Quantitative

Decision Making
Decision Analysis
This document will tell you the decision analysis. That how and in
which situations we can make decisions and what are the
methods by which we can take decision based on.
Document Outline:
Introduction
Six Steps in Decision Making
Types ! Decision Making "nvironments
Decision Making #nder #ncertainty
Decision Making #nder $isk
Sensitivity Analysis
%&'&
(hawa)a *aveed
+aider
#niversity ! Management and Technology, -ahore .akistan
Sunday, /ebruary &0, %&'&
QUANTITATIVE DECISION
MAKING
Introduction To Decision Analysis:
Decision making is very important part in any kind o! business. To take
decision isn1t a big deal but to take the right decision on particular time with
complete alternatives and !acts and !igures is important. So here I would like
to discuss the 2Decision Analysis3 in the context o! Quantitative Decision
Making, a part o! statistical techni4ue in the business.
5e have the six steps in decision making.
'. 6learly de!ine the problem
%. -ist all the possible alternatives
7. Identi!y all the possible outcomes or states o! nature
8. -ist the payo!!s or pro!its in !ront o! each alternatives
9. Select one mathematical decision theory model
:. Apply the model
Eam!le Question:
Ali wants to establish the !actory in .akistan. +e has two outcomes or states
o! nature which are !avorable market and un!avorable market. +e can either
establish last !actory, small !actory or he won1t go !or the !actory that means
do nothing. I! he establishes a large !actory, he could earn pro!it o! .($
%&&,&&& or loose .($ ';&,&&& in un!avorable market. I! he establishes the
small !actory, he could earn .($ '&&,&&& in !avorable market. +e could lose
.($ %&,&&& in un!avorable market. *ow the purpose o! establishing the
!actory is to earn maximum pro!it.
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*ow i! we shape the above example in a tabular !orm, we will get this kind o!
table as given below.
STATES O" NATU#E
A$TE#NATIVES
"AVO#A%$E MA#KET
&'K#(
UN"AVO#A%$E
MA#KET &'K#(
ESTA%$IS) $A#GE
"ACTO#*
%&&,&&& >';&,&&&
ESTA%$IS) SMA$$
"ACTO#*
'&&,&&& >%&,&&&
DO NOT)ING & &
Ty!es o+ decision ma,in- en.ironment:
5e can make decisions in three environments.
'. Decision Making #nder 6ertainty ?We already know@
%. Decision Making #nder #ncertainty ?Probability is not given@
7. Decision Making #nder $isk ?Probability is given@
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Decision Ma,in- Under Certainty:
In this environment, we already know what is best !or us. 5e know the
alternatives and results and we choose the best naturally. -ike i! I have
'&&,&&& $upees and I want to invest, then I would like to open a bank1s
saving account which will give me more interest. -ike I have the options o!
9A annually, '&A annually and '%A annually. So I would automatically and
naturally choose '%A.
Decision Ma,in- Under Uncertainty:
In this environment, probability is not given. So we have the !ive situations
under which we can make decisions.
'. Maximax
%. Maximin
7. 6riterion o! $ealism
8. "4ually -ikely
9. Minimax $egret
-et1s discuss the Maximax !irst.
Maima:
5e usually use the optimistic or positive thinking approach here. 5e will
choose which will give us maximum payo!!.
-et1s have a look to the table that we have constructed be!ore discussing the
environments.
States O+ Nature
Alternati.es "a.ora/le
Mar,et
Un+a.ora/le
Mar,et
Maimum in a
#o0
Esta/lis1 $ar-e
"actory
%&&,&&& >';&,&&& 2334333
Esta/lis1 Small
"actory
'&&,&&& >%&,&&& 5334333
Do Not1in- & & 3
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I! we are taking decision under Maximax, we will go !or establishing a large
!actory because the payo!! o! the large !actory is higher among all the
payo!!s o! alternatives. So the shaded part is the answer.
Maimin:
Maximin is the totally opposite to the Maximax. In this environment, we take
the pessimistic approach. In this scenario, we will take the lowest payo!!
which will be like decreasing the risk !actor. 5e will see the value which will
be minimum in a row. *ow take the above table.
States O+ Nature
Alternati.es "a.ora/le
Mar,et
Un+a.ora/le
Mar,et
Minimum in a
#o0
Esta/lis1 $ar-e
"actory
%&&,&&& >';&,&&& 2334333
Esta/lis1 Small
"actory
'&&,&&& >%&,&&& 5334333
Do Not1in- & & 3
I! we look at the above table, we will come to know that we will not establish
the !actory or you can say do nothing. The lowest value in a row is & that is
kind o! minimum risk.
Criterion O+ #ealism:
In this situation, we are given the percentage o! either pessimistic or
optimistic. -ike a 4uestion may contain that the person is ;&A optimistic. So
the probability will be &.;& and &.%&. &.;& o! optimistic and &.%& o!
pessimistic. 5e have to complete the ' or '&&A like &.;&B&.%&C'
States O+ Nature
Alternati.es "a.ora/le
Mar,et
Un+a.ora/le
Mar,et
Criterion O+
#ealism
Esta/lis1 $ar-e
"actory
%&&,&&& >';&,&&& 5264333
Esta/lis1 Small
"actory
'&&,&&& >%&,&&& 784333
Do Not1in- & & 3
5e can also call criterion o! realism as 5eighted Average. The !ormula o!
calculating weighted average is given below.
9ei-1ted A.era-e C D ?Maximum in a row@ B ?'>D@ ?Minimum in a row@
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C &.;&?%&&,&&&@ B ?'>&.%&@?>';&&&&@
C '%8,&&&
Note: the value o! D will be given to you.
In this pattern, we will take the higher realism value among all the
alternatives. In this table we will take '%8,&&&. That means we will establish
the large !actory.
E:ually $i,ely &$a!lace(:
"4ually likely criterion uses the average outcome. ne criterion that uses all
the payo!!s !or each alternative is e4ually likely. It is also called -aplace
decision criterion. This involves !inding the average payo!! !or each
alternative and selective the alternative with the highest average. The
e4ually likely approach assumes that all probabilities o! occurrence !or the
states o! nature are e4ual and thus each state o! nature is e4ually likely.
States O+ Nature
Alternati.es "a.ora/le
Mar,et
Un+a.ora/le
Mar,et
Criterion O+
#ealism
Esta/lis1 $ar-e
"actory
%&&,&&& >';&,&&& 534333
Esta/lis1 Small
"actory
'&&,&&& >%&,&&& 634333
Do Not1in- & & 3
In the above table, we will take the average o! each alternative like !or large
!actory, we will add %&&,&&& and >';&,&&& and divide it on %, we will get
'&,&&&. Same is !or small !actory. A!ter getting all the values, we will see that
the highest average is o! establishing a small !actory which has the value
rupees 8&,&&&. So our decision will be establishing a small !actory.
Minima #e-ret:
This criterion is based on opportunity loss. 5e will discuss and draw the
opportunity loss table. pportunity loss re!ers to the di!!erence between the
optimal pro!it or payo!! !or a given state o! nature and the actual payo!!
received !or a particular decision. In other words, it is the amount lost by not
picking the best alternative in a given outcome.
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O!!ortunity $oss Ta/le
States ! *ature
"a.ora/le
Mar,et
Un+a.ora/le
Mar,et
%&&,&&& >
%&&,&&& & > ?>';&,&&&@
%&&,&&& >
'&&,&&& & > ?>%&,&&&@
%&&,&&& > & & > &
States O+ Nature
Alternati.es
"a.ora/le
Mar,et
Un+a.ora/le
Mar,et
Maimum in a
#o0
Esta/lis1 $ar-e
"actory & ';&,&&& 5;34333
Esta/lis1 Small
"actory '&&,&&& %&,&&& 5334333
Do Not1in- %&&,&&& & 2334333
+ere the minimum value o! 2Maximum in a $ow3 is '&&,&&& so our minimax
is '&&,&&&. That means we will go !or establishing a small !actory. It is
because o! minimiEing the maximum opportunity loss.
*ow we have completed the entire decision making criterion !or decision
making under uncertainty.
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Decision Ma,in- Under #is,:
In decision making under risk, I have already mentioned that we are given
the probabilities. That means we are aware o! success or !ailure o! decision to
some extent. 5e select the alternative with the highest expected value. 5e
also use the probabilities with the opportunity loss table to minimiEe the
expected opportunity loss. In decision making under risk, we will discuss
about "xpected Monetary Falue, "xpected Falue ! .er!ect In!ormation, and
"xpected pportunity -oss.
E!ected Monetary Value:
The "MF means the long run average value o! that decision. The "MF !or an
alternative is )ust the sum o! possible payo!!s o! the alternatives, each
weighted by the probability o! that payo!! occurring the expected value
material.
5e can calculate "MF with the !ollowing !ormula.
"MF ?alternative i@ C ?.ayo!! o! !irst state o! nature@ G ?probability o! !irst
state o! nature@ B ?.ayo!! o! second state o! nature@ G ?probability o! second
state o! nature@ B H..?.ayo!! o! i state o! nature@ G ?probability o! i state o!
nature@
*ow let1s calculate the "MF o! every alternative. The probability is given that
is &.9
"MF ?-arge /actory@ C ?&.9@ ?%&&,&&&@ B ?&.9@ ?>';&,&&& @ C
'&,&&&
"MF ?Small /actory@ C ?&.9@ ?'&&,&&&@ B ?&.9@ ?>%&,&&&@
C8&,&&&
"MF ?Do *othing@ C ?&.9@ ?&@ B ?&.9@ ?&@ C &
*ow we can put these values in the table.
States O+ Nature
Alternati.es "a.ora/le
Mar,et
Un+a.ora/le
Mar,et
EMV
Esta/lis1 $ar-e
"actory
%&&,&&& >';&,&&& 534333
Esta/lis1 Small
"actory
'&&,&&& >%&,&&& 634333
Do Not1in- & & 3
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'ro/a/ilities &.9 &.9
The largest value o! "MF is o! small !actory. So Ali needs to go and establish
a small !actory. The long run average o! small !actory is high.
E!ected Value O+ 'er+ect In+ormation &EV'I(:
Ali wants to produce another product and he is not aware o! real market
situation. Ali was suggested by the scienti!ic marketing company to avail
their services which will tell the whole scenario a!ter conducting the survey
that whether is it good !or Ali to produce another product or not according to
market situationI The !irm is charging :9,&&& rupees. The term "F.I is used
to check the worth o! the in!ormation that the !irm is giving in a particular
amount.
The !ormula !or "F.I=
"F.I C expected value with per!ect in!ormation J maximum "MF
*ow here comes another 4uestion that what the hell "xpected Falue 5ith
.er!ect In!ormation isI So here is the !ormula !or "Fw.I.
"Fw.I C ?best payo!! !or !irst state o! nature@ G ?probability o! !irst state o!
nature@ B ?best payo!! !or second state o! nature@ G ?probability o! second
state o! nature@ HH. ?best payo!! !or i state o! nature@ G ?probability o! i state
o! nature@
States O+ Nature
Alternati.es "a.ora/le
Mar,et
Un+a.ora/le
Mar,et
EMV
Esta/lis1 $ar-e
"actory
%&&,&&& >';&,&&& 534333
Esta/lis1 Small
"actory
'&&,&&& >%&,&&& 634333
Do Not1in- & & 3
'ro/a/ilities &.9 &.9
-ook at the table given above. 5e have two states o! nature. ne is !avorable
market and the other one is un!avorable market. The best alternative !or
!avorable market is "stablishing a large !actory with the payo!! o! %&&,&&&.
The best alternative !or un!avorable market is Do *othing with the payo!! o! &
only. Ky using this in!ormation, we can put the values in our "Fw.I !ormula.
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"Fw.I C ?%&&&&&@?&.9@ B ?&@?&.9@ C '&&,&&&
5e have the "Fw.I '&&,&&& rupees. *ow we have also the !ormula o! "F.I
where the value o! "Fw.I is used.
"F.I C "Fw.I J Maximum "MF
C '&&&&& J 8&&&&
C :&,&&&
Thus, Ali would be willing to pay !or per!ect in!ormation is :&,&&& rupees and
the !irm is charging :9,&&& rupees. So Ali won1t go !or the scienti!ic
marketing !irm because the value o! in!ormation is not :9,&&&.
E!ected O!!ortunity $oss:
The alternative approach to maximiEing the "MF is to minimiEe expected
opportunity loss. 5e will construct opportunity loss table !irst. Then the "-
is computed !or each alternative by multiplying the opportunity loss by the
probability and adding these together.
States O+ Nature
Alternati.es "a.ora/le Mar,et Un+a.ora/le Mar,et
Esta/lis1 $ar-e "actory & ';&,&&&
Esta/lis1 Small "actory '&&,&&& %&,&&&
Do Not1in- %&&,&&& &
'ro/a/ilities &.9 &.9
The above table is describing the pportunity -oss Table. *ow we will
calculate the "xpected pportunity -oss !or every alternative.
"- /or -arge /actory C ?&.9@ ?&@ B ?&.9@ ?';&&&&@ C <3333
"- /or Small /actory C ?&.9@ ?'&&,&&&@ B ?&.9@ ?%&,&&&@ C 83333
"- /or Do *othing C ?&.9@ ?%&&,&&&@ B ?&.9@ ?&@ C 533333
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*ow we will again construct the table o! opportunity loss and will put the
values o! "- in !ront o! each alternative.
States O+ Nature
Alternati.es "a.ora/le
Mar,et
Un+a.ora/le
Mar,et
EO$
Esta/lis1 $ar-e
"actory
& ';&,&&& <34333
Esta/lis1 Small
"actory
'&&,&&& %&,&&& 834333
Do Not1in- %&&,&&& & 5334333
+ere we have the results in a tabular !orm. I have already told you that our
decision will be based on the minimum "-. So the choice that Ali will select
is to establish a small !actory as the "xpected pportunity -oss is less than
the "- o! -arge !actory and i! he don1t construct a !actory. ne thing to
remember is that minimum "- will always result in the same decision as
maximum "MF and that the "F.I will always e4ual to minim "-. Mou can
compare the "- o! small !actory with the "F.I that we have calculated. The
values o! both the things are :&,&&& rupees.
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Sensiti.ity Analysis:
In previous pages, we have discussed and demonstrated the best decision
with known probabilities !or Ali was to establish a small !actory with an
expected value o! 8&,&&& rupees. This conclusion depends on the values o!
economic conse4uences and the two probability values o! a !avorable and an
un!avorable market. Sensitivity analysis investigates how our decision might
change given a change in the problem data. In this part, we investigate the
impact that a change in the probability value would have on the decision
!acing Ali. 5e !irst would like to de!ine the 2.3 which is probability o!
!avorable market and 2'>.3 is the probability o! un!avorable market. Kecause
we have only two outcomes or you can say states o! nature.
5e can express the "MF in terms o! . as shown in the !ollowing e4uations. I
will also show it on the graph.
"MF !or large !actory C %&&&&&. J ';&&&&?'>.@
C 7;&&&&. J ';&&&&
"MF !or small !actory C '&&&&&. J %&&&&?'>.@
C '%&&&&. J %&&&&
"MF !or do nothing C &p B &?'>.@
C &
*ow we will de!ine two points. .oint ' will be "MF do nothing C "MF small
!actory, .oint % will be "MF small plant C "MF large plant.
'oint 5: 3 = 523333' > 23333
. C %&&&&N'%&&&& C &.':0
'oint 2: 523333' > 23333 = ?;3333' > 5;3333
%:&&&&. C ':&&&&, . C ':&&&&N%:&&&& C &.:'9
*ow the next work is to put all the data in a tabular !orm.
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%est
Alternati.e
#an-e O+ '
Value
Do *othing -ess than &.':0
Small /actory &.':0 > &.:'9
-arge /actory
Oreater than
&.:'9
+ere we have the tabular !orm o! our analysis. I! the value o! . is less than
&.':0 we will go !or the option o! Do *othing.
*ow it could become easier i! we take this data on the graph.
As you can see in the graph, the best decision is to do nothing as los as . is
between & and the probability associated with point ', where the "MF !or
doing nothing is e4ual to the "MF !or the small !actory. 5hen . is between
the probabilities !or point ' and %, the best decision is to establish small
!actory. .oint % where "MF o! small !actory is e4ual to "MF o! large !actory.
5hen . is greater than probability o! point %, the decision will be establishing
a large !actory.
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#ead Me:
Mou have read the whole document. I have taken
help !rom the notes given by my teacher. The topic
is very important and needs to be very easy so that
students could understand about the decision. So
by the grace o! Allah and my teacher, I tried my
best in making you understand about the topic. At
least I am sure that I have written the whole
document in such a manner that everyone who has
a little sense about the statistical topics can
understand this whole document.
I! you like this document, kindly re!ers to other
students, !riends and to whom it may concern. Do
comment on this document i! I am wrong anywhere
in this document. Do tell me. My email address is
written in the end o! every page.
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