QMT429 Quantitative Techniques

Topic 2:
Decision Analysis






Learning Outcome



At the end of this chapter, you should be able to:

Identify the decision-making environment.
Make good decision under uncertainty.
Make good decision under risk.
Make good decision using decision tree analysis.
















Introduction

What is Decision Theory?









An analytical techniques to identify the
optimal decision with several alternatives
and risk or uncertain pattern of the future.
Good
Decision
Bad
Decision
Based on logic, considers all available data
and possible alternatives, and applied
quantitative approach.

Not based on logic, does not use all
available information, does not consider
all alternatives and does not employ
appropriate quantitative techniques.
The Six Steps in Decision Theory

1. Define the problem.
2. List the possible alternatives.
3. Identify the possible outcomes or state of nature.
4. List the payoff or profit of each combination of
alternatives and outcomes.
5. Select on of the mathematical decision theory models.
6. Apply the model and make your decision.




Types of Decision Making
Environment











Decision making
under certainty
Decision making
under uncertainty
Decision making
under risk
I. Decision Making Under Certainty

Example:

Khalid has RM10000 to invest in banks. If he has three choices:
1. Invest in Fixed deposit of Bank A with interest of RM250 per annum.
2. Invest in Fixed deposit of Bank B with interest of RM260 per annum.
3. Invest in Fixed deposit of Bank C with interest of RM300 per annum.
Which will he choose?


The obvious decision is to invest in Bank C as it yields the highest
interest of RM300.


II. Decision Making Under Uncertainty



Also known as optimistic decision criteria.

Looks for alternatives that maximizes the maximum
outcome or consequences for each alternative.





1. Maximax

Example:











Step 1: Locate the MAXIMUM outcome within each alternative.
Step 2: Choose the alternative with MAXIMUM value.


Therefore, the decision is to construct a large plant.


STEP
1
STEP
2
Also known as pessimistic decision criteria.

Look for alternatives that maximizes the minimum
outcome or consequences for each alternative.


2. Maximin

Example:









Step 1: Locate the MINIMUM outcome within every alternative.
Step 2: Choose the alternative with the MAXIMUM value.


Therefore, the decision is to do nothing.


STEP 1
STEP 2
Also known as Laplace.

Look for alternatives with the highest average
outcome/payoffs.


3. Equally Likely

Example:









Step 1: Calculate the average outcome for each alternative.
Step 2: Choose the alternative with the MAXIMUM value.


Therefore, the decision is to construct a small plant.


STEP 1
STEP
2
Often called as weighted average.

The criterion of realism is a compromise between an
optimistic and pessimistic decision.




4. Criterion of Realism
Criterion of realism = (maximum in row) + (1 ) (minimum in row)

Example:









Step 1: Select a coefficient of realism
Step 2: Calculate the outcome by using the formula.
Step 3: Alternative with the higher value is selected.


Therefore, the decision is to construct a large plant.


STEP 2
STEP
3
Based on opportunity loss table.

Minimax look for alternative that minimizes the
maximum opportunity loss within each alternative.

5. Minimax

Example:












Step 1: Develop an opportunity loss table.
Step 2: Find the maximum opportunity loss within each alternative.
Step 3: Choose the alternative with the MINIMUM value.


Therefore, the decision is to construct a small plant.


Exercise 2.1














II. Decision Making Under Risk









EMV is the weighted sum of possible payoffs for each alternative.







Alternative with highest EMV is chosen.









1. Expected Monetary Value (EMV)
EMV = [(Payoff in state i) x (Probability of state i)]
Example 2.2



















EOL is the cost of not picking the best solution.

Also known as regret. The amount you would lose by not
picking the best alternative.

Alternative method to maximize EMV is to minimize EOL.

NOTE:









2. Expected Opportunity Loss (EOL)
EVPI = Minimum EOL

Example 2.3:







Step 1: Create the EOL table by subtract the best outcome in column with
each outcome in the column.
Step 2: Compute EOL. Choose the MINIMUM value.

EOL(large plant) = 0(0.5) + 180000(0.5) = RM90 000
EOL(small plant) = 100000(0.5) + 20000(0.5) = RM60 000
EOL(do nothing) = 200000(0.5) + 0(0.5) = RM100 000


Therefore, the decision is to construct a small plant.


Exercise 2.2











Exercise 2.3


















EVPI is the difference between expected value with
perfect information (EVwPI) and the maximum EMV.

EVwPI is the sum of the product of the best payoff of
each state of nature and its probability.

NOTE:








3. Expected Value of perfect Information (EVPI)
EVPI = EVwPI - Maximum EMV

Example 2.4:


















Step 1: Calculate the EVwPI.
Step 2: Calculate the maximum EMV.
Step 3: Find the EVPI using formula.




Exercise 2.4