MOGADISHU

OPERATION RESEARCH
UNIVERSITY

Chapter Three: Decision Analysis

Introduction to Decision Analysis

The successes or failures that a person experiences in life depend on the decisions
that he or she makes.
One decision may make the difference between a successful career and an
unsuccessful one.
Decision theory is an analytic and systematic approach to the study of decision
making.
A good decision is one that is based on logic, considers all available data and
possible alternatives, and applies the quantitative approach we are about to
describe.
A bad decision is one that is not based on logic, does not use all available
information, does not consider all alterna- tives, and does not employ appropriate
quantitative techniques.

Definition of Decision Analysis

Decision theory is an analytic and systematic way to tackle problems. A good

decision is based on logic.

Instructor : Shire Mohamed Ibrahim 1

 MOGADISHU
OPERATION RESEARCH
UNIVERSITY

The Six Steps in Decision Making

Six Steps in Decision Making

1. Clearly define the problem at hand.
2. List the possible alternatives.
3. Identify the possible outcomes or states of nature.
4. List the payoff (typically profit) of each combination of alternatives and
outcomes.
5. Select one of the mathematical decision theory models.
6. Apply the model and make your decision.

We use the Thompson Lumber Company case as an example to illustrate these

decision the- ory steps. John Thompson is the founder and president of Thompson
Lumber Company, a profItable firm located in Portland, Oregon.
Step 1.
The problem that John Thompson identifies is whether to expand his product line
by manufacturing and marketing a new product, backyard storage sheds.
Step 2.
Example: 1
John Thompson has already evaluated the potential profits associated with the
various out- comes. With a favorable market, he thinks a large facility would result
in a net profit of $200,000 to his firm. This $200,000 is a conditional value because

Instructor : Shire Mohamed Ibrahim 2

 MOGADISHU
OPERATION RESEARCH
UNIVERSITY

Thompson’s receiving the money is conditional upon both his building a large
factory and having a good market.
The conditional value if the market is unfavorable would be a $180,000 net loss. A
small plant would result in a net profit of $100,000 in a favorable market, but a net
loss of $20,000 would occur if the market was unfavorable. Finally, doing nothing
would result in $0 profit in either market. The easiest way to present these values is
by constructing a decision table, sometimes called a payoff table.
John decides that his alternatives are to construct (1) a large new plant to
manufacture the storage sheds, (2) a small plant, or (3) no plant at all (i.e., he has
the option of not developing the new product line).

Decision Table with Conditional Values for Thompson Lumber

Step 3.
Thompson determines that there are only two possible outcomes: the market for
the storage sheds could be favorable, meaning that there is a high demand for the
product, or it could be unfavorable, meaning that there is a low demand for the
sheds.

Instructor : Shire Mohamed Ibrahim 3

 MOGADISHU
OPERATION RESEARCH
UNIVERSITY

Step 4.
Because Thompson wants to maximize his profits, he can use profit to evaluate
each consequence.
Steps 5 and 6.
The last two steps are to select a decision theory model and apply it to the data to
help make the decision. Selecting the model depends on the environment in which
you’re operating and the amount of risk and uncertainty involved.
Types of Decision-Making Environments
There are three decision-making environments:
1. Decision making under certainty
2. Decision making under uncertainty
3. Decision making under risk
Type 1: Decision Making Under Certainty
In the environment of decision making under certainty, decision makers know with
certainty the consequence of every alternative or decision choice. Naturally, they
will choose the alternative that will maximize their well-being or will result in the
best outcome. For example, let’s say that you have $1,000 to invest for a 1-year
period. One alternative is to open a savings account paying 6% interest and another
is to invest in a government Treasury bond paying 10% interest. If both
investments are secure and guaran- teed, there is a certainty that the Treasury bond
will pay a higher return. The return after one year will be $100 in interest.

Instructor : Shire Mohamed Ibrahim 4

 MOGADISHU
OPERATION RESEARCH
UNIVERSITY

TYPE 2: DECISION MAKING UNDER UNCERTAINTY

In decision making under uncertainty, there are several possible outcomes for each
alternative, and the decision maker does not know the probabilities of the various
outcomes. As an example, the probability that a Democrat will be president of the
United States 25 years from now is not known. Sometimes it is impossible to
assess the probability of success of a new undertaking or product.
TYPE 3: DECISION MAKING UNDER RISK
In decision making under risk, there are several pos- sible outcomes for each
alternative, and the decision maker knows the probability of occurrence of each
outcome. We know, for example, that when playing cards using a standard deck,
the probability of being dealt a club is 0.25. The probability of rolling a 5 on a die
is 1/6. In decision making under risk, the decision maker usually attempts to
maximize his or her expected well- being. Decision theory models for business
problems in this environment typically employ two equivalent criteria:
maximization of expected monetary value and minimization of expected
opportunity loss.

Instructor : Shire Mohamed Ibrahim 5

 MOGADISHU
OPERATION RESEARCH
UNIVERSITY

Decision Making Under Uncertainty

When several states of nature exist and a manager cannot assess the outcome
probability with confidence or when virtually no probability data are available, the
environment is called decision making under uncertainty. Several criteria exist for
making decisions under these conditions.
1. Optimistic (maximax)
2. Pessimistic (maximin)
3. Criterion of realism (Hurwicz)
4. Equally likely (Laplace)
5. Minimax regret
Optimistic
In using the optimistic criterion, the best (maximum) payoff for each
alternative is considered and the alternative with the best (maximum) of
these is selected. Hence, the optimistic criterion is sometimes called the
maximax criterion.
Thompson’s Maximax Decision

Instructor : Shire Mohamed Ibrahim 6

 MOGADISHU
OPERATION RESEARCH
UNIVERSITY

Criterion of pessimistic (Maximin Criterion) (Wald Criterion)

In using the pessimistic criterion, the worst (minimum) payoff for each alternative
is considered and the alternative with the best (maximum) of these is selected.
Hence, the pessimistic criterion is sometimes called the maximin criterion. This
criterion guarantees the payoff will be at least the maximin value (the best of the
worst values). Choosing any other alternative may allow a worse (lower) payoff to
occur.
Thompson’s Maximin Decision

Instructor : Shire Mohamed Ibrahim 7

 MOGADISHU
OPERATION RESEARCH
UNIVERSITY

Criterion of Realism (Hurwicz Criterion)

Often called the weighted average, the criterion of realism (the Hurwicz criterion)
is a com- promise between an optimistic and a pessimistic decision. To begin with,
a coefficient of realism, is selected; this measures the degree of optimism of the
decision maker. This coefficient is between 0 and 1. When is 1, the decision maker
is 100% optimistic about the future. When is 0, the decision maker is 100%
pessimistic about the future. The advantage of this approach is that it allows the
decision maker to build in personal feelings about relative optimism and pes-
simism. The weighted average is computed as follows:
Criterion of realism ( )
Weighted Average
Large Plant
Small Plant
Do nothing=
Maximum is corresponding decision is to build the large plant

Instructor : Shire Mohamed Ibrahim 8

 MOGADISHU
OPERATION RESEARCH
UNIVERSITY

Assume a coefficient of realism equal to 0.8

State of Nature

Decision favorable unfavorable Criterion realism

Large plant $200,000 $-180,000 $124,000

Small plant $100,000 $-20,000 $76,000

No plant $0 $0 $0

Instructor : Shire Mohamed Ibrahim 9

 MOGADISHU
OPERATION RESEARCH
UNIVERSITY

Laplace Criterion /Equal Probability/Rationality (Bayes criterion)

Expected payoff [ ]

Where n is the number of events or outcomes and P is payoff value of each

every alternative.

Thompson’s Equally Likely Decision

Minimax Regret Criterion (Savage Criterion)

Opportunity loss table (Regret table)

the first step is to create the
opportunity loss table by determining the opportunity loss for not choosing the best
alternative for each state of nature. Opportunity loss for any state of na- ture, or
any column, is calculated by subtracting each payoff in the column from the best
payoff in the same column.

Instructor : Shire Mohamed Ibrahim 10

 MOGADISHU
OPERATION RESEARCH
UNIVERSITY

Determining Opportunity Losses for Thompson Lumber

Opportunity Loss Table for Thompson Lumber

Thompson’s minimax decision using opportunity loss

Instructor : Shire Mohamed Ibrahim 11

 MOGADISHU
OPERATION RESEARCH
UNIVERSITY

Example: 2

The following matrix gives the payoff of different strategies

( Alternatives) , and against conditions (Events) , and .

Solve by the following Criterion to find best decision

a. Optimistic ( Maximax)
b. Pessimistic (Maximin )
c. Criterion of Realism ( Hurwicz )
d. Equally Likely ( Laplace )
e. Minimax Regret ( Opportunity Loss )

Instructor : Shire Mohamed Ibrahim 12

 MOGADISHU
OPERATION RESEARCH
UNIVERSITY

1000 1500 750 0

250 2000 3750 3000
-500 1250 3000 4750
-1250 500 2250 4000

Solution on the board

Instructor : Shire Mohamed Ibrahim 13

 MOGADISHU
OPERATION RESEARCH
UNIVERSITY

Decision Making Under Risk

Decision making under risk is a decision situation in which several possible states
of nature may occur, and the probabilities of these states of nature are known. In
this section we consider one of the most popular methods of making decisions
under risk: selecting the alternative with the highest expected monetary value (or
simply expected value). We also use the probabilities with the opportunity loss
table to minimize the expected opportunity loss.
Expected Monetary Value
It is possible to determine the expected monetary value (EMV) for each alternative.
The expected value, or the mean value, is the long-run average value of that
decision. The EMV for an alternative is just the sum of possible payoffs of the
alternative, each weighted by the probability of that payoff occurring.
Definition of the expected monetary value
EMV is the weighted sum of possible payoffs for each alternative.
Formula of expected monetary value
EMV (alternative) = Σ P
Where
Payoff for the alternative in state of nature
P Probability of achieving payoff
Σ summation symbol
If this were expanded, it would become

Instructor : Shire Mohamed Ibrahim 14

 MOGADISHU
OPERATION RESEARCH
UNIVERSITY

EMV (alternative) (payoff in first state of nature) (probability of first state

of nature) (payoff in second state of nature) (probability of second state of
nature) ( ) (probability of last state of nature)
The alternative with the maximum EMV is then chosen.
Example 3
Suppose that John Thompson now believes that the probability of a favorable
market is exactly the same as the probability of an unfavorable market; that is, each
state of nature has a 0.50 probability. Which alternative would give the greatest
expected monetary value? To determine this, John has expanded the decision table,
as shown in Table His calculations follow:
Solution
EMV (Large plant) = ($200,000)(0.50) + (-$180,000) (0.50) = $10,000
EMV (Small plant) = ($100,000) (0.50) + (-$20,000) (0.50) = $40,000
EMV (do nothing) = ($0) (0.50) + ($0) (0.50) = $0

Instructor : Shire Mohamed Ibrahim 15

 MOGADISHU
OPERATION RESEARCH
UNIVERSITY

Decision Table with Probabilities and EMVs for Thompson Lumber

Decision Making Under Risk

Interpretation
The largest expected value ($40,000) results from the second alternative, construct
a small plant.‖ Thus, Thompson should proceed with the project and put up a small
plant to manufacture storage sheds.
The EMVs for the large plant and for doing nothing are $10,000 and $0,
respectively. When using the expected monetary value criterion with minimization
problems, the calculations are the same, but the alternative with the smallest EMV
is selected.

Instructor : Shire Mohamed Ibrahim 16

 MOGADISHU
OPERATION RESEARCH
UNIVERSITY

Expected Value with Perfect Information & Expected Value of Perfect

Information
In this section, two related terms are investigated: the expected value of perfect
information (EVPI) and the expected value with perfect information (EVwPI).
These techniques can help John make his decision about hiring the marketing firm.
Expected Value with Perfect Information
Definition
The expected value with perfect information is the expected or average return, in
the long run, if we have perfect information before a decision has to be made. To
calculate this value, we choose the best alternative for each state of nature and
multiply its payoff times the probability of occurrence of that state of nature.
Formula of Expected Value with Perfect Information
EVwPI = ∑
If this were expanded, it would become EVwPI (best payoff in first state of
nature) (probability of first state of nature) (best payoff in second state of
nature) (probability of second state of nature)
( ) (probability of last state of nature)
Expected Value of Perfect Information
Definition
The expected value of perfect information, EVPI, is the expected value with
perfect information minus the expected value without perfect information (i.e., the
best or maximum EMV).

Instructor : Shire Mohamed Ibrahim 17

 MOGADISHU
OPERATION RESEARCH
UNIVERSITY

Thus, the EVPI is the improvement in EMV that results from having perfect
information.
Formula of Expected Value of Perfect Information
EVPI = EVwPI - Best EMV

Expected value with perfect information

Expected value without perfect information
Note when calculated the expected value with perfect information (EVwPI) ,we
choose the best payoff for each state of nature and multiply them by the
probability of their state of nature and add the results
Example 4
Suppose that John Thompson now believes that the probability of a favorable
market is exactly the same as the probability of an unfavorable market; that is, each
state of nature has a 0.50 probability. John has expanded the decision table, as
shown in the following Table:

Instructor : Shire Mohamed Ibrahim 18

 MOGADISHU
OPERATION RESEARCH
UNIVERSITY

Calculate the following:

1. Expected Value with Perfect Information (EVwPI)
2. Expected Value of Perfect Information (EVPI)
Solution
1) Expected Value with Perfect Information (EVwPI)
The expected value with perfect information is EVwPI = ($ 200,000)(0.50) +
($0)(0.50) = $ 100,000
Thus, if we had perfect information, the payoff would average $100,000.
2) Expected Value of Perfect Information (EVPI)
The maximum EMV without additional information is $40,000 Therefore, the
increase in EMV is EVPI = EVwPI - maximum EMV = $100,000 - $ 40,000 =
$60,000

Instructor : Shire Mohamed Ibrahim 19

 MOGADISHU
OPERATION RESEARCH
UNIVERSITY

Interpretation
The most Thompson would be willing to pay for perfect information is $60,000.
This, of course, is again based on the assumption that the probability of each state
of nature is 0.50. This EVPI also tells us that the most we would pay for any
information (perfect or imperfect) is $60,000. In a later section we’ll see how to
place a value on imperfect or sample information.
In finding the EVPI for minimization problems, the approach is similar. The best
payoff in each state of nature is found, but this is the lowest payoff for that state of
nature rather than the highest. The EVwPI is calculated from these lowest payoffs,
and this is compared to the best (lowest) EMV without perfect information. The
EVPI is the improvement that results, and this is the best EMV - EVwPI.
Expected Opportunity Loss
Definition of Expected Opportunity Loss
An alternative approach to maximizing EMV is to minimize expected opportunity
loss (EOL).
Now it is important to note that the minimum EOL decision will always be the
same as the maximum EMV decision.
Min EOL decision EMV Decision.
The expected value of perfect information is actually always the same value as the
minimum EOL.
EVPI min EOL

Instructor : Shire Mohamed Ibrahim 20

 MOGADISHU
OPERATION RESEARCH
UNIVERSITY

Formula of Expected Opportunity Loss

We compute the EOL for each alternative by multiplying the probability of each
state of nature times the appropriate opportunity loss value and adding these
together.
We always make our decision by choosing the alternative with the minimum EOL
Example 5
We presented the opportunity loss table for the Thompson Lumber example. Using
these opportunity losses.
Opportunity Loss Table for Thompson Lumber

Instructor : Shire Mohamed Ibrahim 21

 MOGADISHU
OPERATION RESEARCH
UNIVERSITY

Compute the Expected Opportunity Loss (EOL)

For each alternative, an each state of nature has a 0.50 probability.
Solution
EOL (construct large plant) = (0.5) ($0) + (0.5) ($180,000) =
$ 90,000
EOL (construct small plant) = (0.5) ($100,000) + (0.5)
($ 20,000) = $ 60,000
EOL (do nothing) = (0.5) ($200,000) + (0.5) ($0) = $ 100,000

Instructor : Shire Mohamed Ibrahim 22

 MOGADISHU
OPERATION RESEARCH
UNIVERSITY

Interpretation
Gives these results. Using minimum EOL as the decision criterion, the best
decision would be the second alternative, construct a small plant.
It is important to note that minimum EOL will always result in the same decision
as maximum EMV, and that the EVPI will always equal the minimum EOL.
Referring to the Thompson case, we used the payoff table to compute the EVPI to
be $60,000. Note that this is the minimum EOL we just computed.
EOL will always result in the same decision as the maximum EMV.
Example 6
Payoff Table

Instructor : Shire Mohamed Ibrahim 23

 MOGADISHU
OPERATION RESEARCH
UNIVERSITY

Compute the following:

a) Expected monetary value ( EMV )
b) Expected value of perfect information ( EVPI )
c) Expected Opportunity Loss ( EOL )
Solution on the board
Example 7

The probabilities of the states of nature are 0.5, 0.1 and 0.4 respectively. State
which act can be chosen as the best using:
a) Expected monetary value (EMV)
b) Expected value of perfect information (EVPI)
c) Expected Opportunity Loss (EOL)
Solution on the board

Instructor : Shire Mohamed Ibrahim 24