lecture decision making

Lecture 2 Decision Making

Prepared by: Dr D.K.Hurreeram August 04

Importance of Decision Making Decision Making: The Steps 1. Specify objectives and the criteria for making the decision (cost, profits, return on

investment, increased productivity, risk, company image, demand etc…)

2. Develop alternatives (brainstorm if possible, creativity, teamwork)

3. Analyse and compare alternatives (use statistical techniques if needed)

4. Select the best alternative

5. Implement the chosen alternative (invest, approve applications, authorise

overtime…)

6. Monitor the results to ensure that desired results are achieved

Decision Environments 1. Certainty (variables have known values e.g. cost, production capacity, demand of

product)

2. Risk (certain variables have probabilistic outcomes)

3. Uncertainty (impossible to assess the likelihood of future events)

Example

Profit per unit is $5, you have a demand of 200

Profit per unit is $5, there is 50% chance of an order of 100 and 50% chance

of an order of 200 units

Profit per unit is $5, probabilities for potential demand is unknown

Decision Theory 1. A set of future conditions exist that will have a bearing on the results of the

decision

2. A list of alternatives is available to choose from

3. There is a known payoff for each alternative under possible future condition

The Process 1. Identify the future conditions (demand low, medium, high) known as the states

of nature



2. Develop the list of alternatives (a course of action or strategy that may be

chosen by a decision maker)

3. Determine or estimate the payoff associated with each alternative (The

Expected Monetary Value for an alternative is the sum of possible payoffs

from the alternative, each weighted by the probability of that payoff occurring).

4. Estimate the likelihood of each possible future condition

5. Evaluate alternatives according to some decision criterion (max. profit, reduce

cost etc…)

Example

Table shows expected payoff for each alternative under the various possible states

of nature.

Possible Future Demand ($ present value) Alternatives

Low Moderate High

Small facility 10 10 10

Medium facility 7 12 12

Large facility (4) 2 16

Select one alternative

Under Certainty

� Choose the alternative that has the best payoff under that state of nature

Under Uncertainty

� Maximin: Determine the worst possible payoff for each alternative, and

choose the alternative that has the 'best worst': pessimistic view

� Maximax: Detemine the best possible payoff of each alternative, and

choose the alternative that has the best payoff: optimistic view

� Laplace: Determine the average payoff for each alternative, and choose

the alternative with the best average.

� Minimax Regret: Determine the worst regret for each alternative and

choose the alternative with the ‘best worst’.



Under Risk

� The probability of occurrence of each state of nature is known.

� Use the Expected Monetary Value Criterion (EMV): sum of the payoffs of

an alternative where each payoff is weighted by the probability for the

relevant state of nature

� E.g. probability of low, moderate and high demand is 0.3, 0.5 and 0.2

respectively, which alternative would be best?

Decision Trees* A schematic representation of the alternatives available to a decision maker and

their possible consequences (useful for sequential decisions)

A decision node from which one or several alternatives may be selected

A state of nature out of which one state of nature will occur

Using Decision Trees

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 decision alternatives and

states of nature

5. Solve the problem by computing expected monetary value (EMV) for each

state of nature node. This is done by working backward – that is, by starting at

the right of the tree and working back to decision nodes on the left.

Example

ABC company is investigating the possibility of producing and marketing mouse

pads. Undertaking the project would require the construction of either a large or

small manufacturing plant. The market for the product would be favourable or

unfavourable. The company can of course decide not to produce the product at all.

Construct the decision tree for this project



With a favourable market, a large facility will give ABC a net profit of Rs200000. If

the market is unfavourable a net loss of Rs180000 will occur. A small plant will result

in a net profit of Rs100000 in a favourable market and a net loss of Rs20000 in a

unfavorable market.

Construct the payoff table and decide on the best alternative under minimax,

maximax and Laplace criterion (UNCERTAINTY)

Given that the probability of a fovourable market is the same as that of an

unfavourable market, what do you think should be the best decision? (RISK)

A marketing research team proposes to tell ABC with certainty whether or not the

market is favourable for the proposed product. The cost for the research is Rs65000.

What do you recommend to ABC? How much should ABC pay for the research?

ABC decides to conduct a survey for the sum of Rs10000 instead of subcontracting

the research. The probability that the survey results are favourable is 0.45 and 0.55

for unfavourable…Discuss

Expected Value for Perfect Information (EVPI): upper limit on the amount the decision maker will be willing to spend to obtain perfect information on the issue.

EVPI = EMVcertainty - Maximum EMVrisk

Example

An oil company has recently acquired right in a certain area to conduct surveys and

test drillings to lead to lifting oil if it is found in commercially exploitable quantities.

The area is considered to have good potential for finding oil in commercial quantities.

At the outset the company has the choice to conduct further geological tests or to

carryout a drilling programme immediately. On the known conditions, the company

estimates that there is a 70:30 chance of further tests showing a success.

Whether the tests show the possibility of ultimate success or not or even if no tests

are undertaken at all, the company could still pursue its drilling programme or

alternatively consider selling its rights to drill in the area. Thereafter, however, if it



carries out the drilling programme, the likelihood of final success or failure is

considered dependent on the foregoing stages. Thus:

If successful tests have been carried out, the expectation of success in drilling is

given as 80:20

If the tests indicate failure, then the expectation of success in drilling is 20:80.

If no tests have been carried out the expectation of success in drilling is 55:45.

Costs and revenues have been estimated for all possible outcomes and the net

present value of each is as follows:-

Outcome NPV (Rs Million) Success

� With prior test � Without prior test

100 120

Failure � With prior test � Without prior test

-50 -40

Sale of exploitation rights � Prior test show success � Prior test show failure � Without prior test

65 15 45

lecture decision making

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