2008 Prentice-Hall, Inc.

Chapter 3
To accompany
Quantitative Analysis for Management, Tenth Edition,
by Render, Stair, and Hanna
Power Point slides created by Jeff Heyl
Decision Analysis
2009 Prentice-Hall, Inc.
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Chapter Outline
3.1 Introduction
3.2 The Six Steps in Decision Making
3.3 Types of Decision-Making
Environments
3.4 Decision Making under Uncertainty
3.5 Decision Making under Risk
3.6 Decision Trees

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Introduction
Decision theory is an analytic and
systematic approach to the study of
decision making
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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 or 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
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Thompson Lumber Company
Step 1 Define the problem
Expand by manufacturing and
marketing a new product, backyard
storage sheds
Step 2 List alternatives
Construct a large new plant
A small plant
No plant at all
Step 3 Identify possible outcomes
The market could be favorable or
unfavorable
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Thompson Lumber Company
Step 4 List the payoffs
Identify conditional values for the
profits for large, small, and no plants
for the two possible market conditions
Step 5 Select the decision model
Depends on the environment and
amount of risk and uncertainty
Step 6 Apply the model to the data
Solution and analysis used to help the
decision making
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Thompson Lumber Company
STATE OF NATURE
ALTERNATIVE
FAVORABLE
MARKET ($)
UNFAVORABLE
MARKET ($)
Construct a large plant 200,000 180,000
Construct a small plant 100,000 20,000
Do nothing 0 0
Table 3.1
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Types of Decision-Making
Environments
Type 1: Decision making under certainty
Decision maker knows with certainty the
consequences of every alternative or
decision choice
Type 2: Decision making under uncertainty
The decision maker does not know the
probabilities of the various outcomes
Type 3: Decision making under risk
The decision maker knows the
probabilities of the various outcomes
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Decision Making Under
Uncertainty
1. Maximax (optimistic)
2. Maximin (pessimistic)
3. Criterion of realism (Hurwicz)
4. Equally likely (Laplace)
5. Minimax regret
There are several criteria for making decisions
under uncertainty
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Maximax
Used to find the alternative that maximizes
the maximum payoff
Locate the maximum payoff for each alternative
Select the alternative with the maximum
number
STATE OF NATURE
ALTERNATIVE
FAVORABLE
MARKET ($)
UNFAVORABLE
MARKET ($)
MAXIMUM IN
A ROW ($)
Construct a large
plant
200,000 180,000 200,000
Construct a small
plant
100,000 20,000 100,000
Do nothing 0 0 0
Table 3.2
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Maximax
Used to find the alternative that maximizes
the maximum payoff
Locate the maximum payoff for each alternative
Select the alternative with the maximum
number
STATE OF NATURE
ALTERNATIVE
FAVORABLE
MARKET ($)
UNFAVORABLE
MARKET ($)
MAXIMUM IN
A ROW ($)
Construct a large
plant
200,000 180,000 200,000
Construct a small
plant
100,000 20,000 100,000
Do nothing 0 0 0
Table 3.2
Maximax
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Maximin
Used to find the alternative that maximizes
the minimum payoff
Locate the minimum payoff for each alternative
Select the alternative with the maximum
number
STATE OF NATURE
ALTERNATIVE
FAVORABLE
MARKET ($)
UNFAVORABLE
MARKET ($)
MINIMUM IN
A ROW ($)
Construct a large
plant
200,000 180,000 180,000
Construct a small
plant
100,000 20,000 20,000
Do nothing 0 0 0
Table 3.3
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Maximin
Used to find the alternative that maximizes
the minimum payoff
Locate the minimum payoff for each alternative
Select the alternative with the maximum
number
STATE OF NATURE
ALTERNATIVE
FAVORABLE
MARKET ($)
UNFAVORABLE
MARKET ($)
MINIMUM IN
A ROW ($)
Construct a large
plant
200,000 180,000 180,000
Construct a small
plant
100,000 20,000 20,000
Do nothing 0 0 0
Table 3.3
Maximin
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Criterion of Realism (Hurwicz)
A weighted average compromise between
optimistic and pessimistic
Select a coefficient of realism
Coefficient is between 0 and 1
A value of 1 is 100% optimistic
Compute the weighted averages for each
alternative
Select the alternative with the highest value
Weighted average = (maximum in row)
+ (1 )(minimum in row)
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Criterion of Realism (Hurwicz)
For the large plant alternative using = 0.8
(0.8)(200,000) + (1 0.8)(180,000) = 124,000
For the small plant alternative using = 0.8
(0.8)(100,000) + (1 0.8)(20,000) = 76,000
STATE OF NATURE
ALTERNATIVE
FAVORABLE
MARKET ($)
UNFAVORABLE
MARKET ($)
CRITERION
OF REALISM
( = 0.8)$
Construct a large
plant
200,000 180,000 124,000
Construct a small
plant
100,000 20,000 76,000
Do nothing 0 0 0
Table 3.4
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Criterion of Realism (Hurwicz)
For the large plant alternative using = 0.8
(0.8)(200,000) + (1 0.8)(180,000) = 124,000
For the small plant alternative using = 0.8
(0.8)(100,000) + (1 0.8)(20,000) = 76,000
STATE OF NATURE
ALTERNATIVE
FAVORABLE
MARKET ($)
UNFAVORABLE
MARKET ($)
CRITERION
OF REALISM
( = 0.8)$
Construct a large
plant
200,000 180,000 124,000
Construct a small
plant
100,000 20,000 76,000
Do nothing 0 0 0
Table 3.4
Realism
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Equally Likely (Laplace)
Considers all the payoffs for each alternative
Find the average payoff for each alternative
Select the alternative with the highest average
STATE OF NATURE
ALTERNATIVE
FAVORABLE
MARKET ($)
UNFAVORABLE
MARKET ($)
ROW
AVERAGE ($)
Construct a large
plant
200,000 180,000 10,000
Construct a small
plant
100,000 20,000 40,000
Do nothing 0 0 0
Table 3.5
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Equally Likely (Laplace)
Considers all the payoffs for each alternative
Find the average payoff for each alternative
Select the alternative with the highest average
STATE OF NATURE
ALTERNATIVE
FAVORABLE
MARKET ($)
UNFAVORABLE
MARKET ($)
ROW
AVERAGE ($)
Construct a large
plant
200,000 180,000 10,000
Construct a small
plant
100,000 20,000 40,000
Do nothing 0 0 0
Table 3.5
Equally likely
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Minimax Regret
Based on opportunity loss or regret, the
difference between the optimal profit and
actual payoff for a decision
Create an opportunity loss table by determining
the opportunity loss for not choosing the best
alternative
Opportunity loss is calculated by subtracting
each payoff in the column from the best payoff
in the column
Find the maximum opportunity loss for each
alternative and pick the alternative with the
minimum number
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Thompson Lumber Company
STATE OF NATURE
ALTERNATIVE
FAVORABLE
MARKET ($)
UNFAVORABLE
MARKET ($)
Construct a large plant 200,000 180,000
Construct a small plant 100,000 20,000
Do nothing 0 0
Table 3.1
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Minimax Regret
STATE OF NATURE
FAVORABLE
MARKET ($)
UNFAVORABLE
MARKET ($)
200,000 200,000 0 (180,000)
200,000 100,000 0 (20,000)
200,000 0 0 0
Table 3.6
Table 3.7
STATE OF NATURE
ALTERNATIVE
FAVORABLE
MARKET ($)
UNFAVORABLE
MARKET ($)
Construct a large plant 0 180,000
Construct a small plant 100,000 20,000
Do nothing 200,000 0
Opportunity
Loss Tables
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Minimax Regret
Table 3.8
STATE OF NATURE
ALTERNATIVE
FAVORABLE
MARKET ($)
UNFAVORABLE
MARKET ($)
MAXIMUM IN
A ROW ($)
Construct a large
plant
0 180,000 180,000
Construct a small
plant
100,000 20,000 100,000
Do nothing 200,000 0 200,000
Minimax
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Example 1
1. Maximax (optimistic)
2. Maximin (pessimistic)
3. Criterion of realism (Hurwicz)
4. Equally likely (Laplace)
5. Minimax regret
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Payoff Table
Possible Future
Demand
Alternatives Low Moderate High
Small facility $10 $10 $10
Medium facility 7 12 12
Large Facility (4) 2 16
5S-24
Student Slides
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Example 2
1. Maximax (optimistic)
2. Maximin (pessimistic)
3. Criterion of realism (Hurwicz)
4. Equally likely (Laplace)
5. Minimax regret
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Example 2
Possible Future
Demand
Alternatives for
new store
New Bridge
Built
No New
Bridge
A (Small) 1 14
B (Medium) 2 10
C (Large) 4 6
5S-26
Student Slides
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Types of Decision-Making
Environments
Type 1: Decision making under certainty
Decision maker knows with certainty the
consequences of every alternative or
decision choice
Type 2: Decision making under uncertainty
The decision maker does not know the
probabilities of the various outcomes
Type 3: Decision making under risk
The decision maker knows the
probabilities of the various outcomes
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Decision Making Under Risk
Decision making when there are several possible
states of nature and we know the probabilities
associated with each possible state
Most popular method is to choose the alternative
with the highest expected monetary value (EMV)

EMV (alternative i) = (payoff of first state of nature)
x (probability of first state of nature)
+ (payoff of second state of nature)
x (probability of second state of nature)
+ + (payoff of last state of nature)
x (probability of last state of nature)

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STATE OF NATURE
ALTERNATIVE
FAVORABLE
MARKET ($)
UNFAVORABLE
MARKET ($)
Construct a large plant 200,000 180,000
Construct a small plant 100,000 20,000
Do nothing 0 0
Each market has a probability of 0.50
Which alternative would give the highest EMV?
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EMV for Thompson Lumber
Each market has a probability of 0.50
Which alternative would give the highest EMV?
The calculations are
EMV (large plant) = (0.50)($200,000) + (0.50)($180,000)
= $10,000
EMV (small plant) = (0.50)($100,000) + (0.50)($20,000)
= $40,000
EMV (do nothing) = (0.50)($0) + (0.50)($0)
= $0
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EMV for Thompson Lumber
STATE OF NATURE
ALTERNATIVE
FAVORABLE
MARKET ($)
UNFAVORABLE
MARKET ($) EMV ($)
Construct a large
plant
200,000 180,000 10,000
Construct a small
plant
100,000 20,000 40,000
Do nothing 0 0 0
Probabilities 0.50 0.50
Table 3.9
Largest EMV
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STATE OF NATURE
ALTERNATIVE
FAVORABLE
MARKET ($)
UNFAVORABLE
MARKET ($)
Construct a large plant 200,000 180,000
Construct a small plant 100,000 20,000
Do nothing 0 0
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Expected Opportunity Loss
Expected opportunity loss (EOL) is the
cost of not picking the best solution
First construct an opportunity loss table
For each alternative, multiply the
opportunity loss by the probability of that
loss for each possible outcome and add
these together
Minimum EOL will always result in the
same decision as maximum EMV
Minimum EOL will always equal EVPI
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STATE OF NATURE
ALTERNATIVE
FAVORABLE
MARKET ($)
UNFAVORABLE
MARKET ($)
Construct a large plant 200,000 180,000
Construct a small plant 100,000 20,000
Do nothing 0 0
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Expected Opportunity Loss
EOL (large plant) = (0.50)($0) + (0.50)($180,000)
= $90,000
EOL (small plant) = (0.50)($100,000) + (0.50)($20,000)
= $60,000
EOL (do nothing) = (0.50)($200,000) + (0.50)($0)
= $100,000
Table 3.10
STATE OF NATURE
ALTERNATIVE
FAVORABLE
MARKET ($)
UNFAVORABLE
MARKET ($) EOL
Construct a large plant 0 180,000 90,000
Construct a small
plant
100,000 20,000 60,000
Do nothing 200,000 0 100,000
Probabilities 0.50 0.50
Minimum EOL
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Example 3
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Payoff Table
Possible Future
Demand
Alternatives Low
0.3
Moderate
0.5
High
0.2
Small facility $10 $10 $10
Medium facility 7 12 12
Large Facility (4) 2 16
5S-37
Student Slides
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Example 4
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Example 4
Possible Future
Demand
Alternatives for
new store
New Bridge
Built (0.7)
No New
Bridge (0.3)
A (Small) 1 14
B (Medium) 2 10
C (Large) 4 6
5S-39
Student Slides
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Examples from the Text

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Decision Theory Models
Decision theory problems are
generally represented as one of the
following:
Payoff Table
Decision Tree
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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, time, distance or any
other appropriate measure.
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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.
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Example: CAL Condominium
Complex
A developer must decide how large a
luxury condominium complex to build
small, medium, or large. The profitability
of this complex depends upon the future
level of demand for the complexs
condominiums.

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CAL Condos: Payoff Table

Alternatives
Low High
Small 8 8
Medium 5 15
Large -11 22
States of Nature
(payoffs in millions)
THIS IS A PROFIT PAYOFF TABLE
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CAL Condos: Decision Tree
Medium Complex
8
8
5
1
5
2
2
-
1
1
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Example: Burger Prince
Burger Prince Restaurant is
contemplating opening a new
restaurant on Main Street. It has
three different models, each with a
different seating capacity. Burger
Prince estimates that the average
number of customers per hour will
be 80, 100, or 120. The payoff table
(profits) for the three models is on
the next slide.
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Example: Burger Prince
Payoff Table

Average Number of Customers Per Hour
s
1
= 80 s
2
= 100 s
3
= 120

Model A $10,000 $15,000 $14,000
Model B $ 8,000 $18,000 $12,000
Model C $ 6,000 $16,000 $21,000


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Example: Burger Prince
Expected Value Approach
Calculate the expected value for
each decision. The decision tree on
the next slide can assist in this
calculation. Here d
1
, d
2
, d
3
represent
the decision alternatives of models
A, B, C, and s
1
, s
2
, s
3
represent the
states of nature of 80, 100, and 120.
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Example: Burger Prince
Decision Tree
1
.2
.4
.4
.4
.2
.4
.4
.2
.4
d
1
d
2
d
3
s
1
s
1
s
1
s
2
s
3
s
2
s
2
s
3
s
3
Payoffs
10,000
15,000
14,000
8,000
18,000
12,000
6,000
16,000
21,000
2
3
4
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Example: Burger Prince
Expected Value For Each Decision









Choose the model with largest EV, Model C.
3
d
1
d
2
d
3
EMV = .4(10,000) + .2(15,000) + .4(14,000)
= $12,600
EMV = .4(8,000) + .2(18,000) + .4(12,000)
= $11,600
EMV = .4(6,000) + .2(16,000) + .4(21,000)
= $14,000
Model A
Model B
Model C
2
1
4
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Example

STATES OF NATURE
Alternatives Low (0.35) High (0.65)

Small 8 8
Medium 5 15
Large -11 22