Chapter 2

Supplement

Decision Analysis

© 1998 by Prentice-Hall Inc

Russell/Taylor Oper Mgt 2/e
 Decision Analysis
A set of quantitative decision-making
techniques for decision situations
where uncertainty exists

© 1998 by Prentice-Hall Inc

Russell/Taylor Oper Mgt 2/e C2 Supp - 2
 Decision Making
States of nature
– events that may occur in the future
– decision maker is uncertain which state of
nature will occur
– decision maker has no control over the states
of nature

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Russell/Taylor Oper Mgt 2/e C2 Supp - 3
 Payoff Table
 A method of organizing & illustrating the
payoffs from different decisions given
various states of nature

 A payoff is the outcome of the decision

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Russell/Taylor Oper Mgt 2/e C2 Supp - 4
 Payoff Table
States Of Nature
Decision a b
1 Payoff 1a Payoff 1b
2 Payoff 2a Payoff 2b

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Russell/Taylor Oper Mgt 2/e C2 Supp - 5
 Decision-Making Criteria
Under Uncertainty
 Maximax criterion
choose decision with the maximum of the
maximum payoffs
 Maximin criterion
choose decision with the maximum of the
minimum payoffs
 Minimax regret criterion
choose decision with the minimum of the
maximum regrets for each alternative
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Russell/Taylor Oper Mgt 2/e C2 Supp - 6
 Hurwicz criterion
– choose decision in which decision payoffs are
weighted by a coefficient of optimism, 
– coefficient of optimism () is a measure of a
decision maker’s optimism, from 0 (completely
pessimistic) to 1 (completely optimistic)

 Equal likelihood (La Place) criterion

– choose decision in which each state of nature
is weighted equally

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Russell/Taylor Oper Mgt 2/e C2 Supp - 7
 Decision Making Under
Uncertainty Example
States Of Nature
Good Foreign Poor Foreign
Decision Competitive Conditions Competitive Conditions
Expand $ 800,000 $ 500,000
Maintain status quo 1,300,000 -150,000
Sell now 320,000 320,000

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Russell/Taylor Oper Mgt 2/e C2 Supp - 8
 Maximax Solution
Expand: $ 800,000
Status quo: 1,300,000 Maximum
Sell: 320,000

Decision: Maintain status quo

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Russell/Taylor Oper Mgt 2/e C2 Supp - 9
 Maximin Solution
Expand: $ 500,000 Maximum
Status quo: -150,000
Sell: 320,000

Decision: Expand

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Russell/Taylor Oper Mgt 2/e C2 Supp - 10
 Minimax Regret Solution
Good Foreign Poor Foreign
Competitive Conditions Competitive Conditions
$ 1,300,000 - 800,000 = 500,000 $ 500,000 - $500,000 = 0
1,300,000 - 1,300,000 = 0 500,000 - (-150,000) = 650,000
1,300,000 - 320,000 = 980,000 500,000 - 320,000 = 180,000

Regret Value
Expand: $ 500,000 Maximum
Status quo: 650,000
Sell: 980,000
Decision: Expand

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Russell/Taylor Oper Mgt 2/e C2 Supp - 11
 Hurwicz Solution
 = 0.3, 1-  = 0.7

Expand: $ 800,000 (0.3) + 500,000 (0.7) = $590,000 **

Status quo: 1,300,000 (0.3) -150,000 (0.7) = 285,000
Sell: 320,000 (0.3) + 320,000 (0.7) = 320,000

Decision: Expand
** Maximum

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Russell/Taylor Oper Mgt 2/e C2 Supp - 12
 Equal Likelihood Solution
Two decisions, weight = 0.50 for each state of nature

Expand: $ 800,000 (0.50) + 500,000 (0.50) = $590,000 **

Status quo: 1,300,000 (0.50) -150,000 (0.50) = 285,000
Sell: 320,000 (0.50) + 320,000 (0.50) = 320,000

Decision: Expand

**Maximum
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Russell/Taylor Oper Mgt 2/e C2 Supp - 13
 Decision Making With
Probabilities
 Risk involves assigning probabilities to
states of nature

 Expected value is a weighted average of

decision outcomes in which each future
state of nature is assigned a probability of
occurrence

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Russell/Taylor Oper Mgt 2/e C2 Supp - 14
 Expected Value
n
EV( x)   p xi xi
i1
where
xi  outcome i
p xi  probability of outcome i

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Russell/Taylor Oper Mgt 2/e C2 Supp - 15
 Expected Value Example
70% probability of good foreign competition
30% probability of poor foreign competition

EV(expand) $ 800,000 (0.70) + 500,000 (0.30)

= $710,000
EV(status quo) $1,300,000 (0.70) - 150,000 (0.30)
= 865,000 Maximum
EV(sell) $ 320,000 (0.70) + 320,000 (0.30)
= 320,000

Decision: Maintain status quo

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Russell/Taylor Oper Mgt 2/e C2 Supp - 16
 Expected Value Of Perfect
Information
 The maximum value of perfect information
to the decision maker

 EVPI = (expected value given perfect

information) - (expected value without
perfect information)

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Russell/Taylor Oper Mgt 2/e C2 Supp - 17
 EVPI Example
Good conditions will exist 70% of the time, choose maintain
status quo with payoff of $1,300,000

Poor conditions will exist 30% of the time, choose expand with
payoff of $500,000

Expected value given perfect information

= $1,300,000 (0.70) + 500,000 (0.30) = $1,060,000

EVPI = $1,060,000 - 865,000 = $195,000

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Russell/Taylor Oper Mgt 2/e C2 Supp - 18
 Sequential Decision Trees
 A graphical method for analyzing decision
situations that require a sequence of
decisions over time
 Decision tree consists of
Square nodes - indicating decision points
Circles nodes - indicating states of nature
Arcs - connecting nodes

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Russell/Taylor Oper Mgt 2/e C2 Supp - 19
 Decision Tree Example $2,000,000
0.60 Market growth
2
0.40
No market $225,000
growth Market $3,000,000
Expand growth
(-$800,000) Expand 0.80
(-$800,000) 6
$700,000
0.20
1 Market 4 No market
growth (3 years, Sell land growth
$0 payoff)
Purchase Land
(-$200,000) 0.60 Market $2,300,000
3 growth
0.40 Warehouse 0.30
(-$600,000) 7
0.70 $1,000,000
No market 5
No market
growth (3 years, Sell land growth
$0 payoff)
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Russell/Taylor Oper Mgt 2/e C2 Supp - 20
 Evaluations At Nodes
Compute EV at nodes 6 & 7
EV(node 6) = 0.80($3,000,000) + 0.20($700,000) = $2,540,000
EV(node 6) = 0.30($2,300,000) + 0.70($1,000,000) = $1,390,000

Expected values written above nodes 6 & 7

Decision at node 4 is between

$2,540,000 for Expand and
$450,000 for Sell land
Choose Expand

Repeat expected value calculations and decisions at remaining nodes

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Russell/Taylor Oper Mgt 2/e C2 Supp - 21
 Decision Tree Solution
$1,290,000 $2,000,000
0.60 Market growth
2
0.40
No market $225,000
growth Market $3,000,000
Expand $2,540,000
growth
(-$800,000) Expand 0.80
$1,740,000 (-$800,000) 6
$700,000
0.20
1 $1,160,000 Market 4 No market
growth (3 years, Sell land growth
$0 payoff)
Purchase Land
(-$200,000) 0.60 Market $2,300,000
$1,390,000
3 growth
0.40 Warehouse 0.30
$790,000 (-$600,000) 7
$1,360,000
0.70 $1,000,000
No market 5
No market
growth (3 years, Sell land growth
$0 payoff)
© 1998 by Prentice-Hall Inc $210,000
Russell/Taylor Oper Mgt 2/e C2 Supp - 22