Overview of Chapter 11
In this chapter, we will cover Monte Carlo simulation:
A different approach than those already discussed to
dealing with uncertainty in a decision situation
Constructing a model that captures all of the relevant
aspects of the uncertainty in the decision problem
Then translating this model into a form that a computer
can use to run a simulation
The role of simulation in creating a requisite decision-
analysis model
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Monte Carlo Simulation
What Is a Monte Carlo Simulation?
• A Monte Carlo simulation is a model used to predict the
probability of a variety of outcomes when the potential for
random variables is present.
• Monte Carlo simulations help to explain the impact of risk and
uncertainty in prediction and forecasting models.
• A Monte Carlo simulation requires assigning multiple values to an
uncertain variable to achieve multiple results and then averaging
the results to obtain an estimate.
• A Monte Carlo simulation is used to tackle a range of problems in
many fields including investing, business, physics, and
engineering.
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Monte Carlo Simulation
The Leah Sanchez calendar sales example is simulated
using the DecisionTools software.
We will be going over examples in class made using
MS Excel.
Use the tool(s) you prefer or some other spreadsheet
software such as Google Sheets.
The example spreadsheets are located in
Blackboard. Go to “Lecture Presentations”, “Chapter
11 Materials”.
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Mechanics of Simulation
A simulation model is a mathematical model in
which a probability distribution is used to represent
the possible values of an uncertain variable.
• Similar to decision trees and influence diagrams
• Allow for continuous as well as discrete distributions
Before the development of any model…
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Mechanics of Simulation
Summary of steps in running a simulation:
1. Construct a deterministic model
• A Deterministic Model allows you to calculate a future
event exactly, without using randomness.
• If something is deterministic, you have all of the data
necessary to predict (determine) the outcome with
certainty.
• No probability distributions are in this model.
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Mechanics of Simulation
Summary of steps in running a simulation:
2. Apply distributions to the values in the
deterministic model where you expect variation or
uncertainty
• You now have a probabilistic or stochastic model.
• A stochastic model is a method for predicting possible
outcomes by using for random distributions for one or
more values.
• These distributions may be assumed or based on
beliefs.
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Mechanics of Simulation
3. Randomly draw (sample) values from the
distributions to apply to the model for recalculation
• With each new draw, you are running different
combinations of your model thru 1,000s of iterations.
• Each iteration is a single sample from the distribution.
4. Plot the outcomes of the iterations of the model
• This gives you the distribution of the uncertainty of
interest – risk profile
• You can now factor probabilities into your decisions.
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Mechanics of Simulation
Iteration – a recalculation of the model
For every iteration, a new value is chosen for each
uncertainty according to the corresponding probability
distribution, and this value is used in the calculations for
that particular iteration.
Increasing the number of iterations results in sampled
values more closely aligned with the distribution
At a minimum run 1,000 iterations; 10,000s is not
unusual
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Simulation Models
Since influence diagrams and decision trees also deal
with uncertainties, they can be helpful in constructing
simulation models.
Use them to identify which variables are decisions,
computations, and uncertain
Also they can help to determine the relationships
among the variables
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Simulation Models
Good modeling techniques:
1. Organize the model in a coherent and natural way
2. Put each constant in its own cell location
• Often constants are grouped in a “data area” in the
upper left corner of the spreadsheet.
3. Never enter constants directly into formulas
• Any formula should contain only cell references.
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Simulation Models
Good modeling techniques:
4. Break formulas down into logical pieces, with each
piece having a separate cell location
• Avoid long formulas – they can easily lead to errors!
5. Build in quality checks such as redundant
calculations
6. Verify the model
7. Fully document the model
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Simulating the Model
Next step: model each uncertain variable with its
chosen probability distribution.
• Substitute probability distributions for uncertain variables
• This makes the deterministic model into a probabilistic or
stochastic model, i.e., a model whose values are
indeterminate and governed by probability distributions.
• Run the simulation through many iterations to get a
distribution or risk profile of possible values
• Gain realistic insights into the decision situation
• Can also compare the results of using different input values
and find the best one
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Simulation, Decision Trees, and Influence Diagrams
Monte Carlo simulations are powerful and easy to
use decision-making tools.
However, a few cautions are warranted:
• Consider whether or not your decision model needs to
incorporate dependence. If so, don’t use simulations
since they require independence.
• Only put in your simulation model variables that are
truly explanatory, i.e., those that provide insight.
• Too easy to throw into the simulation every possible source.
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Simulation, Decision Trees, and Influence Diagrams
“When should I use simulation, and when should I use
decision trees?”
• In many cases both approaches work fine.
• However, there are two key issues to consider:
• First, if your decision situation involves a large number of
uncertainties, the necessarily large decision tree can be very
clumsy to work with. Use a simulation approach.
• Second, if your decision situation involves future or
“downstream” decisions then a decision tree might be easier
to work with. Don’t use a simulation approach.
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Summary
In this chapter, you have learned about Monte Carlo
simulation. Specifically, we have discussed:
Choosing values for uncertain variables according
to specified probability distributions
Calculating the consequences based on the values
chosen by running multiple iterations
Tracking the consequences to understand how they
are distributed, i.e., the risk profile
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LAC LEMAN FESTIVAL DE LA MUSIQUE (Synopsis)
The organizers of a music festival may use video from the Friday
concert to create a DVD to sell to those who come to the Saturday
concert. Attendance on Saturday is uncertain, as is the percentage
of those who attend on Saturday that will buy the DVD.
Is this a good idea?
If so, how many DVDs should be burned early Saturday morning and
offered for sale at that evening’s performance?
By that time, Friday attendance is known, along with whether it rained
on Friday, and there is a forecast for whether it will rain on Saturday.
Historical information on these variables may help us to predict
Saturday attendance; along with the results of a marketing survey,
such analysis will help us make better purchasing decisions.
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LAC LEMAN FESTIVAL DE LA MUSIQUE (Synopsis)
Written Submission
Part A: Provide a complete forecast for attendance at Saturday
night’s performance using case Exhibit 1 only. Note: a complete
forecast acknowledges the uncertainty with a probability
distribution.
Part B: If 4,500 DVDs are produced on Saturday for the concert
later Saturday evening, what is the risk profile of profit
(including all costs related to the DVD project)? Also, make a
recommendation for how many DVDs to order from the
production company. Provide a risk profile for the profit that will
result.
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protected website for classroom use.
SPRIGG LANE (Synopsis)
Tom Dingledine, the president of a natural-resources exploration company, has
to decide
whether to invest in a new gas-well-drilling opportunity. He already has a
spreadsheet that projects the most likely scenario for the well and calculates
the net present value (NPV) and internal rate of return (IRR).
Dingledine, however, has discussed six uncertainties with another investor; he
now needs to incorporate them into the analysis.
He has prepared a spreadsheet for two downside scenarios: in the first, gas
cannot be produced after the well is drilled; in the second, gas can be
produced but all other uncertainties are at their one-percentile worst possible
values.
A potential investor, Henry Ostberg, wants to know what the chances are that
the gas well willresult in a loss of value.
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SPRIGG LANE (Synopsis)
Written Submission
Based on the base-case scenario and the two alternative
downside possibilities, is this investment economically
attractive? Also, what benefit can Monte Carlo simulation add to
Dingledine’s understanding of the economic benefits of the
Bailey prospect?
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protected website for classroom use.
APPSHOP, INC. (Synopsis)
A regional director of a consulting firm must decide how to compete for a
major consulting contract.
Appshop can take a level-payment contract, a lower-level payment with
a prospective bonus for high performance, or bid on an RFP where a
significant reward is given contingent on the client’s savings.
Written Submission
Appraise the risk of the alternatives, and recommend what Eric Clark
should choose. Suppose Clark’s specific secondary incentive is to keep
blended revenue per hour above 150. How does that affect your view of
the risk.
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protected website for classroom use.
CALAMBRA OLIVE OIL (Synopsis)
Frank Lockfeld, president and founder of Calambra Olive Oil, is
discussing over dinner with friends the order-quantity decision he is
facing. Lockfeld’s newly launched venture—to bring high quality,
vintage-dated California olive oil to market—has been selling product for
only three months, and has sold only 24 cases to date. Nevertheless,
even though the first-year marketing experiment has barely begun,
Lockfeld must decide by month’s end how many gallons of oil to order
for the next (1994 vintage) year.
Written Submission
How many gallons should Lockfeld order? Then, how would you
describe the situation Lockfeld is facing? Can you graphically depict it?
How and why?
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[Link] (Synopsis)
A potential investor in a new on-line sheet-music business is ready to
deny funding based on simple expected monetary value. Further
reflection identifies potential downstream options. Two options are
important in the case of partial, but incomplete, success: to abandon the
business idea and sell the technology, or to switch to new technology
and keep the Web site.
Written Submission
Provide a description of any other contingent opportunities (generic) that
would add value to this business? Should Bernard invest in the
business? Does Bernard have reasonable cutoff levels to trigger action
on each of the ideas in the initial discussion question? What kinds of
assessment tools would you use to support your answers?
© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-
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