Lecture 4 for Finals

Decision Analysis

Introduction

In the previous chapters dealing with linear programming, models were formulated
and solved in order to aid the manager in making a decision. The solutions to the models
were represented by values for decision variables. However, these linear programming
models were al formulated under the assumption that certainty existed. In other words,
it was assumed that al the model coefficients, constraint values, and solution values
were known with certainty and did not vary.
In actual practice, however, many decision-making situations occur under
conditions of uncertainty. For example, the demand for a product may be not 100 units
next week, but 50 or 200 units, depending on the state of the market (which is
uncertain). Several decision-making techniques are available to aid the decision maker
in dealing with this type of decision situation in which there is uncertainty.
Decision situations can be categorized into two classes: situations in which
probabilities cannot be assigned to future occurrences and situations in which probabilities
can be assigned. In this chapter we will discuss each of these classes of decision
situations separately and demonstrate the decision-making criterion most associated
with each. Decision situations in which there are two or more decision makers who are
in competition with each other are the subject of game theory.

Components of Decision Making

1. States of Nature – an actual event that may occur in the future
2. Payoff Table – a means of organizing a decision situation, including the payoffs
from different decisions, given the various states of nature.
Payoff Table
State of Nature
Decision a b
1 Payoff 1a Payoff 1b
2 Payoff 2a Payoff 2b

Each decision, 1 or 2 in the table will result in an outcome, or payoff, for the
particular state of nature that will occur in the future. Payoffs are typically expressed in
terms of profit revenues, or cost (although they can be expressed in terms of a variety of
quantities). For example, if decision 1 is to purchase a computer and state of nature a is
good economic conditions, payoff 1a could be $100,000 in profit.

Decision Making Without Probabilities

Sample Problem: An investor is to purchase one of three types of real estate,
apartment building, office building and warehouse. The investor must decide among an
apartment building, an office building, and a warehouse. The future states of nature that
will determine how much profit the investor will make are good economic conditions and
poor economic conditions. The profits that will result from each decision in the event of
each state of nature are shown in the table below:
 Payoff Table for Real Estate Investments
State of Nature
Decision (Purchase) Good Economic Condition Poor Economic Condition
Apartment Building Php 250 000 Php 150 000
Office Building Php 500 000 Php 200 000
Warehouse Php 150 000 Php 50 000

Decision-Making Criteria
Once the decision situation has been organized into a payoff table, several criteria
are available for making the actual decision. These decision criteria, which will be
presented in this section, include maximax, maximin, minimax regret, Hurwicz, and equal
likelihood. On occasion these criteria will result in the same decision; however, often they
will yield different decisions. The decision maker must select the criterion or combination
of criteria that best suits his or her needs.

The Maximax Criterion

With the maximax criterion, the decision maker selects the decision that will result
in the maximum of the maximum payoffs. (In fact, this is how this criterion derives its
name a maximum of a maximum.) The maximax criterion is very optimistic. The decision
maker assumes that the most favorable state of nature for each decision alternative will
occur. Thus, for example, using this criterion, the investor would optimistically assume
that good economic conditions will prevail in the future.

The maximax criterion results in the maximum of the maximum payoffs.

The maximax criterion is applied in table below. The decision maker first selects the
maximum payoff for each decision. Notice that all three maximum payoffs occur under
good economic conditions. Of the three maximum payoffs Php 250,000, Php 500,000, and
Php 150,000 the maximum is Php 500,000; thus, the corresponding decision is to
purchase the office building.

Payoff Table for Illustrating the Maximax Decision

State of Nature
Decision (Purchase) Good Economic Condition Poor Economic Condition
Apartment Building Php 250 000 Php 150 000
Office Building Php 500 000 -Php 200 000
Warehouse Php 150 000 Php 50 000

The Maximin Criterion

In contrast to the maximax criterion, which is very optimistic, the maximin criterion
is pessimistic. With the maximin criterion, the decision maker selects the decision that
will reflect the maximum of the minimum payoffs. For each decision alternative, the
decision maker assumes that the minimum payoff will occur. Of these minimum payoffs,
the maximum is selected. The maximin criterion for our investment example is
demonstrated in the table below.
Payoff Table for Illustrating the Maximin Decision
State of Nature
Decision (Purchase) Good Economic Condition Poor Economic Condition
Apartment Building Php 250 000 Php 150 000
Office Building Php 500 000 -Php 200 000
Warehouse Php 150 000 Php 50 000
 The minimum payoffs for our example are Php 150,000, Php 200,000, and Php
10,000. The maximum of these three payoffs is Php 150,000; thus, the decision arrived at
by using the maximin criterion would be to purchase the apartment building. This decision
is relatively conservative because the alternatives considered include only the worst
outcomes that could occur. The decision to purchase the office building as determined by
the maximax criterion includes the possibility of a large loss (Php 200,000). The worst that
can occur from the decision to purchase the apartment building, however, is a gain of Php
300,000. On the other hand, the largest possible gain from purchasing the apartment
building is much less than that of purchasing the office building (i.e., Php 250 000 vs. Php
500 000).
If the table contained costs instead of profits as the payoffs, the conservative
approach would be to select the maximum cost for each decision. Then the decision that
resulted in the minimum of these costs would be selected.

The Minimax Regret Criterion

In our example, suppose the investor decided to purchase the warehouse, only to
discover that economic conditions in the future were better than expected.
Naturally, the investor would be disappointed that she had not purchased the office
building because it would have resulted in the largest payoff (Php 500 000) under good
economic conditions. In fact, the investor would regret the decision to purchase the
warehouse, and the degree of regret would be Php 350 000, the difference between the
payoff for the investor's choice and the best choice.

Regret is the difference between the payoff from the best decision and all other
decision payoffs.

This brief example demonstrates the principle underlying the decision criterion
known as minimax regret criterion. With this decision criterion, the decision maker
attempts to avoid regret by selecting the decision alternative that minimizes the maximum
regret.

The minimax regret criterion minimizes the maximum regret.

To use the minimax regret criterion, a decision maker first selects the maximum
payoff under each state of nature. For our example, the maximum payoff under good
economic conditions is Php 500 000, and the maximum payoff under poor economic
conditions is Php 150 000. All other payoffs under the respective states of nature are
subtracted from these amounts.

Good Economic Condition Poor Economic Condition

Php 500 000 – Php 250 000 = Php 250 000 Php 150 000 – Php 150 000 = Php 0
Php 500 000 – Php 500 000 = Php 0 Php 150 000 – (Php 200 000) = Php 350 000
Php 500 000 – Php 150 000 = Php 350 000 Php 150 000 – Php 50 000 = Php 100 000

Regret Table
State of Nature
Decision (Purchase) Good Economic Condition Poor Economic Condition
Apartment Building Php 250 000 Php 0
Office Building Php 0 Php 350 000
Warehouse Php 350 000 Php 100 000
 To make the decision according to the minimax regret criterion, the maximum regret
for each decision must be determined. The decision corresponding to the minimum of
these regret values is then selected. This process is illustrated in table below.

Regret Table Illustrating the Minimax Regret Decision

State of Nature
Decision (Purchase) Good Economic Condition Poor Economic Condition
Apartment Building Php 250 000 Php 0
Office Building Php 0 Php 350 000
Warehouse Php 350 000 Php 100 000

According to the minimax regret criterion, the decision should be to purchase the
apartment building rather than the office building or the warehouse. This particular
decision is based on the philosophy that the investor will experience the least amount of
regret by purchasing the apartment building. In other words, if the investor purchased
either the office building or the warehouse, Php 350 000 worth of regret could result;
however, the purchase of the apartment building will result in, at most, Php 250 000 in
regret.

The Hurwicz Criterion

The Hurwicz criterion strikes a compromise between the maximax and maximin
criteria. The principle underlying this decision criterion is that the decision maker is
neither totally optimistic (as the maximax criterion assumes) nor totally pessimistic (as
the maximin criterion assumes). With the Hurwicz criterion, the decision payoffs are
weighted by a coefficient of optimism, a measure of the decision maker's optimism. The
coefficient of optimism, which we will define as a, is between zero and one (i.e., 0 a 1.0). If
a = 1.0, then the decision maker is said to be completely optimistic; if a = 0, then the
decision maker is completely pessimistic. (Given this definition, if a is the coefficient of
optimism, 1 - a is the coefficient of pessimism.)

The Hurwicz criterion is a compromise between the maximax and maximin

criteria.

The coefficient of optimism, a, is a measure of the decision maker's optimism.

The Hurwicz criterion requires that, for each decision alternative, the maximum
payoff be multiplied by a and the minimum payoff be multiplied by 1 – a. For our
investment example, if a equals .4 (i.e., the investor is slightly pessimistic), 1 – a = .6, and
the following values will result:
Decision Values
Apartment Building Php 250 000 (.4) + Php 30 000 (.6) = Php 118 000
Office Building Php 500 000 (.4) – Php 200 000 (.6) = Php 80 000
Warehouse Php 150 000 (.4) + Php 50 000 (.6) = Php 90 000

The Hurwicz criterion multiplies the best payoff by a, the coefficient of

optimism, and the worst payoff by 1 – a, for each decision, and the best result is
selected.

The Hurwicz criterion specifies selection of the decision alternative corresponding to

the maximum weighted value, which is Php 118,000 for this example. Thus, the decision
would be to purchase the apartment building.
 It should be pointed out that when a = 0, the Hurwicz criterion is actualy the
maximin criterion; when a = 1.0, it is the maximax criterion. A limitation of the Hurwicz
criterion is the fact that a must be determined by the decision maker. It can be quite
difficult for a decision maker to accurately determine his or her degree of optimism.
Regardless of how the decision maker determines a, it is still a completely subjective
measure of the decision maker's degree of optimism. Therefore, the Hurwicz criterion is a
completely subjective decision-making criterion.

The Equal Likelihood Criterion

When the maximax criterion is applied to a decision situation, the decision maker
implicitly assumes that the most favorable state of nature for each decision will occur.
Alternatively, when the maximin criterion is applied, the least favorable states of nature
are assumed. The equal likelihood, or LaPlace criterion weights each state of nature
equally, thus assuming that the states of nature are equally likely to occur.

The equal likelihood criterion multiplies the decision payoff for each state of
nature by an equal weight.

Because there are two states of nature in our example, we assign a weight of .50
to each one. Next, we multiply these weights by each payoff for each decision:
Decision Values
Apartment Building Php 250 000 (.5) + Php 30 000 (.5) = Php 200 000
Office Building Php 500 000 (.5) – Php 200 000 (.5) = Php 150 000
Warehouse Php 150 000 (.5) + Php 50 000 (.5) = Php 100 000

As with the Hurwicz criterion, we select the decision that has the maximum of
these weighted values. Because Php 200 000 is the highest weighted value, the investor's
decision would be to purchase the apartment building.
In applying the equal likelihood criterion, we are assuming a 50% chance, or .50
probability, that either state of nature will occur. Using this same basic logic, it is possible
to weight the states of nature differently (i.e., unequally) in many decision problems. In
other words, different probabilities can be assigned to each state of nature, indicating that
one state is more likely to occur than another. The application of different probabilities to
the states of nature is the principle behind the decision criteria to be presented in the
section on expected value.

Summary of Criteria Results

The decisions indicated by the decision criteria examined so far can be
summarized as follows:
Criterion Decision (Purchase)
Maximax Office Building
Maximin Apartment Building
Minimax regret Apartment Building
Hurwicz Apartment Building
Equal likelihood Apartment Building

The decision to purchase the apartment building was designated most often by the
various decision criteria. Notice that the decision to purchase the warehouse was never
indicated by any criterion. This is because the payoffs for an apartment building, under
either set of future economic conditions, are always better than the payoffs for a
warehouse. Thus, given any situation with these two alternatives (and any other choice,
such as purchasing the office building), the decision to purchase an apartment building
will always be made over the decision to purchase a warehouse. In fact, the warehouse
decision alternative could have been eliminated from consideration under each of our
criteria. The alternative of purchasing a warehouse is said to be dominated by the
alternative of purchasing an apartment building. In general, dominated decision
alternatives can be removed from the payoff table and not considered when the various
decision-making criteria are applied. This reduces the complexity of the decision analysis
somewhat. However, in our discussions throughout this chapter of the application of
decision criteria, we will leave the dominated alternative in the payoff table for
demonstration purposes.

A dominant decision is one that has a better payoff than another decision under
each state of nature.

The use of several decision criteria often results in a mix of decisions, with no one
decision being selected more than the others. The criterion or collection of criteria used
and the resulting decision depend on the characteristics and philosophy of the decision
maker. For example, the extremely optimistic decision maker might eschew the majority
of the foregoing results and make the decision to purchase the office building because the
maximax criterion most closely reflects his or her personal decision-making philosophy.

The appropriate criterion is dependent on the risk personality and philosophy

of the decision maker.

Decision Making with Probabilities

The decision-making criteria were based on the assumption that no information
regarding the likelihood of the states of nature was available. Thus, no probabilities of
occurrence were assigned to the states of nature, except in the case of the equal likelihood
criterion.

It is often possible for the decision maker to know enough about the future states
of nature to assign probabilities to their occurrence. Given that probabilities can be
assigned, several decision criteria are available to aid the decision maker. We will consider
two of these criteria: expected value and expected opportunity loss (although several others,
including the maximum likelihood criterion, are available).

Expected Value
To apply the concept of expected value as a decision-making criterion, the decision
maker must first estimate the probability of occurrence of each state of nature. Once these
estimates have been made, the expected value for each decision alternative can be
computed. The expected value is computed by multiplying each outcome (of a decision) by
the probability of its occurrence and then summing these products. The expected value of
a random variable x, written symbolically as E(x), is computed as follows:
𝑛

𝐸(𝑥) = ∑ 𝑥𝑖 𝑃(𝑥𝑖 )
𝑖=1

where, n = number of values of the random variable x

 Expected value is computed by multiplying each decision outcome under each
state of nature by the probability of its occurrence.

Using our real estate investment example, let us suppose that, based on several
economic forecasts, the investor is able to estimate a .60 probability that good economic
conditions will prevail and a .40 probability that poor economic conditions will prevail.
This new information is shown in table below.

Payoff Table for Real Estate Investments

State of Nature
Decision (Purchase) Good Economic Condition Poor Economic Condition
(0.60) (0.40)
Apartment Building Php 250 000 Php 150 000
Office Building Php 500 000 Php 200 000
Warehouse Php 150 000 Php 50 000

The expected value (EV) for each decision is computed as follows:

EV (apartment) = Php 250 000 (.60) + Php 150 000 (.40) = Php 210 000
EV (office) = Php 500 000 (.60) – Php 200 000 (.40) = Php 220 000
EV (warehouse) = Php 150 000 (.60) + Php 50 000 (.40) = Php 110 000

The best decision is the one with the greatest expected value. Because the greatest
expected value is Php 220 000, the best decision is to purchase the office building. This
does not mean that Php 220,000 will result if the investor purchases the office building;
rather, it is assumed that one of the payoff values will result (either Php 500,000 or Php
200,000). The expected value means that if this decision situation occurred a large
number of times, an average payoff of Php 220,000 would result. Alternatively, if the
payoffs were in terms of costs, the best decision would be the one with the lowest expected
value.

Expected Opportunity Loss

A decision criterion closely related to expected value is expected opportunity loss.
To use this criterion, we multiply the probabilities by the regret (i.e., opportunity loss) for
each decision outcome rather than multiplying the decision outcomes by the probabilities
of their occurrence, as we did for expected monetary value.

Expected opportunity loss is the expected value of the regret for each decision.

The concept of regret was introduced in our discussion of the minimax regret
criterion. The regret values for each decision outcome in our example were shown in the
previous table (see Regret Table Illustrating the Minimax Regret Decision), with the
addition of the probabilities of occurrence for each state of nature.

Regret (opportunity loss) table with probabilities for states of nature

State of Nature
Decision (Purchase) Good Economic Condition Poor Economic Condition
(0.60) (0.40)
Apartment Building Php 250 000 Php 0
Office Building Php 0 Php 350 000
Warehouse Php 350 000 Php 100 000
 The expected opportunity loss (EOL) for each decision is computed as follows:
EOL(apartment) = Php 250 000(.60) + 0(.40) = Php 150 000
EOL(office) = Php 0(.60) + Php 350 000(.40) = Php 140 000
EOL(warehouse) = Php 350 000(.60) + Php 100 000(.40) = Php 250 000

As with the minimax regret criterion, the best decision results from minimizing the
regret, or, in this case, minimizing the expected regret or opportunity loss. Because Php
140 000 is the minimum expected regret, the decision is to purchase the office building.

The expected value and expected opportunity loss criteria result in the same
decision.

Notice that the decisions recommended by the expected value and expected
opportunity loss criteria were the same to purchase the office building. This is not a
coincidence because these two methods always result in the same decision. Thus, it is
repetitious to apply both methods to a decision situation when one of the two will suffice.

In addition, note that the decisions from the expected value and expected
opportunity loss criteria are totally dependent on the probability estimates determined by
the decision maker. Thus, if inaccurate probabilities are used, erroneous decisions will
result. It is therefore important that the decision maker be as accurate as possible in
determining the probability of each state of nature.

ACTIVITY
Answer each problem. Select the best decision using all the decision criteria. In
using the Hurwicz, use a = 0.45.

1. A farmer in Iowa is considering either leasing some extra land or investing in savings
certificates at the local bank. If weather conditions are good next year, the extra
land will give the farmer an excellent harvest. However, if weather conditions are
bad, the farmer will lose money. The savings certificates will result in the same
return, regardless of the weather conditions. The return for each investment, given
each type of weather condition, is shown in the following payoff table:
Weather
Decision Good Bad
Lease Land Php 450 000 Php 200 000
Buy savings certificate Php 50 000 Php 10 000

2. A farmer in Georgia must decide which crop to plant next year on his land: corn,
peanuts, or soybeans. The return from each crop will be determined by whether a
new trade bill with Russia passes the Senate. The profit the farmer will realize from
each crop, given the two possible results on the trade bill, is shown in the following
payoff table:
Weather
Crop Pass Fail
Corn Php 105 000 Php 40 000
Peanuts Php 90 000 Php 60 000
Soybeans Php 110 000 Php 100 000
3. The owner of the Columbia Construction Company must decide between building a
housing development, constructing a shopping center, and leasing all the company's
equipment to another company. The profit that will result from each alternative will
be determined by whether material costs remain stable or increase. The profit from
each alternative, given the two possibilities for material costs, is shown in the
following payoff table:
Material Cost
Decision Stable Increase
Houses Php 350 000 Php 150 000
Shopping Center Php 525 000 Php 100 000
Leasing Php 200 000 Php 200 000