AE 232: Management Science Short-Term

UNIT 11: Decision Analysis 2019-2020

NOTES
DECISION ANALYSIS – is a systematic, quantitative, and visual approach to addressing and evaluating the important choices that
businesses sometimes encounter. This is used by large and small corporation alike when making various types of decision, including
management, operations, marketing, capital investments, or strategic choices.

1. Problem Formulation
Decision analysis is concerned with selecting an option or alternative course of action (the decision) given prior knowledge of
its outcome (called a payoff) for various future scenarios (called states of nature or events). The decision-maker has control
over the process of selecting an alternative course of action, but not over the states of nature, at least not in the short run.
Let's illustrate these terms with an example.
Illustration:
Suppose a manufacturer has three alternative courses of action for the next production period.
d1 - They can make their product
d2 - Buy their product from another manufacturer and sell it to their customers or
d3 - They can do nothing in the next production period
Suppose further that the manufacture has a simple forecast for the next productions period:
s1 - demand will be low
s2 - demand will be high
The final input for the structure of the decision analysis problem is the outcome or payoff resulting from each state of
nature/decision combination. A convenient structure for displaying the decision alternatives, states of nature and payoffs is a
payoff table.
States of Nature
Decision Alternatives s1 - Low Demand s2 -High Demand
d1 - Make Product (20,000) 90,000
d2 - Buy Product 10, 000 70,000
d3 - Do Nothing, 5,000 5,000

The payoff table shows, for example, that making the product leads to a profit of 90,000 should the demand turn out to be
high, or a loss of 20,000 if demand is low. Buying the product shows that the manufacturer can avoid a loss, compared to
making the product, if the demand turns out to be low since the manufacturer avoids paying fixed production costs. If the
demand is high, the manufacturer makes a profit, but not as much as if they made the product since they miss the production
economies of scale. If the manufacturer does nothing, a small profit is earned from selling existing inventory that just meets a
low level of demand. Another way to display the structure of the decision problem is with a decision tree.
PAYOFFS
(20,000)
s1
B 90,000
s2
d1 10,000

s1
A d2 70,000
C
s2

d3 D 5,000

s1
s2 5,000

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In this decision tree, the cell labeled A denotes a decision node, followed by its three decision branches. The cells labeled B, C
and D denote state of nature nodes which are each followed by the two state of nature branches. Payoffs are shown at the
terminal end of each state of nature branch. Structuring the decision problem, as in formulation of all quantitative models,
establishes the first major benefit of these formal methods of decision making. That is, the decision-maker is required to formally
consider many of the important aspects of a decision problem during the problem-structuring phase. These aspects may be
overlooked when the decision-maker uses "gut feel" or some other purely qualitative technique to make decisions. After the
problem is structured, we can now turn to its analysis: selecting one of the possible decision alternatives according to
predetermine selection criteria. There are two major approaches in decision analysis that depend on the availability of
information on the states of nature. One approach is called decision making without probabilities, and the other, decision making
with probabilities.

2. Decision Making without Probabilities

In this approach, the decision-maker has no information concerning the relative likelihood of each of the states of nature. It is
sometimes called "decision making under risk." There are three classic criteria used in decision-making strategies without
probabilities, as described in the next three subsections.

A. Optimistic Criterion (Maximax Strategy)

In this strategy, the decision-maker evaluates each decision alternative in terms of the best payoff that can occur. The strategy is
best illustrated in the payoff table repeated below.
States of Nature MAXIMUM
Decision Alternatives s1 - Low Demand s2 -High Demand PAYOFF
d1 - Make Product (20,000) 90,000 90,000
d2 - Buy Product 10, 000 70,000 70,000
d3 - Do Nothing, 5,000 5,000 5,000

Note that an extra column is added to record the maximum payoff for each decision alternative (maximum payoff in each row of
the table). The decision-maker employing the optimistic criterion then selects the decision alternative associated with
the maximum of the maximum payoffs. Since 90,000 is the maximum of the maximum payoffs, d 1 is the selected decision. The
"eternal optimist" would be one using this approach - it captures the philosophy of decision-makers that accept risk of large
losses to make substantial gains.

B. Conservative Criterion (Maximim Strategy)

In this strategy, the decision-maker evaluates each decision alternative in terms of the worst payoff that can occur. The payoff
table is repeated here with a new column to record the minimum payoffs for each decision alternative (minimum payoff for each
row in the table).
States of Nature MINIMUM
Decision Alternatives s1 - Low Demand s2 -High Demand PAYOFF
d1 - Make Product (20,000) 90,000 (20,000)
d2 - Buy Product 10, 000 70,000 10,000
d3 - Do Nothing, 5,000 5,000 5,000
This strategy selects that decision alternative associated with the maximum of the minimum payoffs. In this situation, the
decision-maker would select d2, buy the product, since 10,000 is the maximum of the minimum payoffs. Some believe this
strategy is associated with "eternal pessimists", but to be fair, it is actually a conservative strategy used by decision-makers who
seek to avoid large losses.

C. Compromise Minimax Regret Strategy (Minimax Regret Strategy)

The third classic strategy for decision making under risk is neither purely optimistic nor conservative. This approach first starts by
converting the payoff table into a regret table. The regret table looks at each state of nature, one at a time, and asks, "if I knew
ahead of time that state of nature s1 will occur, what would I do?" The answer to maximize profit would be, "buy the product
(d2)", since that leads to the highest profit, 10,000. If the decision-maker selected d 2 and s1 occurred, there would be no regret.

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On the other hand, if the decision-maker selected d3, there would be a regret or opportunity loss of 5,000 (10,000 that could
have been gained minus 5,000 that was gained). Similarly, there would be a regret of 30,000 if the decision-maker selected
d1 and state of nature s1 occurred (10,000 that could have been gained minus the minus 20,000 loss). The regret numbers for
s2 are prepared in a similar fashion. "If I knew ahead of time that state of nature s 2 would occur, what would I do?" The answer,
again to maximize profit, is "make the product (d 1)," since that leads to the highest profit for s2, 90,000. If the decision-maker
selected d1 and s2 occurred, there would be no regret. On the other hand, if the decision-maker selected d 2, there would be an
opportunity loss or regret of 20,000 (90,000 that could have been gained minus 70,000 that was gained). Likewise, if the
decision-maker selected d3 there would be a regret of 85,000 (90,000 minus 5,000). Table 1.3.3 illustrates the completed regret
table.
States of Nature MINIMUM
Decision Alternatives s1 - Low Demand s2 -High Demand Regret
d1 - Make Product 30,000 0 30,000
d2 - Buy Product 0 20,000 20,000
d3 - Do Nothing, 5,000 85,000 85,000

Next, create "Maximum Regret," to record the maximum regret value associated with each decision strategy (the maximum
regret in each row of the regret table). Then selects that decision alternative associated with the minimum of the maximum
regrets. In this situation, the decision-maker would select d2, buy the product, since 20,000 is the minimum of the maximum
regrets. Some believe this strategy follows a "middle of the road" approach of minimizing losses.

D. Laplace Method
In this strategy, the decision-maker evaluates each decision alternative in terms of the average payoff. The payoff table is
repeated here with a new column to record the average payoffs for each decision alternative.
States of Nature AVERAGE
Decision Alternatives s1 - Low Demand s2 -High Demand PAYOFF
d1 - Make Product (20,000) 90,000 (-20,000+90,000)/2= 35,000
d2 - Buy Product 10, 000 70,000 (10,000+70,000)/2= 40,000
d3 - Do Nothing, 5,000 5,000 (5,000+5,000)/2= 5,000

This strategy selects that decision alternative associated with the highest average payoff. In this situation, the decision-maker
would select d2, buy the product, since it has the highest average pay off of 40,000. This criterion treats all feature outcomes as
being equally likely.

3. Decision Making with Probabilities

In this approach, the decision-maker has information concerning the relative likelihood of each of the states of nature. It is
sometimes called "decision making under uncertainty." The criterion used in decision-making strategy with probabilities is to
select that decision so as to maximize the expected value of the outcome. To illustrate the approach, let's refer again to the
payoff table for our make-buy example, this time adding a row for probabilities and a column for the expected value of the
decision alternatives.
States of Nature Expected
Decision Alternatives s1 - Low Demand s2 -High Demand Values**
d1 - Make Product (20,000) 90,000 51,500
d2 - Buy Product 10,000 70,000 49,000
d3 - Do Nothing, 5,000 5,000 5,000
Probabilities P (s1) = 0.35 P (s2) = 0.65
In decision analysis, it is assumed that the probabilities are long-term relative frequencies. Since they are often simply the
subjective judgment of the decision- maker, the techniques is subject to the criticism of this limitation. But this criticism can be
levied against any quantitative approach - the output is only as good as the input. To counter the criticism, we will add a

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sensitivity analysis step after the initial solution. For now, let's learn the expected value approach.

**The expected value (EV) for a decision alternative is the sum of the [probabilities of the states of nature times the payoffs]. For
the "make product" decision: (Vij to represent the payoff associated with decision alternative i and state of nature j)

EV (d1) = [P (s1) * V11] + [P (s2) * V12]

= [0.35 * -20,000] + [0.65 * 90,000]
= 51,500

The EV of 51,500 represents the long run outcome of repeated "make product" experiments. That is, if we could theoretically
conduct the "make product" decision 100 times, 35 times we would lose 20,000, and 65 times we would make 90,000. The
weighted average of these outcomes is 51,500. In reality, we do not conduct the experiment 100 times - we make the decision
once and we are either going to lose 20,000 or make 90,000. However, and this is very important, we use the expected value
approach to assist us in making the decision.

At this point, that to abide by the laws of probability, each probability must be a real number between 0 and 1, and the sum of
the probabilities for the states of nature must sum to one. For this to happen, the states of nature must be mutually exclusive
and exhaustive - that is, there cannot also be a state of nature called, for example, medium demand. If there was such a state of
nature, it would have to be added to the payoff table and accounted for with a third probability. The expected values for the
second and third decision alternatives are calculated in a similar fashion. These are shown in the following figure.

4. Sensitivity Analysis
When you apply quantitative approaches to solve management problems it is always a good idea to ask, "how sensitive is my
solution to changes in data input." This is especially true when the input consists of subjective estimates. When the solution
remains the optimal solution given large changes in selected important inputs, there is a high level of confidence in the solution.
On the other hand, when the optimal solution strategy changes for very small changes to the one or more inputs, the decision-
maker should be cautious before implementation. Perhaps some time should be spent in refining the input.

Suppose the decision-maker examines the solution and realizes that the "buy" decision lost out to the "make" decision by only
2,500. Further suppose the decision-maker has little confidence in the payoff for the "buy product" decision under the "high
demand" state of nature. The question is, "at what "buy product, high demand" payoff would I be indifferent between the
"make" and "buy" decisions, given all other applicable data input items remain the same?" To answer this question, we note that
the point of indifference occurs where the "make" and the "buy" EV's are equal. Mathematically, this is expressed as the
equation:

EVB = EVC
Now writing out the computational formulas for the EV's: (V ij to represent the payoff associated with decision alternative i and
state of nature j)
[P (s1) * V11] + [P (s2) * V12] = [P (s1) * V21] + [P (s2) * V22]

Now, substitute the data input values except for the unknown "buy product, high demand" payoff, V 22:
[0.35 * -20,000] + [0.65 * 90,000] = [0.35 * 10,000] + [0.65 * V 22]

Next, solve the equation for V22:

0.65 * V22 = 51,500 - [0.35 * 10,000]
V22 = 48,000 / 0.65
V22 = 73,846

So, if the decision-maker erred by just 5.5% (estimates the "buy product, high demand" payoff to be 70,000 when it is really
73,850), the decision-maker would have selected the wrong strategy.

As a rule of thumb, if a decision strategy changes based on a five or less percent change to an input, we say that the solution is
very sensitive to change and it might be wise to consider investing in more accurate data input values.

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Probabilities are sometimes also subjective estimates when there has been no history or experience with a particular state of
nature. By observation, we can see that as long as P (s 1) remains at or below 0.35 the decision-maker will favor the optimal
"make product" decision since a low probability for s 1 gives little relative weight to the 20,000 loss. But as P (s 1) increases
(resulting in a decrease for P (s2)), the expected values approach a point of indifference or a break-even point. The question is, at
what P (s1) would the decision-maker be indifferent between the "buy" and "make" decisions, all other data input remaining the
same?

Again, we begin by setting EVB equal to EVC to represent break-even:

EVB = EVC

Next, we write out the computational formulas for the EV's:

[P (s1) * V11] + [P (s2) * V12] = [P (s1) * V21] + [P (s2) * V22]

Now, substitute the data input values except for the unknown state of nature probabilities:
[P (s1) * -20,000] + [P (s2) * 90,000] =
[P (s1) * 10,000] + [P (s2) * 70,000]

You may recall from an algebra class that we cannot solve one equation when there are two unknowns. However, recall that the
sum of the probabilities of the states of nature must equal one. That is, with two states of nature:
P (s1) + P (s2) = 1

We can rewrite this as:

P (s2) = 1 - P (s1)
Then, we can substitute [1 - P (s1)] for each P (s2) in the break-even equation and continue solving for P (s1).
{P (s1) * -20,000} + {[1 - P (s1)] * 90,000} =
{P (s1) * 10,000} + {[1 - P (s1) * 70,000]}

Now simplify the equation:

- 20,000 P (s1) + 90,000 - 90,000 P (s1) =
10,000 P (s1) + 70,000 - 70,000 P (s1)

Finally, collect terms and solve for P (s1):

-110,000 P (s1) + 90,000 = - 60,000 P (s1) + 70,000
- 50,000 P (s1) = - 20,000
P (s1) = -20,000 / - 50,000 = 0.40

Conclusion: as long as P (s1) stays less than or equal to 0.40, the "make" decision strategy will remain the optimal strategy.

5. The Value of Information

What if you find out that your solution is sensitive to changes in the inputs. In that case, it may be appropriate to obtain
additional information concerning your input numbers to make them more accurate or to increase your confidence in their
original value. However, while information has value, it is sometimes expensive to obtain. Our last topic in decision analysis
focuses on the value of information. This technique has found countless applications in assisting managers make decisions. These
helped companies use decision analysis in equipment loan, construction, and enterprise resource planning situations. The formal
steps in structuring the problem, which forces the decision-maker to consider decision alternatives, states of nature, probabilities
and payoffs, is almost as valuable as coming up with the decision itself.

We made the point that information has value, but it also costs money and time to obtain. So the question becomes, how much
would be willing to pay for additional information. The upper limit is established by the first concept, the Value of Perfect
Information.

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a. The Value of Perfect Information.

States of Nature Expected
Decision Alternatives s1 - Low Demand s2 -High Demand Values
d1 - Make Product (20,000) 90,000 51,500
d2 - Buy Product 10,000 70,000 49,000
d3 - Do Nothing, 5,000 5,000 5,000
Probabilities P (s1) = 0.35 P (s2) = 0.65

Suppose we knew ahead of the production period which state of nature would occur - sort of like having a crystal ball. If we knew
ahead of time that s1 would occur, we would select d2 as our optimal strategy to maximize our payoffs. If we knew ahead of time
that s2 would occur, we would select d1 to maximize our payoffs. Over time, the expected value with this perfect information
(abbreviated as EV w PI) would be:

EV w PI = [P (s1) * V21] + [P (s2) * V12]

= [ 0.35 * 10,000 ] + [ 0.65 * 90,000 ] = 62,000

Recall that without this perfect information, the expected value was 51,500 by going with d 1. The difference between the
expected value with perfect information and the expected value without perfect information is called the Expected Value of
Perfect Information (EVPI):
EVPI = EV w PI - EV w/o PI = 62,000 - 51,500 = 10,500

EVPI places an upper bound on how much we should be willing to pay someone to get additional information on the future
states of nature in order to improve our decision making strategy.

For example, we might be willing to pay a consultant for a market research study to help us learn more about the demand states
of nature. We don't expect the research study to result in perfect information, but we hope it will represent a good proportion of
the 10,500. We also know that we do not want to pay more than 10,500 for the new information.

New information about the states of nature takes the form of revisions to the probability estimates in decision analysis. This
information may be obtained through market research studies, product testing or some other sampling process. In decision
analysis, this topic is called the Expected Value of Sample Information.

b. The Expected Value of Sample Information (EVSI)

Recall that we have probabilities on the states of nature, P (s 1) and P (s2). These are more technically called prior probabilities. If
we plan to obtain sample information, the results will be expressed as revisions to these prior probabilities.

Suppose a market research consultant offers to conduct a demand analysis that will result in two indicators. I1 will be the
indicator used to represent a prediction of low demand in the next production period. I1 then corresponds to the state of nature
we labeled s1, the difference is that one is a prediction and one is an actual occurrence. I2 will be the indicator used to represent a
prediction of high demand in the next production period. This indicator corresponds to our state of nature s 2.

This indicator information will be used to calculate conditional probabilities. P (s1 given I1) will be the probability that s1 will occur
given or conditioned on the consultant's I1 prediction. P (s1 given I1) is generally written as P (s1 | I1). Since there are two states of
nature and two indicators, we will need three additional conditional probabilities, P (s1 | I2), P (s2 | I1) and P (s2 | I2).

In order to compute these conditional probabilities and then EVSI, we need to know the consultant's track record. That is, how
has the consultant done in prior market demand studies? In terms of decision analysis, we want to know the accuracy of
indicator predictions given what state of nature actually occurred. Suppose the following information is available from the
consultant.
Market Research
State of Nature I1, Predict Low Demand I2, Predict High Demand
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s1, Low Demand P ( I1 | s1 ) = 0.90 P ( I2 | s2 ) = 0.10

s2, High Demand P ( I1 | s2 ) = 0.20 P ( I 2 | s2 ) = 0.80

We are almost there, but note that these conditional probabilities are the reverse of what we need. To get from P (I 1 | sj) to P (sj |
I1), we need to set up a table and do some calculations. Same for Indicator 2. Let's do I 1 first.

States
Prior Consultants
of Joint Probabilities, Conditional Probabilities,
Probabilities, Track
Nature, P ( I1 and sj) P ( sj | I1 )
P (sj) Record, P ( I1| sj )
sj
s1 P (s1) = 0.35 P (I1|s1) = 0.90 0.35*0.90 = 0.315 P( s1| I1)=.315 / 0.445 =0 .7079
s2 P (s2) = 0.65 P (I1|s2) = 0.20 0.65*0.20 = 0.13 P( s2| I1 ) =0.13/0.445 = 0.2921
P(I1)=.315 + .13 =0.445 Note: 0.7079 + 0.2921 = 1.00

The first three columns in the table are from input information. The joint probabilities column is computed by multiplying the
prior probabilities times the consultant track record probabilities in each row. The conditional probabilities in the last column are
computed by dividing the joint probabilities by P(I1).

Note how consultant research information can change the estimates on the probabilities. Now the probability of low demand
becomes 0.71 given that the consultant predicts low demand, and taking into account the consultant's track record. This revision
reflects prior accuracy for the low demand case. Note that the probability of high demand, s 2 goes from 0.65 to 0.29 given that
the consultant predicts that demand will be low. The above procedure illustrate the power of the complete decision analysis
technique. The steps illustrate how information has value to justify its expense. Now, we do similar calculations for Indicator two

States of Prior Probabilities, Consultants Track Joint Probabilities, Conditional Probabilities,

Nature, sj P (sj) Record, P ( I2| sj ) P ( I2 and sj) P ( sj | I2 )
s1 P (s1) = 0.35 P (I2|s1) = 0.10 0.35*0.10 = 0.035 P( s1| I2)=.035 / 0.555 = 0 .0631
s2 P (s2) = 0.65 P (I2|s2) = 0.80 0.65*0.80 = 0.52 P( s2| I2 )=0.52 / 0.555 = 0.9369
P(I2)=.035 + .52 =0.555 Note: 0.0631 + 0.9369 = 1.00
The following figure will illustrate the decision problem incorporating the sample information.
Payoffs
I1: Predict Low Demand: P(I1)= 0.445 C 27,528.01

Do Mkt Research B EVB = (0.445 * 27,528.01) +( 0.555 * 83,063.06) = 58,349.96

A I2: Predict High Demand: P(I2 )= 0.555 D 83,063.06

No Mkt Research -> EV w/o Perfect Information = 51,500 (Make Product)

RULE FOR ROUNDING OFF:

You may present your solution using four decimal points, however please use the complete value for computation purposes.
Only the final answer would be rounded off in two decimal places.

EXPLANATION
This shows a new decision to our problem: the decision of whether or not to engage the services of the market research consultant.
If the manufacturer does not engage the services, the expected value has already been determined to be 51,500 by selecting d 1,
"make " the product. Note that we have added the expected value that would be obtained should the decision maker engage the
services of the marketing consultant, 58,400. The first event after engaging the services of the consultant is the consultant's

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predictions. The consultant's predictions are then followed by the manufacturer's decisions to "make,", "buy," or "do nothing;"
which are then followed by the actual states of nature, low and high demand.

The next figure illustrates the decision tree leading from the node labeled C in the following Figure, the consultant's prediction of
low demand.
Payoffs
s1: Low Demand: P(s1|I1) = 0.7079 -20,000

d1: Make E EVE = 0.7079*-20,000 + 0.2921*90,000 = 12,134.83

s2: High Demand: P(s2|I1) = 0.2921 90,000

s1: Low Demand: P(s1|I1) = 0.7079 10,000

C d2: Buy F EVF = 0.7079*10,000 + 0.2921*70,000 = 27,528.01

s2: High Demand: P(s2|I1) = 0.2921 70,000

s1: Low Demand: P(s1|I1) = 0.7079 5,000

d3: Do Nothing G EVG = 0.7079*5,000 + 0.2921*5,000 = 5,000

s2: High Demand: P(s2|I1) = 0.2921 5,000

This part of the decision tree provides back-up for the calculation of the 27,500 expected value for node 3. That value represents the
highest expected value and is associated with the "buy" decision. Thus, if the consultant is hired to conduct the market research, and
predicts low demand, the best decision is to "buy" the product. When working out decision trees by hand, we always start at the
right of the tree, move left, pruning branches coming from decision nodes as we go. You should observe that every state of nature
node gets an expected value computation, the sum of the products of probabilities times payoffs. Every decision node simply gets
the highest expected value from its branches.

Next, we examine the computations for the node labeled D the event that occurs if we engage the consultant and the consultant's
prediction is high demand.

Payoffs

s1: Low Demand: P(s1|I2) = 0.063 -20,000

d1: Make H EVE = 0.063*-20,000 + 0.937*90,000 = 83,063.06

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90,000
s2: High Demand: P(s2|I2) = 0.937

s1: s1: Low Demand: P(s1|I2) = 0.063 10,000

D d2: Buy I EVF = 0.063*10,000 + 0.937*70,000 = 66,216.22

s2: High Demand: P(s2|I2) = 0.937 70,000

s1: Low Demand: P(s1|I2)= 0.063 5,000

d3: Do Nothing J EVG = 0.063*5,000 + 0.967*5,000 = 5,000

s2: High Demand: P(s2|I2) = 0.967 5,000

This part of the decision tree provides back-up for the calculation of the 83,100 expected value for node D. That value represents the
highest expected value and is associated with the "make" decision. Thus, if the consultant is hired to conduct the market research,
and predicts high demand, the best decision is to "make" the product.

Looking back at the first figure, we see that the expected value with the market research consultant report, named the expected
value with sample information (EV w SI), is 58,349.96. The expected value without the sample information (EV w/o SI)  (same as
the expected value without perfect information) is 51,500.

To get the expected value of sample information, we just make the subtraction:

EVSI = EV w SI - EV w/o SI = 58,349.96 - 51,500 = 6,849.96

Like EVPI, this is a powerful piece of information. We now know how much we would be willing to spend to obtain market research
from the consultant - that is a great bargaining chip to have at negotiation time!

c. Efficiency of the Sample Information

Pause and Reflect
Recall that the expected value of perfect information was 10,500 - that placed a theoretical upper bound on how much we would
be willing to spend for perfect information. But forecasts and consultants are not perfect. If we can get the "track record" of a
forecaster consultant, we can then determine how they stack up to the theoretical EVPI.

To compute the efficiency of the sample information, we simply divide the EVSI by EVPI and convert the decimal to a percent:
Efficiency = EVSI / EVPI
= 6,849.96 / 10,500
= .652377142
= 65.24
The closer this number is to 100%, the better.

We are not suggesting that every decision analysis exercise includes this last procedure of computing EVSI and its efficiency. Often
the track record of the sample information producer may not be available. But when it is (and it should ALWAYS be available if you
do the market research "in-house"), this is a powerful tool to put some limits on how much you would want to spend to acquire
more information.

Activity 11

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Bob plans to operate a poultry farm. He currently is deciding the capacity of this farm. Its size could either be for 100,
150 or 200 chickens. In terms of market forecasts, demand may be low, medium or high. The expected monthly income
matrix for the capacities and market forecasts is as follows:

Capacity Low Demand Medium Demand High Demand

100 chickens P85,000 P85,000 P85,000
150 chickens 40,000 130,000 130,000
200 chickens (25,000) 75,000 175,000

Required:

Strategy Decision Relevant Income of the Decision

Maximin a. b.

Maximax c. d.
 
Laplace e. f.
 
Minimax Regret g. h.
 
Expected Value i. j.
(20:50:30 probabilities for Low:  
Medium: High)
k. Assuming the same probabilities in i and j, how much should Bob be willing to pay for perfect information?

PROBLEM 11

ABC Condominium Corp. of Baguio City, recently purchased land and is attempting to determine the size of the condominium
development it should build. It is considering three sizes of development: small (d1 ); medium (d1 ); and large (d1 ). With the three
levels of demand- low (s1 ), medium (s2 ) and high (s3 ), the company’s management has prepared the following profit payoff table:

State of Nature
Decision Alternatives Low (s1 ) Medium (s2 ) High (s3 )
d1 – Small Condo 400,000 400,000 400,000
d2 – Medium Condo 100,000 600,000 600,000
d3 - Large Condo (300,000) 300,000 900,000

Required:
1. What decision should ABC Condominium Corp make using Optimistic Criterion?
2. Under Optimistic Criterion, what is the relevant income in ABC's decision?
3. What decision should ABC Condominium Corp make using Conservative Criterion?
4. Under Conservative Criterion, what is the relevant income in ABC's decision?
5. What decision should ABC Condominium Corp make using Compromise Minimax Regret Strategy?
6. Under Compromise Minimax Regret Strategy, what is the relevant income in ABC's decision?
7. What decision should ABC Condominium Corp make using Laplace Method?
8. Under Laplace Method, what is the relevant income in ABC's decision?
9. Assuming the probabilities for the state of nature are P(s1 )=0.20; P(s2 )=0.35 and P(s3 )= 0.45, what decision should ABC
Condominium Corp make?

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AE 232: Management Science Short-Term
UNIT 11: Decision Analysis 2019-2020

10. Using the information from no. 9, what is the relevant income in ABC's decision?
11. Using information in No.9 , at how much will the "Medium condo, high demand" payoff would be indifferent between the
"Medium condo" and "Large condo” decisions, given all other applicable data input items remain the same? (2 points)
12. Using information in No. 9, Compute for the Expected Value of Perfect Information. (2 points)
13. Using information in No. 9, Suppose that before making a final decision, ABC Condominium Corp is considering conducting a
survey to help evaluate the demand for the new condominium development. The survey report anticipated to indicate one o
the three levels of demand: weak (W), average (A) or strong (S). The relevant probabilities are as follows: RULE FOR ROUNDING
OFF: You may present your solution using four decimal points, however please use the complete value for computation
purposes. Only the final answer would be rounded off in two decimal places.

P(s1 I W) = .75 P(s1 I S) = .25

P(s2 I W) = .70 P(s2 I S) = .30
P(s3 I W) = .45 P(s3 I S) = .55

A. What is the expected Value with sample information? (5 points)

B. What is the expected value of sample information? (5 points)
C. What is the efficiency of the survey information (present your answer in decimal number NOT percentage for ex: 0.2000
not 20%)? (5 points)

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