UNIT 2

DECISION ANALYSIS
 Decision may be defined as:
• A process which results in the selection from a set of
alternative course of action, that course of action
which is considered to meet the objectives of the
decision problem more satisfactorily than others
judged by the decision maker.
• The process of logical and quantitative analysis of all
factors that influences the decision problem, assists
the decision maker in analyzing theses problems with
several courses of action and consequences.
• Decision theory is an analytic and systematic
way to tackle problems.
• A good decision is based on logic.
 The 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.
 Few Management Applications of Decision theory
1. Select the best from among several job offers.
2. Select the most profitable investment portfolio.
3. Select the best way to build a modern electronic component.
4. Determine the number of units to order for an office supply store.
5. Determine whether or not to expand a manufacturing facility.
6. Determine if a large plant , small plant or no plant should be built.
7. Decide if it is worthwhile to hire a marketing research team to gather
additional data.
8. Decide whether to lease, subcontract or manufacture or select a quality
control plan.
9. Decide whether to invest in a new plant, equipment, research programmes,
marketing facilities , even risky orders, etc.
10.Decide about the area of design and development of new and improved
products and equipment from invention to commercialization stage.
Concepts associated with decision theory
approach to problem solving:

1. The decision maker: the decision maker refers to

individual or a group of individuals responsible for
making the choice of an appropriate course of action
amongst the available course of action.
2. Courses of Action: the alternative courses of action
or strategies are the acts that are available to
decision maker.
An example of an act or state of nature is the
number of units of a particular item to be ordered for
stock.
Concepts associated with decision theory approach to
problem solving:

3. States of Nature: The events identify the

occurrences which are outside of the decision
makers control and which determine the level
of success for a given act.
An example of an event or state of nature is
the level of market demand for a particular
item during a stipulated time period.
4. Payoff: each combination of a course of
action and a state of nature is associated with
payoff, which measures the net benefit to the
decision maker that accrues from a given
combination of decision alternatives and
events.
for example, the conditional profit can be Rs.
50 associated with the action of stocking 15
units of an item when the outcome is a
demand of 10 units of that item. costs can be
handled as negative profit.
5. Payoff table: For a given problem, payoff
table lists the state of nature which are
mutually exclusive as well as collectively
exhaustive and a set of given course of
action. For each combination of state of
nature and course of action, the payoff is
calculated.
6. Regret or opportunity loss table: the
opportunity loss is the loss incurred due to
failure of not adopting the best possible
course of action or strategy.
 Types of Decision-Making Environments

The types of decisions people make depend on

how much knowledge or information they
have about the situation. There are three
decision-making environments:
• Decision making under certainty
• Decision making under uncertainty
• Decision making under risk
 Decision making under certainty
• Complete and accurate knowledge of the
outcome of alternative. There is only one
outcome of each alternative.
• In simple words a decision making
environment where the future outcomes or
states of nature are known with certainty.
 Decision making under certainty

• For example:
I. Hostel Mess Manager – how many students will eat in my
mess today?
II. How many litres of petrol should I put in my car before
starting for trip?
III. 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 guaranteed,
there is a certainty that the Treasury bond will pay a higher
return. The return after one year will be $100 in interest.
 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.
 DECISION MAKING UNDER UNCERTAINTY

• For example:
I. Food corporation of India - How much
wheat / rice should we stock for this year?
II. Indian team – if we bat first, how many runs
are we likely to score?
III. The probability that a Democrat will be
president of the United States 25 years from
now is not known.
 DECISION MAKING UNDER RISK
• In decision making under risk, there are several
possible outcomes for each alternative, and the
decision maker knows the probability of
occurrence of each outcome.
• In this decision maker usually attempts to
maximize his or her expected wellbeing.
• 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.
 DECISION MAKING UNDER RISK

• for example:
I. when playing cards using a standard deck,
the probability of being dealt a club is 0.25.
II. The probability of rolling a 5 on a die is 1/6.
 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.
 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
• The first four criteria can be computed directly from the
decision (payoff) table, whereas the minimax regret
criterion requires use of the opportunity loss table.
 Maximax Criterion (Optimistic )
• 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.
• Maximax is an optimistic approach.
• In using the optimistic criterion for minimization problems
in which lower payoffs (e.g. cost) are better, you would
look at the best (minimum) payoff for each alternative and
choose the alternative with the best (minimum) of these.
 Maximin Criterion (Pessimistic )
• This criterion provides the decision maker with
pessimistic criterion.
• To use this criterion the decision maker maximizes his
minimum possible pay offs. He finds first the minimum
possible payoff for each alternatives and then chooses
the alternative with maximum payoff within this group.
• In using the pessimistic criterion for minimization
problems in which lower payoffs (e.g. cost) are better,
you would look at the worst (maximum) payoff for
each alternative and choose the alternative with the best
(minimum) of these.
 Criterion of Realism (Hurwicz Criterion)
• Criterion of realism uses the weighted average
approach.
• It is a compromise between an optimistic and a
pessimistic decision.
• a coefficient of realism,α, 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.
 Criterion of Realism (Hurwicz Criterion)

• The advantage of this approach is that it allows the

decision maker to build in personal feelings about
relative optimism and pessimism.
• The weighted average is computed as follows:
• Weighted average =
α (best in row) + (1 - α )(worst in row)
• when α = 1, this is the same as the optimistic
criterion, and when α = 0 this is the same as the
pessimistic criterion.
 Criterion of Realism (Hurwicz Criterion)

• For a maximization problem, the best payoff for an

alternative is the highest value, and the worst
payoff is the lowest value. This value is computed for
each alternative ,and the alternative with the highest
weighted average is then chosen.
• In using the criterion of realism for minimization
problems, the best payoff for an alternative would be
the lowest payoff in the row and the worst would be
the highest payoff in the row. The alternative with the
lowest weighted average is then chosen.
 Equally Likely (Laplace)

• One criterion that uses all the payoffs for each alternative is
the equally likely, also called Laplace, decision criterion.
• Equally likely criterion uses the average outcome.
• This involves finding the average payoff for each alternative,
and selecting the alternative with the best or highest average.
• The equally likely approach assumes that all probabilities of
occurrence for the states of nature are equal, and thus each
state of nature is equally likely.
• In using the equally likely criterion for minimization
problems, the calculations are exactly the same, but the best
alternative is the one with the lowest average payoff.
 Minimax Regret

• Minimax regret criterion is based on opportunity loss.

• Opportunity loss refers to the difference between the
optimal profit or payoff for a given state of nature and
the actual payoff received for a particular decision.
• In other words, it’s the amount lost by not picking the
best alternative in a given state of nature.
• The decision maker might experience regret after the
decision has been made . Thus the decision maker
would attempt to minimize regret before selecting a
particular alternative (strategy).
Q1(3-16).Kenneth Brown is the principal owner of Brown Oil,Inc. After
quitting his university teaching job, Ken has been able to increase his
annual salary by a factor of over 100. At the present time, Ken is forced to
consider purchasing some more equipment for Brown Oil because of
competition. His alternatives are shown in the following table: For
example, if Ken purchases a Sub 100 and if there is a favourable market,
he will realize a profit of $300,000. On the other hand, if the market is
unfavourable, Ken will suffer a loss of $200,000. But Ken has always been
a very optimistic decision maker.
(a) What type of decision is Ken facing?
(b) What decision criterion should he use?
(c) What alternative is best?
Equipm Favourable Favourable Maximu
ent market market m

Sub 100 300,000 -200,000 300,000 Maxi max

OilverJ 250,000 -100,000 250,000

Texan 75,000 -18,000 75,000

Q2. (3-17)
Although Ken Brown (discussed in Problem 1)
is the principal owner of Brown Oil, his
brother Bob is credited with making the
company a financial success. Bob is vice
president of finance. Bob attributes his success
to his pessimistic attitude about business and
the oil industry. Given the information from
Problem 3-16, it is likely that Bob will arrive
at a different decision. What decision criterion
should Bob use, and what alternative will he
select?
Equipm Favourable Favourable Minimum
ent market market

Sub 100 300,000 -200,000 -200,000

OilverJ 250,000 -100,000 -100,000

Texan 75,000 -18,000 -18,000 Maxi min

Q3. Even though independent gasoline stations have been having a difficult time,
Susan Solomon has been thinking about starting her own independent gasoline
station. Susan’s problem is to decide how large her station should be. The
annual returns will depend on both the size of her station and a number of
marketing factors related to the oil industry and demand for gasoline. After a
careful analysis, Susan developed the following table: For example, if Susan
constructs a small station and the market is good, she will realize a profit of
$50,000.(a) Develop a decision table for this decision.
(b) What is the maximax decision?
(c) What is the maximin decision?
(d) What is the equally likely decision?

(e) What is the criterion of realism decision? Use an value of 0.8.

(f) Develop an opportunity loss table.
(g) What is the minimax regret decision?
State of Good Fair Poor Maximum Minimum Equally α= 0.8
nature→ Market Market Market likely
Alternati
ves↓
Small 50,000 20,000 -10,000 50,000 -10,000 20,000 38000
Maximin
Medium 80,000 30,000 -20,000 80,000 -20,000 30,000 60,000

Large 100,000 30,000 -40,000 100,000 -40,000 30,000 72,000

Very 300,000 25,000 -160,000 300,000 -160,000 55,000 208000

Large Maximax Maximu Maximu
m m
Q4.A firm manufactures three types of products. The fixed and
variable costs are given below:
Fixed cost(Rs) Variable cost per
unit (Rs)
Product A 25,000 12
Product B 35,000 9
Product C 53,000 7

The likely demand (units) of the products is given below:

Poor Demand 3,000

Moderate Demand 7,000
High Demand 11,000

If the sale price of each type of product is Rs. 25, then prepare the
payoff matrix.
Solution 4:
Let D1,D2,D3 be the poor , moderate and high demand,
respectively.
The payoff will be:
Payoff = sales revenue- cost

Product type Alternative Demand (in ‘000 Rs)

D1(Poor demand) D2(Moderate demand) D3( High demand)

A 3x25-(25+3x12) =14 7x25-(25+7x12)= 66

B 3x25-(35+3x9)=13 7x25-(35+7x9)= 77

C 3x25-(53+3x7)=1 7x25-(53+7x7)= 73
Q5. The following matrix gives the payoff (in Rs.) of different strategies
(alternatives) S1,S2,S3 against conditions (events)N1,N2,N3 and N4indiacate
the decision taken under the following approaches (i) pessimistic (ii)
optimistic (iii) equal probability (iv) regret (v) Hurwicz criterion , the
degree of optimism being 0.7
Strategy State of Nature
N1 N2 N3 N4
S1 4,000 -100 6,000 18,000
S2 20,000 5,000 400 0
S3 20,000 15,000 -2,000 1,000
 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.
• the most popular methods of making decisions under
risk is selecting the alternative with the highest
expected monetary value (or simply expected value).
• the probabilities are used with the opportunity loss
table to minimize the expected opportunity loss.
 Expected Monetary Value

• EMV is the weighted sum of possible payoffs for each

alternative.
• EMV (alternative)= (payoff first state of nature)* (probability
of first state of nature)
+ (payoff in second state of nature) * (probability of second
state of nature) + ...+(payoff in last state of nature)*
(probability of last state of nature)
• The alternative with the maximum EMV is then chosen.
• When using the expected monetary value criterion with
minimization problems, the calculations are the same, but the
alternative with the smallest EMV is selected.
Q6.Mr. Fleet flies quite often from town A to town B.
He can use the airport bus which costs Rs. 25 but if
he takes it, there is a 0.08 chance that he will miss the
flight. The stay in hotel cost Rs 270 with a .96 chance
of being on time for the flight . For Rs. 350 he can
use a taxi which will make 99per cent chance of
being on time for the flight. If Mr. Fleet catches the
plane on time, he will conclude a business transaction
that will produce a profit of Rs. 10,000, otherwise he
will lose it . Which mode of transport should Mr.
Fleet use? Answer on the basis of the MV criterion.
Q7.The probability demand for hiring cars on any day
in a given city is as follows:
No. Of 0 1 2 3 4
Cars
demanded

Probability 0.1 0.2 0.3 0.2 0.2

cars have a fixed cost of Rs. 90 each day to keep the

daily hire charges (variable costs of running) Rs. 200.
if the car- hire company owns 4 cars, what is its daily
expectations? If the company is about to go into
business and currently has no cars, how many car
should it buy?
 Expected Opportunity Loss
• An alternative approach to maximizing EMV is to
minimize expected opportunity loss (EOL).
• EOL is the cost of not picking the best solution.
• First, an opportunity loss table is constructed.
• Then the EOL is computed for each alternative by
multiplying the opportunity loss by the probability and
adding these together.
• 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
Expected Value of Perfect Information (EVPI)

• Average or expected value of the decision if the decision

maker knew what would happen ahead of time. he has
perfect knowledge.
• EVPI places an upper bound on what to pay for
information.
• 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). EVPI = EVwPI - Best EMV
• Thus, the EVPI is the improvement in EMV that results
from having perfect information.
 Expected value with perfect information
(EVPI or EVwPI)
• 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.
• EVwPI = ∑(best payoff in state of nature i)(probability
of state of nature i)
Q8.Maria Rojas is considering the possibility of opening a small
dress shop on Fairbanks Avenue, a few blocks from the university.
She has located a good mall that attracts students. Her options are
to open a small shop, a medium-sized shop, or no shop at all. The
market for a dress shop can be good, average, or bad. The
probabilities for these three possibilities are 0.2 for a good market,
0.5 for an average market, and 0.3 for a bad market. The net profit
or loss for the medium-sized and small shops for the various
market conditions are given in the following table. Building no
shop at all yields no loss and no gain.
a. What do you recommend?
b. Calculate the EVPI.
c. Develop the opportunity loss table for this situation. What
decisions would be made using the minimax regret criterion and
the minimum EOL criterion?
Solution
a. Since the decision-making environment is risk (probabilities are known), it is
appropriate to use the EMV criterion.

here, the best decision is to build the medium-sized shop. The EMV for this
alternative is $19,500.
b. EVwPI = (0.2)$100,000 + (0.5)$35,000 +
(0.3)$0 = $37,500.
EVPI = $37,500 - $19,500 = $18,000
c. The opportunity loss table is shown here
• The minimax regret criterion considers the
maximum regret for each decision, and the decision
corresponding to the minimum of these is selected.
The decision would be to build a small shop since
the maximum regret for this is 40,000, while the
maximum regret for each of the other two
alternatives is higher as shown in the opportunity
loss table.
• The decision based on the EOL criterion would be
to build the medium shop. Note that the minimum
• EOL ($18,000) is the same as the EVPI computed
in part b.
Q9. Mickey Lawson is considering investing some money
that he inherited. The following payoff table gives the
profits that would be realized during the next year for
each of three investment alternatives Mickey is
considering:

(a) What decision would maximize expected profits?

(b) What is the maximum amount that should be paid for a
perfect forecast of the economy?
Solution (a)

(b) EVPI= {0.5(80000)+ 0.5(23000)} - 30000 =

21500
Q10.Develop an opportunity loss table for the
investment problem that Mickey Lawson faces
in Problem 9.What decision would minimize
the expected opportunity loss? What is the
minimum EOL?
Solution:

Minimum EOL = 21500

 Sensitivity Analysis
• Sensitivity analysis investigates how our decision might
change with different input data.
• Sensitivity analysis can be used to determine how changes
to the following inputs affect the recommended decision
alternative:
– 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.
 DECISION TREE ANALYSIS
• One of the for representing a diagrammatic
presentation of sequential and multi dimensional
aspects of a particular decision problem for
systematic analysis and evaluation is ‘decision tree’-
whereby the decision problem, alternative courses of
action, states of nature and the likely outcomes of
alternatives are diagrammatically or graphically
depicted as if they are branches and sub branches of
horizontal tree.
• Any problem that can be presented in a decision table can also be
graphically illustrated in a decision tree. All decision trees are
similar in that they contain decision points or decision
nodes and state-of-nature points or state-of-nature nodes:
1. A decision node from which one of several alternatives may be
chosen
2. A state-of-nature node out of which one state of nature will occur
• In drawing the tree, we begin at the left and move to the right.
Thus, the tree presents the decisions and outcomes in sequential
order.
• Lines or branches from the squares (decision nodes) represent
alternatives, and branches from the circles represent the states of
nature. The next step is to put the payoffs and probabilities on the
tree and begin the analysis.
 Five Steps of Decision Tree Analysis

1. Define the problem.

2. Structure or draw the decision tree.
3. Assign probabilities to the states of nature.
4. Estimate payoffs for each possible combination of
alternatives and states of nature.
5. Solve the problem by computing expected monetary values
(EMVs) for each state of nature node. This is done by
working backward, that is, starting at the right of the tree and
working back to decision nodes on the left. Also, at each
decision node, the alternative with the best EMV is selected.
 Advantages of Decision Tree
1. It is useful for portraying the inter-related , sequential and multi
dimensional aspects of any major decision problem within the systems
framework.
2. The decision maker will be position to visualize the entire complex of the
problem in all its dimensions as also the actual processes and stages for
arriving at the final choice.
3. Focuses attention on critical elements.
4. Enable the decision maker to seethe various elements of his problem in
content and in a systematic way.
5. Multi-dimensional decision sequence can be strung on a decision tree
without conceptual difficulties.
6. This can be applied in various fields such as introduction of a new
product, marketing strategy, make vs. buy decision, pricing assets
acquisition investment decisions etc
 Two types of nodes are used:
• Decision node is represented by a square □ and the
state of nature( chance or future event)node
represented by a circle ○.
• Alternative course of action (strategies ) originate
from the decision node as main branch (Decision
branches) .At the end of each decision branch , there
is a state of nature node from which emanate chance
events in the form of sub branches (chance branches)
• Expected Value of Sample Information (EVSI) The increase in
EMV that results from having sample or imperfect information.
• When we like to know what the actual value of doing a survey is.
One way of measuring the value of market information is to
compute the expected value of sample information (EVSI) which
is the increase in expected value resulting from the sample
information.
• The expected value with sample information (EV with SI) is found
from the decision tree, and the cost of the sample information is
added to this since this was subtracted from all the payoffs before
the EV with SI was calculated.
• The expected value without sample information (EV without SI) is
then subtracted from this to find the value of the sample
information.
• EVSI = (EV with SI + cost) – (EV without SI)
Q7Monica Britt has enjoyed sailing small boats since she was 7 years old, when her mother
started sailing with her. Today, Monica is considering the possibility of starting a
company to produce small sailboats for the recreational market. Unlike other mass-
produced sailboats, however, these boats will be hmade specifically for children between
the ages of 10 and 15. The boats will be of the highest quality and extremely stable, and
the sail size will be reduced to prevent problems of capsizing. Her basic decision is
whether to build a large manufacturing facility, a small manufacturing facility,or no
facility at all. With a favorable market, Monica can expect to make $90,000 from the
large facility or $60,000 from the smaller facility. If the market is unfavorable, however,
Monica estimates that she would lose $30,000 with a large facility, and she would lose
only $20,000 with the small facility. Because of the expense involved in developing the
initial molds and acquiring the necessary equipment to produce fiberglass sailboats for
young children, Monica has decided to conduct a pilot study to make sure that the
market for the sailboats will be adequate. She estimates that the pilot study will cost her
$10,000. Furthermore, the pilot study can be either favorable or unfavorable. Monica
estimates that the probability of a favorable market given a favorable pilot study is 0.8.
The probability of an unfavorable market given an unfavorable pilot study result is
estimated to be 0.9. Monicafeels that there is a 0.65 chance that the pilot study will be
favorable. Of course, Monica could bypass the pilot study and simply make the decision
as to whether to build a large plant, small plant, or no facility at all. Without doing any
testing in a pilot study, she estimates that the probability of a favorable market is 0.6.
What do you recommend? Compute the EVSI.
Q.11 You are given the following estimates consisting a research and
development programme:

Decision Di Probabilit Outcomes Probabilit Payoff

y of Number y of value of
decision Di Outcomes Outcomes
given xi Given Di Xi (Rs.’000)
research R P(xi ǀ Di)
P(Di ǀ R)
Develop 0.5 1 0.6 600
2 0.3 -100
3 0.1 0
Do Not 0.5 1 0 600
Develop 2 0 -100
3 1 0

Construct and evaluate the decision tree diagram for the above data.
Represent workings for evaluation.
1.In decision theory terminology, a course of action or a
strategy that may be chosen by a decision maker is
called
a. a payoff.
b. an alternative.
c. a state of nature.
d. none of the above.
2. In decision theory, probabilities are associated with
a. payoffs.
b. alternatives.
c. states of nature.
d. none of the above.
3. If probabilities are available to the decision maker,
then the decision-making environment is called
a. certainty.
b. uncertainty.
c. risk.
d. none of the above.
4. Which of the following is a decision-making criterion
that is used for decision making under risk?
a. expected monetary value criterion
b. Hurwicz criterion (criterion of realism)
c. optimistic (maximax) criterion
d. equally likely criterion
5. The minimum expected opportunity loss
a. is equal to the highest expected payoff.
b. is greater than the expected value with perfect information.
c. is equal to the expected value of perfect information.
d. is computed when finding the minimax regret decision.

6. In using the criterion of realism (Hurwicz criterion), the

coefficient of realism (α )
a. is the probability of a good state of nature.
b. describes the degree of optimism of the decision maker.
c. describes the degree of pessimism of the decision maker.
d. is usually less than zero.
7. The most that a person should pay for perfect
information is
a. the EVPI.
b. the maximum EMV minus the minimum EMV.
c. the maximum EOL.
d. the maximum EMV.
8. The minimum EOL criterion will always result in the
same decision as
a. the maximax criterion.
b. the minimax regret criterion.
c. the maximum EMV criterion.
d. the equally likely criterion.
9. A decision tree is preferable to a decision table when
a. a number of sequential decisions are to be made.
b. probabilities are available.
c. the maximax criterion is used.
d. the objective is to maximize regret.
10. Bayes’ theorem is used to revise probabilities. The
new (revised) probabilities are called
a. prior probabilities.
b. sample probabilities.
c. survey probabilities.
d. posterior probabilities.