Mathematics for Management Science Notes 09

prepared by Professor Jenny Baglivo

© Jenny A. Baglivo 2002. All rights reserved.

Decision analysis can be used to determine an optimal strategy when a decision

maker is faced with several decision alternatives and an uncertain or risk-filled pattern of
future events. For example, the owner of a snow removal business may need to decide
now whether or not to update snow-removal equipment; the decision to update would be
wise if the amount of snowfall in the next season is high and would be unwise if the
amount of snowfall in the next season is low.

The components of the problem are as follows:

• Decision alternatives: di for i=1,2,...,M

• States of nature: sj for j=1,2,...,N
• Payoffs: Vij for i=1,2,...,M; j=1,2,...,N.

To solve the problem, we construct a payoff table and then choose the “best” alternative.
There are several different approaches to choosing the “best”.

(1) Optimistic Approach (Maximax approach)

• For each alternative, identify the maximum payoff.
• Choose the alternative with the largest maximum payoff.

(2) Pessimistic Approach (Maximin approach)

• For each alternative, identify the minimum payoff.
• Choose the alternative with the largest minimum payoff.

(3) Minimax Regret Approach

1. For each ij, compute the regret (Rij), which is the maximum
payoff for state j minus Vij.
2. For each alternative, determine the maximum regret.
3. Choose the alternative with the smallest maximum regret.

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Example 1: Pittsburgh Development Corporation (PDC) has purchased land for a luxury,
riverfront condominium complex. The site provides a spectacular view of downtown
Pittsburgh and the Golden Triangle where the Allegheny and Monongahela rivers meet to
form the Ohio River. The individual condominium units will be priced from $300,000 to
$1,200,000, depending on the floor the unit is located on, the square footage of the unit,
and optional features such as fireplaces and large balconies.

The company has had preliminary architectural drawings developed for three different
project sizes:

• A small condominium complex with six floors and thirty units,

• A medium condominium complex with twelve floors and sixty units, and
• A large condominium complex with eighteen floors and ninety units.

The financial success of the project will depend heavily on the decision that PDC makes
regarding the size of the condominium project.

When asked about possible market acceptance of the project, management identified two
possibilities:

• High market acceptance and hence substantial demand for the units, and
• Low market acceptance and hence a limited demand for the units.

Further, using the best information available, management has estimated the payoffs (or
profits) for the PDC condominium project:

Payoffs (in millions of dollars)

High Acceptance Low Acceptance
Build Small 8 7
Build Medium 14 5
Build Large 20 -9

PDC would like to determine the best size complex to build.

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• Determine PDC’s “best” strategy using the optimistic, pessimistic, and minimax regret
approaches.

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Example 2: Hartsfield International Airport in Atlanta, Georgia, is one of the busiest
airports in the world. During the past 30 years, the airport has expanded again and again
to accomodate the increasing numbers of flights being routed through Atlanta. Analysts
project that this increase will continue well into the next century. However, commercial
development around the airport prevents it from building additional runways to handle
the future air-traffic demands. As a solution to this problem, plans are being developed
to build another airport outside the city limits. Two possible locations for the new airport
have been identified, but a final decision on the new location is not expected to be made
for another year.

The Magnolia Inns hotel chain intends to build a new facility near the new airport once
its site is determined. Barbara Monroe is responsible for real estate acquisition for the
company, and she faces a difficult decision about where to buy land. Currently, land
values around the two possible sites for the new airport are increasing as investors
speculate that property values will increase greatly in the vicinity of the new airport.
The following table summarizes the current price of each parcel of land, the estimated
present value of the future cash flows that a hotel would generate at each site if the
airport is ultimately located at the site, and the present value of the amount for which the
company believes it can resell each parcel if the airport is not built at that site.

Parcel near .
Location A Location B .
Purchase Price (in Millions $$) 18 12

Present Value (in Millions $$)

of Future Cash Flow if airport

• Is built at that site 31 23

• Is not built at that site 6 4

The company can buy either site, both sites, or neither site. Barbara must determine
which sites, if any, the company should purchase.

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• Determine the “best” strategy for Magnolia Inns using the optimistic, pessimistic, and minimax
approaches.

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Incorporating Probabilities:

For each state of nature, let

P(sj) = the probability that state j will occur.

The probabilities you use must satisfy

P(s1) + P(s2) + . . . + P(sN) = 1.

Expected Value (EV) Approach:

(1) For each decision alternative, calculate

EV(di) = P(s1) Vi1 + P(s2) Vi2 + ... + P(sN) ViN

(2) Choose the alternative with maximum EV.

Expected Opportunity Loss (EOL) Approach:

(1) For each decision alternative, calculate

EOL(di) = P(s1) Ri1 + P(s2) Ri2 + ... + P(sN) RiN

(2) Choose the alternative with the minimum EOL.

In addition, we define the expected value of perfect information (EVPI) as follows:

EVPI = EVwPI - EVwoPI

where
1. The expected value with perfect information (EVwPI) is the weighted average of the
maximum payoffs for each state of natures, and
2. The expected value without perfect information (EVwoPI) is the maximum of the
expected values for each decision alternative.

Notes:
(1) The EV and EOL approaches always result in the selection of the same decision alternative.
(2) The value of EOL at the best decision is exactly equal to EVPI.

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Example 1, continued: Suppose that PDC is optimistic abou the potential for a high
demand and assigns P(High Acceptance) = 80% and P(Low Acceptance) = 20%.

• Determine the best strategy using the EV and EOL approaches.

• Find the value of EVPI.

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Example 2, continued: The management at Magnolia Inns assigns the following
probabilities to building at the two sites: P(Build at A)=40%, P(Build at B)=60%.

• Determine the best strategy using the EV approach.

• Find the value of EVPI.

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Graphical Sensitivity Analysis

We can do a graphical sensitivity analysis when using the EV approach and with two
states of nature. Let

P(State 1) = p and P(State 2) = 1-p.

The problem is to determine the ranges of probabilities for which you would choose each
alternative.

Example 1, continued: The following table shows the expected value for each decision
alternative as a function of p=P(High Acceptance) :

High Low
Acceptance Acceptance Expected Value
Build Small 8 7 EV = 8 p + 7 (1–p) = 7 + p
Build Medium 14 5 EV = 14 p + 5 (1–p) = 5 + 9 p
Build Large 20 –9 EV = 20 p – 9 (1–p) = –9 + 29 p

• Construct a plot of the three functions:

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• Determine the ranges of probabilities for which PDC would choose to build small, build
medium, or build large.

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Decision Trees:

A decision tree is a graphical representation of a decision problem.

There are three types of nodes in a decision tree:

• Decision nodes (where you make a decision).
• Event nodes (where an event occurs not under your control).
• Terminal nodes.

Example 1: Decision tree for the PDC problem, incorporating the EV solution.

Example 1: Pittsburgh Development 80%

High Acceptance
8
Build Small 8

7.8 20%
Low Acceptance
7
7

80%
High Acceptance
14
Build Medium 14
3
14.2 12.2 20%
Low Acceptance
5
5

80%
High Acceptance
20
Build Large 20

14.2 20%
Low Acceptance
-9
-9

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Example 2: Decision tree for the Magnolia Inns problem, incorporating the EV solution.

Example 2: Magnolia Inns 40%

Airport Built at A
13
Buy A 31 13

-18 -2 60%
Airport Built at B
-12
6 -12

40%
Airport Built at A
-8
Buy B 4 -8

-12 3.4 60%

Airport Built at B
11
2 23 11
3.4
40%
Airport Built at A
5
Buy A & B 35 5

-30 1.4 60%

Airport Built at B
-1
29 -1

Buy Nothing
0
0 0

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Example 3: The Occupational Safety and Health Administration (OSHA) has recently
announced it will award an $85,000 research grant to the person or company submitting
the best proposal for using wireless communications technology to enhance safety in the
coal-mining industry. Steve Hinton, the owner of COMTECH, a small communications
research firm is considering whether or not to apply for this grant. Steve estimates he
would spend approximately $5,000 preparing his grant proposal and that he has about a
50-50 chance of actually receiving the grant.

If he is awarded the grant, he would then need to decide whether to use microwave,
cellular or infrared communications technology. He has some experience in all three
areas but would need to acquire some new equipment depending on which technology is
used. The cost of the equipment needed for each technology is summarized as

Technology Equipment Cost

Microwave $4,000
Cellular $5,000
Infrared $4,000

In addition to the equipment costs, Steve knows he will spend money in research and
development (R&D) to carry out the research proposal, but he doesn’t exactly know what
the R&D costs will be. For simplicity, Steve estimates the following best-case and
worst-case R&D costs associated with using each technology, and he assigns
probabilities to each outcome based on his degree of expertise in the area.

R&D Costs Probability .

Best Case Worst Case Best Case Worst Case.
Microwave $30,000 $60,000 40% 60%
Cellular $40,000 $70,000 80% 20%
Infrared $40,000 $80,000 90% 10%

Steve needs to synthesize all the factors in the problem to decide whether or not to submit
a grant proposal to OSHA.

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• Design a decision tree:

Example 3: COMTECH 40%

Best Case
46
Microwave -30

-4 60%
Worst Case
16
-60

80%
Best Case
50% 35
Receive Grant Cellular -40

85 -5 20%
Worst Case
5
-70

90%
Best Case
Submit Proposal 36
Infrared -40
-5
-4 10%
Worst Case
-4
-80

50%
Do Not Receive
-5
0 -5

Do Not Submit
0
0 0

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• Use the EV approach to solve Steve’s problem:

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Example 4: A real estate investor wants to determine whether to buy an existing
apartment building or to buy land now with the potential of developing the land later.

The cost of the apartment building is $800,000. If the building is purchased, then two
states of nature are possible (the town’s population will grow or not over the next ten
years) with pertinent information summarized in the following table:

State of Nature Probability Earnings over 10-year

period
Population Growth 60% $2,000,000
No Population Growth 40% $225,000

The cost of the land is $200,000. If the land is purchased, then the investor will wait
three years to determine whether to develop or sell the land.

If the town exhibits population growth over the first period (probability 60%), then the
investor can build an apartment building at a cost of $800,000 or sell the land for
$450,000. The probabilities for continued growth and earnings if the apartment building
is constructed are summarized in the following table:

State of Nature Probability Earnings over 10-yr

period
Growth in 2nd Period 80% $3,000,000
No Growth in 2nd 20% $700,000
Period

If the town does not exhibit population growth over the first period (probability 40%), then
the investor can construct a commercial building at a cost of $600,000 or sell the land for
$210,000. The probabilities for continued growth and earnings if the commercial building
is constructed are summarized in the following table:

State of Nature Probability Earnings over 10-yr

period
Growth in 2nd Period 30% $2,300,000
No Growth in 2nd 70% $1,000,000
Period

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• Design a decision tree

Real Estate Example 60%

Growth
________
Buy Apt Bdg

40%
No Growth
________

80%
Growth 2
Build ________
Apartments

20%
60% No Growth 2
Growth 1 ________

Sell Land
________

Buy Land
30%
Growth 2
Build ________
Commercial

70%
40% No Growth 2
No Growth1 ________

Sell Land
________

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• Use the EV approach to solve the investor's problem.

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