Chapter 3

Decision Analysis

To accompany
Quantitative Analysis for Management, Eleventh Edition, Global Edition
by Render, Stair, and Hanna
Power Point slides created by Brian Peterson
 Learning Objectives
After completing this chapter, students will be able to:

1. List the steps of the decision-making

process.
2. Describe the types of decision-making
environments.
3. Make decisions under uncertainty.
4. Use probability values to make decisions
under risk.

Copyright © 2012 Pearson Education 3-2

 Learning Objectives
After completing this chapter, students will be able to:

5. Develop accurate and useful decision

trees.
6. Revise probabilities using Bayesian
analysis.
7. Use computers to solve basic decision-
making problems.
8. Understand the importance and use of
utility theory in decision making.

Copyright © 2012 Pearson Education 3-3

 Chapter Outline
3.1 Introduction
3.2 The Six Steps in Decision Making
3.3 Types of Decision-Making
Environments
3.4 Decision Making under Uncertainty
3.5 Decision Making under Risk
3.6 Decision Trees
3.7 How Probability Values Are
Estimated by Bayesian Analysis
3.8 Utility Theory
Copyright © 2012 Pearson Education 3-4
 Introduction

 What is involved in making a good

decision?
 Decision theory is an analytic and
systematic approach to the study of
decision making.
 A good decision is one that is based
on logic, considers all available data
and possible alternatives, and the
quantitative approach described here.

Copyright © 2012 Pearson Education 3-5

 The Six Steps in Decision Making

1. Clearly define the problem at hand.

2. List the possible alternatives.
3. Identify the possible outcomes or states
of nature.
4. List the payoff (typically profit) of each
combination of alternatives and
outcomes.
5. Select one of the mathematical decision
theory models.
6. Apply the model and make your
decision.
Copyright © 2012 Pearson Education 3-6
 Thompson Lumber Company

Step 1 – Define the problem.

 The company is considering
expanding by manufacturing and
marketing a new product – backyard
storage sheds.
Step 2 – List alternatives.
 Construct a large new plant.
 Construct a small new plant.
 Do not develop the new product line
at all.
Step 3 – Identify possible outcomes.
 The market could be favorable or
unfavorable.
Copyright © 2012 Pearson Education 3-7
 Thompson Lumber Company

Step 4 – List the payoffs.

 Identify conditional values for the
profits for large plant, small plant, and
no development for the two possible
market conditions.
Step 5 – Select the decision model.
 This depends on the environment and
amount of risk and uncertainty.
Step 6 – Apply the model to the data.
 Solution and analysis are then used to
aid in decision-making.

Copyright © 2012 Pearson Education 3-8

 Thompson Lumber Company

Decision Table with Conditional Values for

Thompson Lumber

STATE OF NATURE

FAVORABLE UNFAVORABLE
ALTERNATIVE MARKET ($) MARKET ($)
Construct a large plant 200,000 –180,000

Construct a small plant 100,000 –20,000

Do nothing 0 0

Table 3.1

Copyright © 2012 Pearson Education 3-9

 Types of Decision-Making
Environments

Type 1: Decision making under certainty

 The decision maker knows with
certainty the consequences of every
alternative or decision choice.
Type 2: Decision making under uncertainty
 The decision maker does not know the
probabilities of the various outcomes.
Type 3: Decision making under risk
 The decision maker knows the
probabilities of the various outcomes.

Copyright © 2012 Pearson Education 3-10

 Decision Making Under
Uncertainty
There are several criteria for making decisions
under uncertainty:
1. Maximax (optimistic)
2. Maximin (pessimistic)
3. Criterion of realism (Hurwicz)
4. Equally likely (Laplace)
5. Minimax regret

Copyright © 2012 Pearson Education 3-11

 Maximax
Used to find the alternative that maximizes the
maximum payoff.
 Locate the maximum payoff for each alternative.
 Select the alternative with the maximum
number.
STATE OF NATURE
FAVORABLE UNFAVORABLE MAXIMUM IN
ALTERNATIVE MARKET ($) MARKET ($) A ROW ($)
Construct a large
200,000 –180,000 200,000
plant
Maximax
Construct a small
100,000 –20,000 100,000
plant
Do nothing 0 0 0
Table 3.2
Copyright © 2012 Pearson Education 3-12
 Maximin
Used to find the alternative that maximizes
the minimum payoff.
 Locate the minimum payoff for each alternative.
 Select the alternative with the maximum
number.
STATE OF NATURE
FAVORABLE UNFAVORABLE MINIMUM IN
ALTERNATIVE MARKET ($) MARKET ($) A ROW ($)
Construct a large
200,000 –180,000 –180,000
plant
Construct a small
100,000 –20,000 –20,000
plant
Do nothing 0 0 0
Table 3.3 Maximin
Copyright © 2012 Pearson Education 3-13
 Criterion of Realism (Hurwicz)
This is a weighted average compromise
between optimism and pessimism.
 Select a coefficient of realism , with 0≤α≤1.
 A value of 1 is perfectly optimistic, while a
value of 0 is perfectly pessimistic.
 Compute the weighted averages for each
alternative.
 Select the alternative with the highest value.

Weighted average = (maximum in row)

+ (1 – )(minimum in row)

Copyright © 2012 Pearson Education 3-14

 Criterion of Realism (Hurwicz)
 For the large plant alternative using  = 0.8:
(0.8)(200,000) + (1 – 0.8)(–180,000) = 124,000
 For the small plant alternative using  = 0.8:
(0.8)(100,000) + (1 – 0.8)(–20,000) = 76,000
STATE OF NATURE
CRITERION
FAVORABLE UNFAVORABLE OF REALISM
ALTERNATIVE MARKET ($) MARKET ($) ( = 0.8) $
Construct a large
200,000 –180,000 124,000
plant
Realism
Construct a small
100,000 –20,000 76,000
plant
Do nothing 0 0 0
Table 3.4
Copyright © 2012 Pearson Education 3-15
 Equally Likely (Laplace)
Considers all the payoffs for each alternative
 Find the average payoff for each alternative.
 Select the alternative with the highest average.

STATE OF NATURE
FAVORABLE UNFAVORABLE ROW
ALTERNATIVE MARKET ($) MARKET ($) AVERAGE ($)
Construct a large
200,000 –180,000 10,000
plant
Construct a small
100,000 –20,000 40,000
plant
Equally likely
Do nothing 0 0 0

Table 3.5

Copyright © 2012 Pearson Education 3-16

 Minimax Regret
Based on opportunity loss or regret,
regret this is
the difference between the optimal profit and
actual payoff for a decision.
 Create an opportunity loss table by determining
the opportunity loss from not choosing the best
alternative.
 Opportunity loss is calculated by subtracting
each payoff in the column from the best payoff
in the column.
 Find the maximum opportunity loss for each
alternative and pick the alternative with the
minimum number.

Copyright © 2012 Pearson Education 3-17

 Minimax Regret
Determining Opportunity Losses for Thompson Lumber
STATE OF NATURE

FAVORABLE MARKET ($) UNFAVORABLE MARKET ($)

200,000 – 200,000 0 – (–180,000)

200,000 – 100,000 0 – (–20,000)

200,000 – 0 0–0

Table 3.6

Copyright © 2012 Pearson Education 3-18

 Minimax Regret
Opportunity Loss Table for Thompson Lumber

STATE OF NATURE

FAVORABLE UNFAVORABLE
ALTERNATIVE MARKET ($) MARKET ($)
Construct a large plant 0 180,000

Construct a small plant 100,000 20,000

Do nothing 200,000 0

Table 3.7

Copyright © 2012 Pearson Education 3-19

 Minimax Regret

Thompson’s Minimax Decision Using Opportunity Loss

STATE OF NATURE
FAVORABLE UNFAVORABLE MAXIMUM IN
ALTERNATIVE MARKET ($) MARKET ($) A ROW ($)
Construct a large
0 180,000 180,000
plant
Construct a small
100,000 20,000 100,000
plant
Minimax
Do nothing 200,000 0 200,000

Table 3.8

Copyright © 2012 Pearson Education 3-20

 Decision Making Under Risk
 This is decision making when there are several
possible states of nature, and the probabilities
associated with each possible state are known.
 The most popular method is to choose the
alternative with the highest expected monetary
value (EMV).
 This is very similar to the expected value calculated in
the last chapter.

native i) = (payoff of first state of nature)

x (probability of first state of nature)
+ (payoff of second state of nature)
x (probability of second state of nature)
+ … + (payoff of last state of nature)
x (probability of last state of nature)
Copyright © 2012 Pearson Education 3-21
 EMV for Thompson Lumber
 Suppose each market outcome has a probability of
occurrence of 0.50.
 Which alternative would give the highest EMV?
 The calculations are:

rge plant) = ($200,000)(0.5) + (–$180,000)(0.5)

= $10,000
mall plant) = ($100,000)(0.5) + (–$20,000)(0.5)
= $40,000
o nothing) = ($0)(0.5) + ($0)(0.5)
= $0

Copyright © 2012 Pearson Education 3-22

 EMV for Thompson Lumber

STATE OF NATURE
FAVORABLE UNFAVORABLE
ALTERNATIVE MARKET ($) MARKET ($) EMV ($)
Construct a large
200,000 –180,000 10,000
plant
Construct a small
100,000 –20,000 40,000
plant
Do nothing 0 0 0
Probabilities 0.50 0.50

Table 3.9 Largest EMV

Copyright © 2012 Pearson Education 3-23

 Expected Value of Perfect
Information (EVPI)
 EVPI places an upper bound on what you should
pay for additional information.
EVPI = EVwPI – Maximum EMV

 EVwPI is the long run average return if we have

perfect information before a decision is made.

EVwPI = (best payoff for first state of nature)

x (probability of first state of nature)
+ (best payoff for second state of nature)
x (probability of second state of nature)
+ … + (best payoff for last state of nature)
x (probability of last state of nature)
Copyright © 2012 Pearson Education 3-24
 Expected Value of Perfect
Information (EVPI)
 Suppose Scientific Marketing, Inc. offers
analysis that will provide certainty about
market conditions (favorable).
 Additional information will cost $65,000.
 Should Thompson Lumber purchase the
information?

Copyright © 2012 Pearson Education 3-25

 Expected Value of Perfect
Information (EVPI)
Decision Table with Perfect Information

STATE OF NATURE
FAVORABLE UNFAVORABLE
ALTERNATIVE MARKET ($) MARKET ($) EMV ($)
Construct a large
200,000 -180,000 10,000
plant
Construct a small
100,000 -20,000 40,000
plant
Do nothing 0 0 0
With perfect
200,000 0 100,000
information
EVwPI
Probabilities 0.5 0.5
Table 3.10
Copyright © 2012 Pearson Education 3-26
 Expected Value of Perfect
Information (EVPI)
The maximum EMV without additional information is
$40,000.
EVPI = EVwPI – Maximum EMV
= $100,000 - $40,000
= $60,000

So the maximum Thompson

should pay for the additional
information is $60,000.

Copyright © 2012 Pearson Education 3-27

 Expected Value of Perfect
Information (EVPI)
The maximum EMV without additional information is
$40,000.
EVPI = EVwPI – Maximum EMV
= $100,000 - $40,000
= $60,000

So the maximum Thompson

should pay for the additional
information is $60,000.
Therefore, Thompson should not
pay $65,000 for this information.
Copyright © 2012 Pearson Education 3-28
 Expected Opportunity Loss
 Expected opportunity loss (EOL) is the
cost of not picking the best solution.
 First construct an opportunity loss table.
 For each alternative, multiply the
opportunity loss by the probability of that
loss for each possible outcome and add
these together.
 Minimum EOL will always result in the
same decision as maximum EMV.
 Minimum EOL will always equal EVPI.

Copyright © 2012 Pearson Education 3-29

 Expected Opportunity Loss
STATE OF NATURE
FAVORABLE UNFAVORABLE
ALTERNATIVE MARKET ($) MARKET ($) EOL
Construct a large plant 0 180,000 90,000
Construct a small
100,000 20,000 60,000
plant
Do nothing 200,000 0 100,000
Probabilities 0.50 0.50
Table 3.11 Minimum EOL
arge plant) = (0.50)($0) + (0.50)($180,000)
= $90,000
mall plant) = (0.50)($100,000) + (0.50)($20,000)
= $60,000
o nothing) = (0.50)($200,000) + (0.50)($0)
= $100,000
Copyright © 2012 Pearson Education 3-30
 Sensitivity Analysis
 Sensitivity analysis examines how the decision
might change with different input data.
 For the Thompson Lumber example:

P = probability of a favorable market

(1 – P) = probability of an unfavorable market

Copyright © 2012 Pearson Education 3-31

 Sensitivity Analysis
EMV(Large Plant) = $200,000P – $180,000)(1 – P)
= $200,000P – $180,000 + $180,000P
= $380,000P – $180,000
EMV(Small Plant) = $100,000P – $20,000)(1 – P)
= $100,000P – $20,000 + $20,000P
= $120,000P – $20,000
EMV(Do Nothing) = $0P + 0(1 – P)
= $0

Copyright © 2012 Pearson Education 3-32

 Sensitivity Analysis
EMV Values

$300,000

$200,000 Point 2 EMV (large plant)

$100,000 Point 1 EMV (small plant)

0 EMV (do nothing)

.167 .615 1
–$100,000 Values of P

–$200,000

Figure 3.1
Copyright © 2012 Pearson Education 3-33
 Sensitivity Analysis
Point 1:
EMV(do nothing) = EMV(small plant)
20,000
0 $120,000 P  $20,000 P 0.167
120,000

Point 2:
EMV(small plant) = EMV(large plant)
$120,000 P  $20,000 $380,000 P  $180,000
160,000
P 0.615
260,000

Copyright © 2012 Pearson Education 3-34

 Sensitivity Analysis
BEST RANGE OF P
ALTERNATIVE VALUES
Do nothing Less than 0.167
EMV Values Construct a small plant 0.167 – 0.615
$300,000 Construct a large plant Greater than 0.615

$200,000 Point 2 EMV (large plant)

$100,000 Point 1 EMV (small plant)

0 EMV (do nothing)

.167 .615 1
–$100,000 Values of P

–$200,000
Figure 3.1
Copyright © 2012 Pearson Education 3-35
 Using Excel

Input Data for the Thompson Lumber Problem

Using Excel QM

Program 3.1A

Copyright © 2012 Pearson Education 3-36

 Using Excel

Output Results for the Thompson Lumber Problem

Using Excel QM

Program 3.1B

Copyright © 2012 Pearson Education 3-37

 Decision Trees
 Any problem that can be presented in a
decision table can also be graphically
represented in a decision tree.
 Decision trees are most beneficial when a
sequence of decisions must be made.
 All decision trees contain decision points
or nodes, from which one of several alternatives
may be chosen.
 All decision trees contain state-of-nature
points or nodes, out of which one state of
nature will occur.

Copyright © 2012 Pearson Education 3-38

 Five Steps of
Decision Tree Analysis

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 alternatives and states of
nature.
5. Solve the problem by computing
expected monetary values (EMVs) for
each state of nature node.

Copyright © 2012 Pearson Education 3-39

 Structure of Decision Trees
 Trees start from left to right.
 Trees represent decisions and outcomes
in sequential order.
 Squares represent decision nodes.
 Circles represent states of nature nodes.
 Lines or branches connect the decisions
nodes and the states of nature.

Copyright © 2012 Pearson Education 3-40

 Thompson’s Decision Tree
A State-of-Nature Node

Favorable Market
A Decision Node
1
Unfavorable Market
uct nt
r
n st P l a
e
Co arg
L Favorable Market
Construct
2
Small Plant Unfavorable Market
Do
No
th
in
g
Figure 3.2

Copyright © 2012 Pearson Education 3-41

 Thompson’s Decision Tree
EMV for Node = (0.5)($200,000) + (0.5)(–$180,000)
1 = $10,000
Payoffs
Favorable Market (0.5)
$200,000
Alternative with best
EMV is selected 1
Unfavorable Market (0.5)
ct nt –$180,000
r u
n st P l a
e
Co arg
L Favorable Market (0.5)
$100,000
Construct
2
Small Plant Unfavorable Market (0.5)
–$20,000
Do
No
th EMV for Node = (0.5)($100,000)
in
g 2 = $40,000 + (0.5)(–$20,000)
Figure 3.3
$0
Copyright © 2012 Pearson Education 3-42
 Thompson’s Complex Decision Tree
First Decision Second Decision Payoffs
Point Point
Favorable Market (0.78)
$190,000
nt 2 Unfavorable Market (0.22)
ePla –$190,000
g
Lar Favorable Market (0.78)
$90,000
Small
5) 3 Unfavorable Market (0.22)
0 .4 Plant –$30,000
(
e y ts e
u rv sul abl No Plant
–$10,000
S Re vor
a
1 S u rv F Favorable Market (0.27)
e $190,000
y

Re y (
ve

nt 4 Unfavorable Market (0.73)

Ne su 0.5 Pla
ur

e –$190,000
5) g
tS

ga lts
tiv Lar Favorable Market (0.27)
$90,000
Small
ke

e 5 Unfavorable Market (0.73)

ar

Plant –$30,000
Mt
uc

No Plant
–$10,000
nd
Co

Do Favorable Market (0.50)

Not $200,000
Con nt 6 Unfavorable Market (0.50)
duc Pla –$180,000
t ge
Sur
ve y Lar Favorable Market (0.50)
$100,000
Small
Plant
7 Unfavorable Market (0.50)
Figure 3.4 –$20,000
No Plant
$0

Copyright © 2012 Pearson Education 3-43

 Thompson’s Complex Decision Tree

Given favorable survey results,

EMV(node 2) = EMV(large plant | positive survey)
= (0.78)($190,000) + (0.22)(–$190,000) = $106,400
EMV(node 3) = EMV(small plant | positive survey)
= (0.78)($90,000) + (0.22)(–$30,000) = $63,600
EMV for no plant = –$10,000
Given negative survey results,
EMV(node 4) = EMV(large plant | negative survey)
= (0.27)($190,000) + (0.73)(–$190,000) = –$87,400
EMV(node 5) = EMV(small plant | negative survey)
= (0.27)($90,000) + (0.73)(–$30,000) = $2,400
EMV for no plant = –$10,000

Copyright © 2012 Pearson Education 3-44

 Thompson’s Complex Decision Tree

Compute the expected value of the market survey,

EMV(node 1) = EMV(conduct survey)
= (0.45)($106,400) + (0.55)($2,400)
= $47,880 + $1,320 = $49,200
f the market survey is not conducted,
EMV(node 6) = EMV(large plant)
= (0.50)($200,000) + (0.50)(–$180,000) = $10,000
EMV(node 7) = EMV(small plant)
= (0.50)($100,000) + (0.50)(–$20,000) = $40,000
EMV for no plant = $0
The best choice is to seek marketing information.

Copyright © 2012 Pearson Education 3-45

 Thompson’s Complex Decision Tree
First Decision Second Decision Payoffs
Point Point
$106,400 Favorable Market (0.78)
$190,000
la nt Unfavorable Market (0.22)

$106,400
P –$190,000
ge
Lar $63,600 Favorable Market (0.78)
$90,000
Small
5) Unfavorable Market (0.22)
0 .4 Plant –$30,000
(
e y ts e
u rv sul abl No Plant
–$10,000
S Re vor
Su Fa –$87,400 Favorable Market (0.27)
rv $190,000
e
y

Re y (
ve

a n t Unfavorable Market (0.73)

Ne su 0.5 Pl
ur

–$190,000
5) ge
tS

ga lts r $2,400
$2,400
La Favorable Market (0.27)
tiv Small $90,000
ke

e Unfavorable Market (0.73)

ar

Plant –$30,000
M
ct

No Plant
du

–$10,000
on
$49,200
C

Do $10,000 Favorable Market (0.50)

Not $200,000
Con t Unfavorable Market (0.50)
duc P lan –$180,000
ge
$40,000

t Sur Lar $40,000 Favorable Market (0.50)

ve y Small $100,000
Unfavorable Market (0.50)
Plant –$20,000
Figure 3.5
No Plant
$0

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