Decision Analysis

 Decision Problem Identification

 Decision Making without Probabilities
 Decision Making with Probabilities
 Risk Analysis and Sensitivity Analysis
 Decision Analysis with Sample Information
 Computing Branch Probabilities
 Utility and Decision Making
 Decision Problem Identification
 A decision problem is characterized by decision
alternatives, states of nature, and resulting payoffs.
 The decision alternatives are the different possible
strategies, the decision maker can employ.
 The states of nature refer to future events, not
under the control of the decision maker, which
will ultimately affect decision results i.e. the
Payoffs. States of nature should be defined in a
way that they are mutually exclusive. They should
contain all possible future events that could affect
results of all potential decisions.
 Decision Theory Models
 Decision theory problems are generally represented as
one of the following:
 Influence Diagram
 Payoff Table
 Decision Tree
Influence Diagram
An influence diagram is a graphical device showing the
relationships among the decisions, the chance events, and the
consequences.
Squares or rectangles depict decision nodes.
Circles or ovals depict chance nodes.
Diamonds depict consequence nodes.
Lines or arcs connecting the nodes show the direction of
influence.
 Payoff Tables
 The consequence resulting from a specific
combination of a decision alternative and a
state of nature is a payoff.
 A table showing payoffs for all combinations
of decision alternatives and states of nature is a
payoff table.
 Payoffs can be expressed in terms of profit,
cost, or any other appropriate measure.
 Decision Trees
 A decision tree is a chronological representation of the
decision problem.
 Each decision tree has two types of nodes; round nodes
correspond to the states of nature while square nodes
correspond to the decision alternatives.
 The branches leaving each round node represent the different
states of nature while the branches leaving each square node
represent the different decision alternatives.
 At the end of each limb of a tree are the payoffs attained from
the series of branches making up that limb.
 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
 the conservative approach
 the minimax regret approach.
 Optimistic Approach
 The optimistic approach would be used by an
optimistic decision maker.
 The decision with the best possible payoff is
chosen.
 If the payoff table was in terms of costs, the
decision with the lowest cost would be chosen.
 If the payoff table was in terms of profits, the
decision with the highest profit would be chosen.
 Conservative Approach
 The conservative approach would be used by a
conservative decision maker.
 For each decision worst payoff is listed and then decision
corresponding to best of these worst payoffs is selected.
(Hence, the worst possible payoff is maximized.)
 If payoff was in terms of costs, the maximum costs would
be determined for each decision and then the decision
corresponding to minimum of these maximum costs is
selected. (Hence, maximum possible cost is minimized.)
 If payoff was in terms of profits, minimum profits would
be determined for each decision and then the decision
corresponding to maximum of these minimum profits is
selected. (Hence minimum possible profit is maximized.)
 Minimax Regret Approach
1. 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
best payoff for that state of nature.
2. Then, using this regret table, the maximum regret
for each possible decision is listed.
3. The decision chosen is the one corresponding to
the minimum of the maximum regrets .
Decision Making with Probabilities
 Expected Value Approach
 If probabilistic information regarding the states of

nature is available, one may use the expected value

(EV) approach.
 Here the expected return for each decision is

calculated by summing the products of the payoff

under each state of nature and the probability of the
respective state of nature occurring.
 The decision yielding the best expected return is

chosen.
Expected Value of a Decision Alternative
 The expected value of a decision alternative is the sum of
weighted payoffs for the decision alternative.
 The expected value (EV) of decision alternative di is
defined as:
N
EV ( d i )   P ( s j )V ij
j 1

where: N = the number of states of nature

P(sj ) = the probability of state of nature sj
Vij = the payoff corresponding to decision
alternative di and state of nature sj
 Sensitivity Analysis
 Some of the quantities in a decision analysis, particularly
the probabilities, are often intelligent guesses at best.
 It is important to accompany any decision analysis with a
sensitivity analysis.
 Sensitivity analysis can be used to determine how changes
to following inputs affect recommended decision
alternatives:
 probabilities for the states of nature

 values of the payoffs

 If a small change in the value of one of the inputs causes a

change in the recommended decision alternative, extra
effort and care should be taken in estimating the input
value.
 1. Criterion of Optimism (Maximax
Criterion)
This criterion is based on optimistic
approach i.e. it assumes the best possibility.
The working method is as follows:
Step I: Locate the maximum pay-off for
each action.
Step II: Select that action as the best action
which corresponds to the maximum of the
above maximum pay-offs.
 2. Criterion of Pessimism (Maximin
Criterion)
This criterion is based on conservative
approach i.e. it assumes the worst
possibility. The working method is as
follows:
Step I: Locate the minimum pay-off for
each action.
Step II: Select that action as the best action
which corresponds to the maximum of the
above minimum pay-offs.
 3. Criterion of Realism (Hurwicz
Criterion)
The working method is as follows:
Step I: Decide the coefficient of optimism α and
coefficient of pessimism (1-α).
Step II: Locate the maximum and minimum pay-offs
for each action and calculate for each action the value
of
h = α (maximum pay-off) + (1- α) (minimum pay-off)
Step III: Select that action as the optimum action
which corresponds to the maximum of the above
determined value of h.
 4. Equally Likely Decision Criterion
(Laplace’s Criterion)
The working method is as follows:
Step I: Assign equal probabilities to each
pay-off of an action.
Step II: Calculate the expected pay-off for
each action.
Step III: Select that action as an optimum
action which corresponds to the maximum
of the above calculated expected pay-offs.
 5. Criterion of Regret (Savage
Criterion or Minimax Criterion)
Step I: From the given pay-off matrix, develop an
opportunity loss matrix (table) or regret table as:
(i) Find the best pay-off corresponding to each
state of nature and
(ii) Subtract all pay-offs of that action from this
best pay-off.
Step II: Locate the maximum regret for each
action.
Step III: Select that action as the best action which
corresponds to the minimum of the above
maximum regrets.
 Applications of
Mathematical Optimization in Decision Analysis

 Determining Product Mix

 Manufacturing
 Routing and Logistics
 Financial Planning
 References
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