table by determining the
opportunity loss from not choosing the best alternative.
◦ Opportunity loss is calculated by subtracting each payoff 200,000 – 200,000 0 – (–180,000)
in the column from the best payoff in the column.
◦ Find the maximum opportunity loss for each alternative 200,000 – 100,000 0 – (–20,000)
and pick the alternative with the minimum number.
200,000 – 0 0–0

Table 3.6

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Minimax Regret Decision Making Under Risk

This is decision making when there are several possible
Thompson’s Minimax Decision Using Opportunity Loss states of nature, and the probabilities associated with each
possible state are known.
STATE OF NATURE
FAVORABLE UNFAVORABLE MAXIMUM IN
The most popular method is to choose the alternative with
ALTERNATIVE MARKET ($) MARKET ($) A ROW ($) the highest expected monetary value (EMV).
Construct a large
plant 0 180,000 180,000
Construct a small EMV (alternative i) = (payoff of first state of nature)
100,000 20,000 100,000
plant x (probability of first state of nature)
Minimax
Do nothing 200,000 0 200,000 + (payoff of second state of nature)
x (probability of second state of nature)
Table 3.8 + … + (payoff of last state of nature)
x (probability of last state of nature)

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EMV for Thompson Lumber EMV for Thompson Lumber

n Suppose each market outcome has a probability of
STATE OF NATURE
occurrence of 0.50.
FAVORABLE UNFAVORABLE
n Which alternative would give the highest EMV? ALTERNATIVE MARKET ($) MARKET ($) EMV ($)
n The calculations are: Construct a large
200,000 –180,000 10,000
plant
EMV (large plant) = ($200,000)(0.5) + (–$180,000)(0.5)
Construct a small 100,000 –20,000 40,000
= $10,000 plant
EMV (small plant) = ($100,000)(0.5) + (–$20,000)(0.5) Do nothing 0 0 0
= $40,000
Probabilities 0.50 0.50
EMV (do nothing) = ($0)(0.5) + ($0)(0.5)
= $0 Table 3.9 Largest EMV

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Expected Value of Perfect Information (EVPI) Expected Value of Perfect Information (EVPI)
EVPI places an upper bound on what you should pay for additional
information. Suppose Scientific Marketing, Inc. offers analysis
that will provide certainty about market conditions
EVPI = EVwPI – Maximum EMV
(favorable).
Additional information will cost $65,000.
EVwPI is the long run average return if we have perfect
information before a decision is made. Should Thompson Lumber purchase the
information?
EVwPI = (best payoff for first state of nature)
x (probability of first state of nature)
+ (best payoff for second state of nature)
x (probability of second state of nature)
+ … + (best payoff for last state of nature)
x (probability of last state of nature)
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Expected Value of Perfect Information (EVPI) Expected Value of Perfect Information (EVPI)
Decision Table with Perfect Information The maximum EMV without additional information is
$40,000.
STATE OF NATURE EVPI = EVwPI – Maximum EMV
FAVORABLE UNFAVORABLE = $100,000 - $40,000
ALTERNATIVE MARKET ($) MARKET ($) EMV ($)
Construct a large = $60,000
plant 200,000 -180,000 10,000
Construct a small
plant
100,000 -20,000 40,000 So the maximum Thompson
Do nothing 0 0 0 should pay for the additional
information is $60,000.
With perfect
200,000 0 100,000
information
EVwPI Therefore, Thompson should not
Probabilities 0.5 0.5 pay $65,000 for this information.
Table 3.10
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Expected Opportunity Loss Expected Opportunity Loss

STATE OF NATURE
Expected opportunity loss (EOL) is the cost of not
FAVORABLE UNFAVORABLE
picking the best solution. ALTERNATIVE MARKET ($) MARKET ($) EOL
Construct a large plant 0 180,000 90,000
First construct an opportunity loss table. Construct a small
100,000 20,000 60,000
plant
For each alternative, multiply the opportunity loss by
Do nothing 200,000 0 100,000
the probability of that loss for each possible Probabilities 0.50 0.50
outcome and add these together. Table 3.11 Minimum EOL
Minimum EOL will always result in the same EOL (large plant) = (0.50)($0) + (0.50)($180,000)
= $90,000
decision as maximum EMV.
EOL (small plant) = (0.50)($100,000) + (0.50)($20,000)
Minimum EOL will always equal EVPI. = $60,000
EOL (do nothing) = (0.50)($200,000) + (0.50)($0)
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= $100,000
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PROBLEM SOLVING: PROBLEM SOLVING:

Mickey’s Investments Mickey’s Investments
Mickey Lawson is considering investing some money that he inherited. The The expected value (EMV) is computed for each alternative.
following payoff table gives the profits that would be realized during the
next year for each of three investment alternatives. Mickey is considering: EMV(stock market) = 0.5(80,000) + 0.5(–20,000) = 30,000
EMV(Bonds) = 0.5(30,000) + 0.5(20,000) = 25,000
EMV(CDs) = 0.5(23,000) + 0.5(23,000) = 23,000
Therefore, he should invest in the stock market.

(a) What decision would maximize expected profits?

(b) What is the maximum amount that should be paid for a perfect forecast of the
economy?
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PROBLEM SOLVING:
Mickey’s Investments

EVPI = EV(with perfect information)

– (Maximum EV without P, I)
= [0.5(80,000) + 0.5(23,000)] – 30,000
= 51,500 – 30,000 = 21,500
Thus, the most that should be paid is $21,500.

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