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Chapter 8

Decision Analysis

Slides 8a: Introduction


Decision Analysis

 A set of alternative actions


 We may chose whichever we please
 A set of possible states of nature
 Onlyone will be correct, but we don’t know in
advance
 A set of outcomes and a value for each
 Each is a combination of an alternative action and a
state of nature
 Value can be monetary or otherwise
Decision Analysis
 Certainty
 Decision Maker knows with certainty what the state of
nature will be - only one possible state of nature
 Ignorance
 Decision Maker knows all possible states of nature,
but does not know probability of occurrence
 Risk
 Decision Maker knows all possible states of nature,
and can assign probability of occurrence for each
state
Decision Making Under Certainty
Decision Variable
Units to build 150

Parameter Estimates
Cost to build (/unit) $ 6,000
Revenue (/unit) $ 14,000
Demand (units) 250

Consequence Variables
Total Revenue $ 2,100,000
Total Cost $ 900,000

Performance Measure
Net Revenue $ 1,200,000
Decision Making Under Ignorance
– Payoff Table
Kelly Construction Payoff Table (Prob. 8-17)

State of Nature

Alternative Demand
Actions Low (50 units) Medium (100 units) High (150 units)

Build 50 400,000 400,000 400,000

Build 100 100,000 800,000 800,000

Build 150 (200,000) 500,000 1,200,000


Decision Making Under Ignorance
 Maximax
 Select the strategy with the highest possible
return
 Maximin
 Select the strategy with the smallest possible
loss
 LaPlace-Bayes
 All states of nature are equally likely to occur.
 Select alternative with best average payoff
Maximax:
The Optimistic Point of View
 Select the “best of the best” strategy
 Evaluates each decision by the maximum possible
return associated with that decision (Note: if cost data
is used, the minimum return is “best”)
 The decision that yields the maximum of these
maximum returns (maximax) is then selected
 For “risk takers”
 Doesn’t consider the “down side” risk
 Ignores the possible losses from the selected
alternative
Maximax Example
Kelly Construction
State of Nature
Maximax
Demand Criterion
Alternative
Actions
Low (50 units) Medium (100 units) High (150 units) Max

Build 50 400,000 400,000 400,000 400,000

Build 100 100,000 800,000 800,000 800,000

Build 150 (200,000) 500,000 1,200,000 1,200,000


Maximin:
The Pessimistic Point of View
 Select the “best of the worst” strategy
 Evaluates each decision by the minimum
possible return associated with the decision
 The decision that yields the maximum value
of the minimum returns (maximin) is selected
 For “risk averse” decision makers
 A “protect”
strategy
 Worst case scenario the focus
Maximin
Kelly Construction

State of Nature
Maximin
Demand Criterion
Alternative
Actions
Low (50 units) Medium (100 units) High (150 units) Min

Build 50 400,000 400,000 400,000 400,000

Build 100 100,000 800,000 800,000 100,000

Build 150 (200,000) 500,000 1,200,000 (200,000)


Decision Making Under Risk
 Expected Return (ER)*
 Select the alternative with the highest (long term)
expected return
 A weighted average of the possible returns for
each alternative, with the probabilities used as
weights
* Also referred to as Expected Value (EV) or Expected
Monetary Value (EMV)
**Note that this amount will not be obtained in the short
term, or if the decision is a one-time event!
Expected Return
State of Nature
Expected
Demand Return
Alternative
Actions
Low (50 units) Medium (100 units) High (150 units) ER

Build 50 400,000 400,000 400,000 400,000

Build 100 100,000 800,000 800,000 660,000

Build 150 (200,000) 500,000 1,200,000 570,000

Probability 0.2 0.5 0.3 1.0


Expected Value of Perfect Information
 EVPI measures how much better you could do on
this decision if you could always know when each
state of nature would occur, where:
 EVUPI = Expected Value Under Perfect Information
(also called EVwPI, the EV with perfect information, or
EVC, the EV “under certainty”)
 EVUII = Expected Value of the best action with
imperfect information (also called EVBest )
 EVPI = EVUPI – EVUII
 EVPI tells you how much you are willing to pay for
perfect information (or is the upper limit for what you
would pay for additional “imperfect” information!)
Expected Value of Perfect
Information
State of Nature
Expected
Demand Return
Alternative
Actions
Low (50 units) Medium (100 units) High (150 units) ER

Build 50 400,000 400,000 400,000 400,000

Build 100 100,000 800,000 800,000 660,000

Build 150 (200,000) 500,000 1,200,000 570,000

Probability 0.2 0.5 0.3 1.0

Best Decision 400,000 800,000 1,200,000 840,000

EVPI 180,000
Using Excel to Calculate EVPI:
Formulas View
Kelly Construction
A B C D E
1
2
3 Payoffs States of Nature Expected Return
4 Alternatives Low (50 units) Medium (100 units) High (150 units) ER
5 Build 50 400000 400000 400000 =SUMPRODUCT(B5:D5,B$8:D$8)
6 Build 100 100000 800000 800000 =SUMPRODUCT(B6:D6,B$8:D$8)
7 Build 150 -200000 500000 1200000 =SUMPRODUCT(B7:D7,B$8:D$8)
8 Probability 0.2 0.5 0.3
9 Best Decision =MAX(B5:B7) =MAX(C5:C7) =MAX(D5:D7)
10
11 EVwPI = =SUMPRODUCT(B9:D9,B8:D8)
12 EVBest = =MAX(E5:E7)
13 EVPI = =E11-E12
14
The Newsvendor Model

A newsvendor can buy the Wall Street Journal


newspapers for 40 cents each and sell them for 75
cents.
However, he must buy the papers before he knows
how many he can actually sell. If he buys more
papers than he can sell, he disposes of the excess at
no additional cost. If he does not buy enough
papers, he loses potential sales now and possibly in
the future.
Suppose that the loss of future sales is captured by a
loss of goodwill cost of 50 cents per unsatisfied
customer.
The demand distribution is as follows:

P0 = Prob{demand = 0} = 0.1

P1 = Prob{demand = 1} = 0.3

P2 = Prob{demand = 2} = 0.4

P3 = Prob{demand = 3} = 0.2

Each of these four values represent the states of


nature. The number of papers ordered is the decision.
The returns or payoffs are as follows:
State of Nature (Demand)
Decision 0 1 2 3
0 0 -50 -100 -150
1 -40 35 -15 -65
2 -80 -5 70 20

3 -120 -45 30 105

Payoff = 75(# papers sold) –


40(# papers ordered) – 50(unmet demand)
Where 75¢ = selling price
40¢ = cost of buying a paper
50¢ = cost of loss of goodwill
Now, the ER is calculated for each decision:
ER0 = 0(0.1) – 50(0.3) – 100(0.4) – 150(0.2) = -85
ER1 = -40(0.1) + 35(0.3) – 15(0.4) – 65(0.2) = -12.5
ER2 = -80(0.1) – 5(0.3) + 70(0.4) + 20(0.2) = 22.5
ER3 = -120(0.1) – 45(0.3) + 30(0.4) – 105(0.2) = 7.5

State of Nature (Demand)


Decision 0 1 2 3 ER
0 0
Of these -50 ER’s,
four -100 -150 -85
1 choose
-40 the maximum,
35 -15 -65 -12.5
2 -80 -5 70 20 22.5
and order 2 papers
3 -120 -45 30 105 7.5

Prob. 0.1 0.3 0.4 0.2


State of Nature
Decision 0 1 2 3
0 0 -50 -100 -150
1 -40 35 -15 -65
2 -80 -5 70 20

3 -120 -45 30 105


Prob. 0.1 0.3 0.4 0.2

ER(new) = 0(0.1) + 35(0.3) + 70(0.4) + 105(0.2)


= 59.5
ER(current) = 22.5
EVPI = 59.5 – 22.5 = 37.0 cents
Maximax Criterion: The Maximax criterion is an
optimistic decision making criterion.
This method evaluates each decision by the maximum
possible return associated with that decision.

The decision that yields the maximum of these maximum


returns (maximax) is then selected.
Maximin Criterion: The Maximin criterion is an
extremely conservative, or pessimistic, approach to
making decisions.
Maximin evaluates each decision by the minimum possible
return associated with the decision.
Then, the decision that yields the maximum value of the
minimum returns (maximin) is selected.
So, using the 3 criteria, we made the following
decisions regarding the newsvendor data:

Criteria Decision
Maximin Cash Flow Order 1 paper

Expected Return Order 2 papers

Maximax Cash Flow Order 3 papers


THE RATIONALE FOR UTILITY

Most people are risk-averse, which means they


would feel that the loss of a certain amount of
money would be more painful than the gain of
the same amount of money.

Utility functions in decision analysis measure the


“attractiveness” of money.

Utility can be thought of as a measure of


“satisfaction.”
Typical risk-averse utility function:

A gain Utility
in 1.0
0.910
utility 0.850
of 0.06 0.775

0.680

0.524

100 200 300 400 500 600 Dollars

Go from $400 to
$500 results in
To illustrate, first suppose you have $100 and someone
gives you an additional $100. Note that your utility
increases by

U(200) – U(100) = 0.680 – 0.524 = 0.156


Now suppose you start with $400 and someone gives you
an additional $100. Now your utility increases by

U(500) – U(400) = 0.910 – 0.850 = 0.060


This illustrates that an additional $100 is less attractive if
you have $400 on hand than it is if you start with $100.
Utilities and Decisions under Risk

Summary:
Utility is a way to incorporate risk aversion into the
expected return calculation.

Calculating a utility function is out of the scope of


this course, but it can be calculated by a series of
lottery questions (e.g., Would you prefer one million
dollars or a 50% chance of earning five million?).