Lecture Outline

Decision Analysis Decision Making without Probabilities Decision Making with Probabilities Expected Value of Perfect Information Sequential Decision Tree

Decision Making Without Probabilities

States of nature

Events that may occur in the future Examples of states of nature:

high or low demand for a product good or bad economic conditions

Decision making under risk

probabilities can be assigned to the occurrence of states of nature in the future probabilities can NOT be assigned to the occurrence of states of nature in the future

Decision making under uncertainty

Payoff Table
Payoff: outcome of a decision

States Of Nature Decision a b 1 Payoff 1a Payoff 1b 2 Payoff 2a Payoff 2b

Decision Making Criteria Under Uncertainty

Maximax

Choose decision with the maximum of the maximum payoffs

Maximin

Choose decision with the maximum of the minimum payoffs

Choose decision with the minimum of the maximum regrets for each alternative

Minimax regret

Decision Making Criteria Under Uncertainty (cont.)

Hurwicz

Choose decision in which decision payoffs are weighted by a coefficient of optimism, alpha Coefficient of optimism is a measure of a decision makers optimism, from 0 (completely pessimistic) to 1 (completely optimistic) Choose decision in which each state of nature is weighted equally

Equal likelihood (La Place)

Southern Textile Company

STATES OF NATURE
Good Foreign Poor Foreign

DECISION
Expand Maintain status quo Sell now

Competitive Conditions

Competitive Conditions

1,300,000 $ 800,000 320,000

-150,000 $ 500,000 320,000

Maximax Solution
STATES OF NATURE
Good Foreign Poor Foreign Competitive Conditions

DECISION Expand Maintain status quo Sell now

Competitive Conditions

1,300,000 $ 800,000 320,000

-150,000 $ 500,000 320,000

Expand: Status quo: Sell:

1,300,000 Maximum $800,000 320,000

Decision: Expand

Maximin Solution
STATES OF NATURE
Good Foreign Poor Foreign Competitive Conditions

DECISION Expand Maintain status quo Sell now

Competitive Conditions

1,300,000 $ 800,000 320,000

-150,000 $ 500,000 320,000

Expand: -150,000 Status quo: $500,000 Maximum Sell: 320,000 Decision: Maintain status quo

Minimax Regret Solution

Good Foreign Competitive Conditions Poor Foreign Competitive Conditions

1,300,000 - 1,300,000 = 0 500,000 - (-150,000)= 650,000 $1,300,000 - 800,000 = 500,000 $500,000 - 500,000 = 0 1,300,000 - 320,000 = 980,000 500,000 - 320,000= 180,000

Expand: Status quo: Sell:

650,000 $500,000 Minimum 980,000 Decision: Status Quo

Hurwicz Criteria
STATES OF NATURE
Good Foreign Poor Foreign Competitive Conditions

DECISION Expand Maintain status quo Sell now

Competitive Conditions

1,300,000 $ 800,000 320,000

-150,000 $ 500,000 320,000

= 0.3

1 - = 0.7

Expand: 1,300,000(0.3) -150,000(0.7) = 285,000 Status quo: $800,000(0.3) + 500,000(0.7) = $590,000 Maximum Sell: 320,000(0.3) + 320,000(0.7) = 320,000

Decision: Status Quo

Equal Likelihood Criteria

STATES OF NATURE
Good Foreign Poor Foreign Competitive Conditions

DECISION Expand Maintain status quo Sell now

Competitive Conditions

$ 800,000 1,300,000 320,000

$ 500,000 -150,000 320,000

Two states of nature each weighted 0.50

Expand: 1,300,000(0.5) -150,000(0.5) = 575,000 Status quo: $800,000(0.5) + 500,000(0.5) = $650,000 Maximum Sell: 320,000(0.5) + 320,000(0.5) = 320,000

Decision: Status Quo

Decision Making with Probabilities

Risk involves assigning probabilities to states of nature Expected value

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

Expected value
EV (x) =
where xi = outcome i p(xi) = probability of outcome i

p(xi)xi
i =1

Decision Making with Probabilities: Example

STATES OF NATURE
Good Foreign Poor Foreign
Competitive Conditions

DECISION Expand Maintain status quo Sell now

Competitive Conditions

1,300,000 $ 800,000 320,000

-150,000 $ 500,000 320,000

EV(expand): 1,300,000(0.7) -150,000(0.3) = 865,000 Maximum EV(status quo): $800,000(0.7) + 500,000(0.3) = $710,000 EV(sell): 320,000(0.7) + 320,000(0.3) = 320,000

p(good) = 0.70

p(poor) = 0.30

Decision: Expand

Expected Value of Perfect Information

EVPI

maximum value of perfect information to the decision maker

Maximum amount that an investor would pay to purchase perfect information

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 Recall that expected value without perfect information was $865,000 (maintain status quo) EVPI= $1,060,000 - 865,000 = $195,000

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

Decision Tree Analysis

$1,290,000 0.60 2 0.40 $225,000 $2,540,000 0.80 $3,000,000 Market growth $2,000,000

$1,740,000
1 $1,160,000 4

6 0.20

$700,000

$450,000 0.60 3 $1,360,000 0.40 $790,000 5 7 0.70 $1,000,000

$1,390,000
0.30

$2,300,000

$210,000

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 7)= 0.30($2,300,000) + 0.70($1,000,000)= $1,390,000

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