4th Edition

N. D. Vohra

Quantitative Techniques in Management

2010

Chapter 13

1. Decision Analysis 2. Pay-off Table and Opportunity Loss, or Regret Table 3. Decision Rules
a) Decisions Under Uncertainty
Laplace Principle Maximin or Minimax Principle Maximax or Minimin Principle Hurwicz Principle Savage Principle

b) Decisions Under Risk

Maximum Likelihood Principle Expectation Principle Expected Opportunity Loss or Expected Regret EPPI and EVPI

(continued)
4. Special Topics 5. Bayesian Decision Rule : Posterior Analysis EVSI 6. Decision Trees
a) Decisions Under Uncertainty b) Decision and Chance Nodes c) Rollback Method

5. Dual of the Transportation Problem 6. Utility Theory

Utility as a Basis of DecisionMaking Assumptions of Analysis Utility Functions Expected Utility

Decision process calls for:

1.

Identification of states of nature, or events Identification of courses of action, or acts Determination of the pay-offs, depicting outcomes of various combinations of acts and events (pay-offs resulting from various actevent combinations can be either gains/losses or costs) Choosing, on the basis of some criterion, from among different alternatives

2.

3.

4.

A conditional pay-off table is set up either using given detailed information or through an algebraically expressed pay-off function A conditional regret matrix can also be set up as follows: When pay-offs are represented as gains: For every event, consider each act one by one and find excess of largest pay-off (coming from optimal act) over pay-off from the act in consideration When pay-offs are represented as costs: For every event, consider each act one by one and find excess of pay-off from the act in consideration over the smallest pay-off (coming from optimal act)

A toy company is bringing out a new type of toy. The company is attempting to decide whether to bring out a full, partial or minimal product line. The company has three levels of product acceptance. The management will make its decision on the basis of anticipated profit from the first year of production. The relevant data are shown in the following table:
Anticipated First Year Profit (in '000 Rs)
Demand High Medium Low Level of Production

Full
180 110 -70

Partial
110 90 -40

Minimal
60 30 10

The given matrix is a conditional pay-off matrix. The levels of demand are the states of nature as they are not in control of manager, while levels of production are the possible courses of action. Profits/losses resulting from various combinations are the pay-offs. Mark the largest value in each row, and subtract each value of the row from it. It gives the regret values.
Conditional Regret Matrix
Demand High Medium Low

Level of Production
Full
0 0 80

Partial
70 20 50

Minimal
120 80 0

Decisions under Uncertainty

Laplace Principle: assumes equal likelihood of various states of nature Maximin (or Minimax in case of pay-offs as cost) Principle: pessimists criterion considers best of the worst Maximax (or Minimin in case of pay-offs as cost) Principle: optimists criterion considers best of the best

Hurwicz Principle: uses decision-makers degree of optimism

Savage Principle: uses minimum of the maximum regret values of various acts

Demand High

Level of Production

Full
180

Partial
110

Minimal
60

Medium
Low Average Minimum Maximum Hurwicz ( = 0.6)

110
-70 80 -70 180 80

90
-40 53.3 -40 110 50

30
10 33.3 10 60 40

(continued)
S. No.
1 2

Criterion
Laplace Maximin

Decision
Full Production Minimal Production

3
4 5

Maximax
Hurwicz ( = 0.6) Minimax Regret

Full Production
Full Production Partial Production

Demand High Medium Low Maximum Regret

Level of Production Full

0 0 80 80

Partial
70 20 50 70

Minimal
120 80 0 120

Decisions under Risk

Maximum likelihood principle: for event with highest probability, choose the act with best pay-off Expectation principle: choose the act with best expected pay-off (highest in case of gains and lowest in case of costs) Expected regret principle: choose the act with lowest expected regret value; decision identical to one under expectation principle

EVPI: Expected Value of Perfect Information

EVPI = Expected regret with optimal course of action. Also, In case of gains as pay-offs:
EVPI = EPPI minus Expected pay-off under optimal action EPPI = Expected Pay-off under Perfect Information

In case of costs as pay-offs:

EVPI = Expected pay-off under optimal action minus ECPI ECPI = Expected Cost under Perfect Information

(continued)
Suppose the probabilities of high, medium and low demands are 0.2, 0.3 and 0.5 respectively Maximum likelihood is for low demand. The best pay-off is for minimal prod production.
Decision is: Minimal Production

Expected Pay-off:
Full Production: 34 Partial Production: 29 Minimal Production: 26

Optimal Decision

Expected Regret:
Full Production: 40 Partial Production: 45 Minimal Production: 48

Note that the decision on the basis of expected pay-off criterion is same as on the basis of expected regret. It is in fact always so

Expected Pay-off Information

under

Perfect
= 74

(EPPI) = 0.2180+0.3110+0.510 (thousand rupees)

Expected Value of Perfect Information

EVPI = EPPI Expected Pay-off of Optimal Policy = 74 34 = 40 (thousand rupees)

(continued)
For every course of action, note that Expected Pay-off + Expected Regret = EPPI For Partial Production: 29 + 45 = 74 For Minimal Production: 26 + 48 = 74 Maximisation of Expected Pay-off obviously leads to minimisation of Expected Regret

Uses additional given information in taking decisions Using given information, prior probabilities are revised and posterior probabilities calculated

Decision taken probabilities

using

posterior

Expected Value of Sample Information,

EVSI = Expected pay-off with given information minus Expected pay-off without given information

Efficiency of EVSI = {EVSI/EVPI}100

Used where sequential decisionmaking is involved

Decision trees are drawn taking appropriate decision nodes (where decision-maker has control) and chance nodes (where decisionmaker has no control) Optimal sequence of decisions is determined by rolling back technique and using the expected value criterion

Decision Node 1
Water, 0.2 Drill Up to 25 m No Water Drill 20 m 0.3 Stop Rs 25,000 Water 0.7 Rs 10,000 Rs 12,500 No Water Rs 27,500

Decision Node 2

Buy Water Rs 15,000 Rs 15,000 + Rs 10,000 = Rs 25,000

Decision Tree for Example 13.19

Decision Node

Options

Expected Cost
0.8(15,000 +12,500) + 0.212,500 = Rs 24,500 Rs 25,000 0.324,500+ 0.710,000 = Rs 14,350 Rs 15,000

Decision

Drill to 25 m

Stop 2 Drill to 20 m Do not Drill

Optimal Decision: Drill up to 20 m, if no water, then drill up to 25 m

Uses utility as basis of decisionmaking rather than monetary values with the notion that people have different utility for money Utility is measured in arbitrarily defined units, called utils For a given decision-maker, utility function is defined which depicts utility to him/her for various monetary values Uses the criterion of expected utility for taking decisions

Mark the incorrect statement:

1. Decision theory provides an analytic framework for decisionmaking under conditions of uncertainty. 2. A decision problem must have alternative courses of action. 3. The actions and events both are under control of the decisionmaker. 4. Events are also called states of nature.

Mark the correct statement:

1. Each value in a pay-off table is conditional in the sense that that it is associated with the adoption of a certain strategy and happening of a particular event. 2. A decision-making situation with 5 possible states of nature and 6 courses of action will involve a total of 11 possible pay-offs.

3. A conditional pay-off table always involves profits.

4. Every decision-making situation involves an equal number of courses of actions and events.

A vendor buys a weekly magazine for Rs. 8 and sells for Rs. 12. Any quantity unsold at the weekend can be sold at Re 1 per copy. For this problem, assuming P is the profit, D is the demand and S is the stock, which of the following is not true?
1. P = 4S when D S.
2. P = 12S 8D when D < S.

3. P = 4D 7(S D) when D < S.

4. P = 11D 7S when D < S.

Mark the wrong statement:

1. In developing a pay-off matrix, the listing of courses of action and possible outcomes (events) must be distinct, mutually exclusive and collectively exhaustive. 2. Total number of courses of action cannot be more than the number of events.

3. Opportunity loss for an action is the amount of pay-off foregone by not adopting the optimal course of action. 4. Opportunity loss is also called regret.

Mark the correct statement:

1. In decisions under uncertainty, the decision-maker has no idea about the possible states of nature and their probabilities. 2. Laplace principle is based on the premise that in the absence of specific information, all events be treated equally likely. 3. Minimin choice. principle is pessimists

4. Opportunity loss for an event-action combination may be negative, positive or zero.

Which of these is not correct?

1. Hurwicz principle uses an index of optimism for taking a decision. 2. For a given strategy in a profit maximising problem, Hurwicz criterion = Maximum profit + (1 ) Minimum profit. 3. For a profit maximising decision problem, the minimax principle involves choosing minimum of the maximum pay-offs, since a pessimist adopts such a policy. 4. Savage principle uses the concept of regret.

Mark the correct statement:

1. Under expectation principle, the expected pay-offs for each of the states of nature are calculated for taking decision. 2. For a given problem, the decisions under expected cost principle and expected regret principle would be different. 3. Decision on expected regret basis underlies the Savage principle. 4. For any strategy, the expected regret value refers to the summation of the products of regret values and the corresponding probabilities.

Choose the wrong statement:

1. EPPI is the summation of the product of the payoff corresponding to optimal policy in every event and the probability of the event.
2. EVPI cannot exceed EPPI. 3. ECPI is the expected cost under perfect information. 4. EPPI is equal to the expected regret corresponding to optimal course of action.

Mark the wrong statement:

1. In Bayesian approach, the optimal strategy is chosen on the basis of expected value criterion using posterior probabilities. 2. Posterior probabilities are calculated from prior probabilities with the help of conditional and joint probabilities. 3. Posterior probabilities are obtained as ratio of joint probabilities and total probability. 4. The sum of prior probabilities, conditional probabilities and posterior probabilities has each to be equal to one.

Mark the correct statement:

1. EVSI is expected value of strategic information. 2. Efficiency of EVSI = (EVSI / EPPI) 100. 3. EVSI is the difference between expected payoffs with and without sample information. 4. Higher the value of EVSI in relation to EVPI, lower the efficiency of sample information.

Choose the wrong statement about decision-trees:

1. They are used where sequential decision-making is involved. 2. This approach uses expectation principle for decision-making. 3. The decision is reached by rollback technique. 4. The rollback technique involves rolling the tree from left to right.

Mark the wrong statement:

1. As a basis of decision-making, utility approach uses expected utility.

2. Utility function provides a scale for converting monetary values into utils. 3. Utility approach to decisionmaking is objective in nature.
4. Utility function must possess the property of completeness.

Mark the wrong statement:

1. A util is an imaginary unit.
2. The utility function of a riskneutral decision-maker is linear. 3. A risk-seeker has increasing marginal utility of money. 4. For a given problem, the decision under EMV and EU criteria would always be identical.

Mark the incorrect statement:

1. If U(0) = 0 and U(10) = 5, then a bet with outcomes of zero and 10 with probabilities 0.3 and 0.7 respectively has expected utility equal to 3.5. 2. A utility function always ranges between zero and 100. 3. The utility approach to decisionmaking assumes that if an individual indifferent between two alternatives A1 and A2, then A1 and A2 have equal utility for him. 4. Von Neumann and Morgenstern provided the concept of index for measurement of utility.

Mark the correct statement:

1. Maximum likelihood and expectation principles deal with decision-making under risk. 2. Expected regret criterion leads to same decision as the expected payoff criterion in a given situation. 3. The probabilities of various outcomes at each chance node of a decision tree may or may not add to 1. 4. A utility function holds for a particular individual in a given situation only.