Single stage vs.

Multi stage:

Introduction:

A process which results in the section from a set of alternative courses of action, that course of the action which is considered to meet the objectives of the decision problem more satisfactorily then others as judged by the decision maker. The process of logical and quantitative analysis of all factors that influences the decision problem assists the decisionmaker in analysing these problems with several courses of action and consequences. Decision theory provides an analytical and systematically approach to study of decision making. It provides a method of nature decision-making wherein data concerning the occurrence outcomes may be evaluated to enable the decision-maker to identify the suitable alternative (course of action). According to the functional cycles of management, the managerial activity as a whole includes five phases or life processes which are planning, organisation, direction, supervision and control. In performing all of these activities the management has to face several such situations where they have to make a choice of the best among a number of alternative courses of action. This choice making is technically termed as decision making or decision taking. A decision is simply a selection from two or more courses of action. Decision making permeates all management activities. It is essential for the setting objective, deciding the basic corporate policies, preparing future product and other major plans or proposals that will have an important long-run influence on the future profits and assets requirements of the enterprise. Decision analysis is whether to make the needed decision immediately or to first do some testing (at some expense) to reduce the level of uncertainty about the outcome of the decision. Decision analysis divides decision making between the case of without experimentation and with experimentation.

Steps in decision theory approach: The decision-making process involves the following steps: I. Identify and define the problem. II. Listing of all possible future events, called states of nature, which can occur in the context of the decision problem. Such events are not under the control of decision-maker because these are erratic in nature III.Identification of all the courses of action (alternation or decision choices) which are available to the decision-maker. The decision maker has control over these courses of action.
IV.

Expressing the payoff (pij) resulting from each pair of courses of action and states of nature. These payoffs are normally expressed in a monetary value.

V. Apply an appropriate mathematical decision theory to select the best course of action from the given list on the basis of some criterion that results in the optimal (desired) payoff.

TYPES OF DECISION MAKING ENVIRONMENTS: Basically decision analysis is divided into two types. (a) Single stage,(b) Multi stage. Decisions are made based upon the data available about the occurrence of events as well as the decision situation (or environment). There are three types of single stage decision environment: certainty, uncertainty and risk. The multistage decision is decision tree.

DECISION MAKING WITH EXPERIMENTATION: In this case the decision-maker has the complete knowledge (perfects information) of consequence of every decision choice (course of action or alternative) with certainty. Obviously, he will select an alternative that yields the largest return (payoff) for the known future (state of nature).For example, the decision to purchase either N.S.C (National Saving Certificate); Indira Vikas Patra, or deposit in N.S.S (National Saving Scheme) is one in which it is reasonable to assume complete information about the future because there is no

doubt that the Indian government will pay the interest when it is due and the principal at maturity. In this decision-model, only one possible state of nature (future) exists.

The various techniques used for solving problem under certainty are: (a)System of equations, (b) Linear programming, (c) Integer programming, (d) Dynamic programming, (e) Queuing models, (f) Inventory models, DECISION MAKING WITHOUT EXPERIMENTATION: In the absence of knowledge about the probability of any state of nature (future) occurring, the decision-maker must arrive at a decision only on the actual conditional payoff values, together with a policy (attitude). That is, there is no historical data available or no relative frequency which could indicate the probability of the occurrence of the particular state of nature. In the other words the decision-maker has no way to calculating the expected payoff for his courses of action or strategies. Such situations arise when a new product is introduced in the market or a new plant is set up. There are certain essential characteristics which are common to all as listed below: Decision alternatives: There is a finite number of decision alternatives available with the decisionmaker at each point in the time when a decision made. The number and type of such alternatives may depend on the previous decision is made and on what has happened subsequent to those decisions. These alternatives are also called course action (actions, acts, strategies) and are under control and known to the decision-maker.

State of nature: A possible future condition resulting from the choice of a decision alternative depends upon certain factors beyond the control of decision-maker. These factors are called states of nature (future).The state of nature mutually exclusive and collectively exhaustive with respect to any decision problem.

 Pay off: A numerical value resulting from each possible combination of alternatives and states of nature is called payoff. The payoff values are always condition values because of unknown states of nature. If the consequences or condition of the outcome do not become completely certain even when the state of nature is given, then the payoff become an expected value of the measure of consequences. A payoff table commonly is used to provide the payoff for each combination of an action and a state of nature.

The numbers of different criteria available under the condition of uncertainty are given below: The maximin payoff criterion The maximum likelihood criterion Bayes Decision Rule

The maximin payoff criterion: For each possible decision alternative, find minimum payoff over all possible states of nature. Next, find the maximum of these minimum payoffs. Choose the alternative whose minimum payoff gives this maximum. The Maximum Likelihood criterion: Indentify the most likely state of nature (the one with the largest prior probability). For this state of nature, find the decision alternative with the maximum payoff. Choose this decision alternative.

Bayes Decision Rule: Using the best available estimates of the probabilities of the respective states of nature (currently the prior probabilities), calculate the expected value of the payoff for each of the possible decision alternatives. Choose the decision alternative with the maximum expected payoff. A case: The company owns a tract of land that may contain oil. A consulting geologist has reported to management that she believes that is 1 chance in 4 of oil. Because of this prospect, another oil company has offered to purchase the land for $90,000. However, the company considering holding the land in order to drill for oil itself. The cost of drilling is $100,000.If oil is found, the resulting expected revenue will be $800,000.So the companys expected profit will be $700,000. A loss of $100,000 (drilling cost) will be incurred if the land is dry (no oil). Description: Now we summarize these data in below table. Status of land or alternative

State of nature

Oil Drill for oil sell the lend Sell the land Chance of status

Dry $700,000 $90,000 1 in 4 (1/4) -$100,000 $90,000 3 in 4 (3/4)

Prospective profit for the company:

Now using the Maximin payoff criterion in the below table. Thus, since the minimum payoff for selling ($90,000) is larger than for drilling ($-100,000).The principle for this criterion is that provides the best guarantee of the payoff that will be obtained. So, in this example the payoff from selling the land cannot be less than $90,000, which provides the best available guarantee. In this criterion, we found that it quite valid when one is competing a rational. Nature is not a malevolent opponent, and the decision maker does not need to focus only on the worst possible payoff from each alternative. This is especially true when the worst possible payoff from an alternative comes a relatively unlikely state of nature. Thus, this criterion normally is of interest only to a very cautious decision maker.

Application of the maximum payoff criterion to the company problem Drill for oil sell the lend $700,000 -$100,000 -$100,000 Sell the land $90,000 $90,000 $90,000 Prior probability $.25 $.75

Status of land or alternative State of nature Oil Dry

Application of the maximum likelihood criterion to the company Drill for oil sell the lend -$100,000Sell the land Prior probability $90,000 $.25

Maximum Maximum in this column This table indicates that Dry state has the largest prior probability. In the Dry column, the sell

alternative has the maximum payoff, so the choice is to sell the land. The appeal of this criterion is that the most important state of nature is most likely one, so the alternative chosen is the best one for this particularly important state of nature. It does not rely on questionable subjective estimates of probabilities of the respective states of nature other than identifying the most likely state. The major drawback of the criterion is that it completely ignores much relevant information. No state of nature is considered other than the most likely one. In a problem with any possible states of nature, the probability of the nature likely one may be quite small, so focusing on just this one state of nature is quite unwarranted. Again consider the example, where the prior probability of dry state is

0.75, this criterion ignores extremely attractive payoff of 700 if the company drills and finds oil.

Status of land or alternative

Drill for oil sell the lend Sell the land Prior probability

$700,000 $90,000 0.25

-$100,000 $90,000 0.75

Application of Bayes Decision Rule in the company

For the prototype example, these expected payoffs are calculated directly from above table as follows: E[Payoff (oil)] = 0.25($700,000) + 0.75(-$100,000) = $100,000 E[payoff (sell)]= 0.25($90,000) + 0.75($90,000) = $90,000 Since $100,000 is larger than $90,000, the alternative selected is to drill for oil. The best advantage of the Bayess decision rules is it incorporate wills the available information including all the payoff and the best available estimates of the probability of the respective states of nature.

DECISION MAKING UNDER RISK:

Decision making under risk is a probabilistic decision situation, in which more than one state of nature exists and the decisionmaker has sufficient information to assign probability values to the likely occurrence of each of these states. Here probabilities could be assigned to the future events by reference to similar previous experience and information. Sometimes past experience or past records often enable the decision-maker to assign probability values to the likely possible occurrence of each state of nature. Knowing the probability distribution of the states of nature, the best decision is to select that course of action which has the largest expected payoff value. The most widely used criterion for evaluating various courses of action (alternatives) under risk is the Expected Monetary Value (EMV) or Expected Utility. Expected Monetary Value (EMV): The expected monetary value (EMV) for a given course of action is the weighted average payoff, which is the sum of the payoffs for each of action multiplied by the probabilities associated with each state of nature. The objective of decision-making here is to optimize the expected payoff, which may mean either maximization of expected profit or minimization of expected regret. Mathematically EMV is stated as follows: EMV (Course of action, sj) = i=0npij pi Where n=number of possible states of nature Pi=Probability of occurrence of state of nature i Pij=Payoff associated with state of nature Ni and course of action, sj Steps for calculating EMV: Construct payoff table listing all possible courses of action and states of nature. List the conditional payoff values associated with each possible combination of course of action and state of nature along with the corresponding probabilities of the occurrence of each state of nature.

 Calculate the EVM for each course of action by multiplying the condition payoffs by the associated probabilities and add these weighted values for each course of action. Select the course of action that yields the optimal EMV.

Expected Opportunity Loss (EOL): An alternative approach to maximizing expected monetary value (EMV) is to minimize the expected opportunity loss (EOL), also called expected value of regret. The EOL is defined as the difference the highest profit (or payoff) for a state of nature and the actual profit obtained for the particular course of action taken. In the other words, EOL is the amount of payoff that is lost by not selecting the course of action that has the greatest payoff for the state of nature that actually occurs. The course of action due to which EOL is minimum is recommended. Expected opportunity loss or expected value of regrets is calculated in the same manner as the EMV. Mathematically, it is stated as follows: EOL (state of nature, Ni) = i=1mlij pi Where lij= opportunity loss due to state of nature, Ni and course of action, Si Pi= probability of occurrence of state of nature, Ni.

Steps for calculating EOL: Prepare a condition profit table for each course of action and state of nature combination along with the associated probabilities. For each state of nature calculate the condition opportunity loss (COL) values by subtracting each payoff from the maximum payoff for that outcome. Calculate EOL for each course of action by multiplying the probability of each state of nature with the COL value and then adding the values.

 Select a course of action for which the EOL value is minimum. Expected Value of Perfect Information (EVPI): 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. In order 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. Mathematically it is stated as ECPI= Expected profit (or value) with perfect information under certainty -Expected profit without perfect information = i=1mpij Nipi-EMV* DECISION TREE: Decision-making problem discussed so far are referred to as single stage decision problems, because the payoffs, states of nature, course of action and probabilities associated with the occurrence of states of nature are not subject to change. However, situations may arise when a decision-maker needs to revise his previous decisions on getting new information and make a sequence of other decisions. Thus, the problem becomes a multi-stage decision problem because the consequence of one decision affects the future decisions. Decision trees provide a useful way of visually displaying the problem and then organizing the computational work. These trees are especially helpful when a sequence of decisions must be made. A decision tree consists of network of nodes, branches, probability estimates and pay-offs. There two types of nodes: decision node and event node (or chance node).A decision node represented by a square and indicates places where a decision-maker must make a decision. Each branch leading away from a decision node is represents one of the several possible courses of action available to the decision-maker.the chance node is represents by a circle and indicates a point at which the decision-maker will discover the response to his decision, i.e. different possible outcomes occurred from a chosen course of action.

There are two types of branches: decision branches and chance branches. Each branches leading away from a decision node represents a course of action that can be chosen at a decision point, where as a branch leading away from a chance node or event node represents the states of nature of a set chance factors. Associated probabilities are indicated along side of respective chance branch. Any branch that makes the end of the decision tree, i.e. it is not followed by either a decision or a chance outcome, is called a terminal node. It can represent either a course of action or a chance outcome. The payoffs can be positive (i.e. revenue or sales) or negative (i.e. expenditure or cost) and they can be associated either with decision or chance branches. Rules and conventions for drawing a decision tree: Indentify all decisions (and their alternatives) to be made and order in which they must be made. Indentify the chance events or state of nature that might occur as a result of each decision alternative. Develop a tree diagram showing the sequence of decisions and chance events. The tree is constructed starting from left and moving towards right. Estimate probabilities that possible events or states of nature will occur as a result of decision alternatives. Obtain outcomes of the possible interactions among decision alternatives and events. Calculate the expected value of all possible decision alternatives. Select the decision alternative (or course of action ) offering yhe most attractive expected value.

A case: The company owns a tract of land that may contain oil. A consulting geologist has reported to management that she believes that is 1 chance in 4 of oil. Because of this prospect, another oil company has offered to purchase the land for $90,000. However, the company considering holding the land in order to

drill for oil itself. The cost of drilling is $100,000.If oil is found, the resulting expected revenue will be $800,000.So the companys expected profit will be $700,000. A loss of $100,000 (drilling cost) will be incurred if the land is dry (no oil). An available option before making a decision is to conduct a detailed seismic survey of the land to obtain a better estimate of the probability of oil. The cost (seismic survey price) is $30,000. Informations are: unfavourable seismic sounding (oil is fairly unlike) 0.7, favourable seismic sounding (oil is fairly like) 0.3, oil (unfavourable dill) = 0.143, dry (unfavourable dry) = 0.257 Description: Drill
C

800 Oil (0.143)

F

670

0 Dry (0.857) -130 90 60 670

-100 Sell

Unfavourable (0.7)

800 Oil (0.5) -30 Seismic survey

A B

Drill
D

Favourable (0.3)

-100 Sell

0 Dry (0.5) -130 90 60 800 Oil (0.25)

700 Drill No seismic survey -100 0 Sell 90 90 -100

E H

0 Dry (0.75)

In this figure, the first decision is represented by decision node A. Node B is an event node representing the random event of outcome of the seismic survey. The two branches emanating from event node B represent the two possible outcomes of survey. Next comes the 2nd decision nodes (C, D, and E) with its two possible

choices. If the decision is to drill for oil, then we come to another event node (nodes F, G, and H), where its two branches correspond to the possible states of nature. Note that the path followed from node A to reach any terminal branch (expect the bottom one) is determined both by decision made and by random events that are outside the control of the decision maker. The next step in constructing the decision tree is to insert numbers into the tree as shown in above figure.

Performing analysis: Now we are ready to analyze the problem by using the following procedure 1. Start at the right side of the decision tree and move left one column at time. For each column, perform either step 2 or step 3 depending upon whether the nodes in that column are event nodes or decision nodes. 2. For each event node, calculate its expected payoff by multiplying the expected payoff of each branch by the probability of the branch and then summing these products. Record this expected payoff for each decision node, designate this quantity as also being the expected payoff for the branch leading to this node. 3. For each decision node, compare the expected payoffs of the branches and choose the alternative whose branch has the largest expected payoff. In each case, record the choice on the decision tree by inserting a double dash as a barrier through each rejected branch.

800 Oil (0.143) 670

B -15.7

Drill
C

0 Dry (0.857) -130 90

G 270

-100 Sell 670

Unfavourable (0.7)
B 123

60

60

800 Oil (0.5) -30 Seismic survey (0.3)

A 123

Drill 0
D

Favourable Dry (0.5) -130 Sell 90 700

-100

60 800 Oil (0.25) Drill

H 100

No seismic survey (0.75) -100 0

-100
E 100

0 Dry

Sell

90

90

Applying step 2 to the event nodes F, G, and H, their expected payoffs re calculated EP (F) = 0.143(670) + 0.857(-130) = -15.7 EP (G) = 0.5(670) + 0.5(-130) = 270 EP (H) = 0.25(700) + 0.75(-100) = 100 Next, we move one column to the left, which consists of decision nodes C, D, E. Therefore, step 3 can be applied as follows. Node C: drill alternative has EP = -15.7

Sell alternative has EP = 60 60 > -15.7 So, choose the sell alternative. Node D: drill alternative has EP = 270 Sell alternative has EP = 60 60 < 270 So, choose the drill alternative. Node E: drill alternative has EP = 100 Sell alternative has EP = 90 100 > 90 So, choose the drill alternative. Now, applying step 2 to node B EP (B) = 0.7(60) + 0.3(270) = 123 Finally, we move left node A, a decision node. Applying step 3 yields Node A: do seismic survey has EP = 123 No seismic survey has EP = 100 123 > 100, so choose seismic survey. Following the open paths from left to right in the above figure yield the following optimal policy: Do the seismic survey. If the result is unfavourable, sell the land. If the result is favourable, drill the oil. The expected payoff is $123,000.

Advantage decision tree: Decision tree diagram is useful for portraying the inter-related, sequential, and multi-dimensional aspects of any major decision-problem within the systems framework. Focuses attention on the critical elements in a decision problem in a decision problem over the duration of its solution, apart from bringing to light the relationship between the presently available course of action and the network of future events. Decision tree device is especially useful in cases where an initial decision and its outcome affects the subsequent decisions and where the decision maker has to make a sequence of decisions on major decision-problem.

Enable the decision-maker to see the various elements of his problem in content and in systematic way.

Obvious advantage of decision tree structure is that complex managerial problems and decision of a chain-like nature can be systematically and explicitly defined and evaluated.

Limitation of decision tree: The decision tree will be complicated as the decision alternative increases and more variables are introduced. It assumes that utility of money is linear with money. Changes of in consistence in assigning probability for different events.

REFERENCES:

Books: Operations Research (J K Sharma) Operations Research (v. K. Kapoor) Operations Research (Hillier & Lieberman)