Displaying a Decision Problem

Outcomes

Decision trees Decision tables

States of Nature Alternatives Decision Problem

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Types of Decision Models

Decision making under uncertainty Decision making under risk Decision making under certainty

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Fundamentals of Decision Theory

Terms: Terms: Alternative: course of action or choice State of nature: an occurrence over which the decision maker has no control Symbols used in a decision tree: tree: A decision node from which one of several alternatives may be selected A state of nature node out of which one state of nature will occur
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Getz Products Decision Tree

A state of nature node

Favorable market 1 Unfavorable market

A decision node Construct small plant 2

Favorable market Unfavorable market

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Expected Monetary Value

N: Number of states of nature k: Number of alternative decisions Xij: Value of Payoff for alternative i in state of nature j, i=1,2,...,k and j=1,2,...,N. Pj: Probability of state of nature j

EMV ( Ai ) j 1 X ij Pj

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Example:
States of Nature
Alternatives

Construct large plant Construct small plant Do nothing

Favorable Unfavorable Market Market P(0.5) P(0.5) $200,000 -$180,000 $100,000 $0 -$20,000 $0

Expected value $10,000 $40,000 Best choice $0

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Example: Expected Value of Perfect Information

A ltern a tiv e
Construct a large plant Construct a small plant Do nothing

S ta te o f N a tu re Favorable Unfavorable Market ($) Market ($)

200,000 $100,000 $0 0.50 0.50 -$180,000 -$20,000 $0

EMV $10,000 $40,000 $0

P ro b a b ilities

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Expected Value of Perfect Information

Expected Value Under Certainty =($200,000*0.50 + 0*0.50)= 0*0.50)= $100,000 Max(EMV)= Max{10,000, 40,000, 0}=$40,000 EVPI = Expected Value Under Certainty - Max(EMV) = $100,000 - $40,000 = $60,000
So Getz should not be willing to pay more than $60,000
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Decision Trees
Graphical display of decision process, process, i.e., alternatives, states of nature, probabilities, payoffs. Decision tables are convenient for problems with one set of alternatives and states of nature nature. . With several sets of alternatives and states of nature (sequential decisions), decision trees are used used! ! EMV criterion is the most commonly used criterion in decision tree analysis.

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Softwares for Decision Tree Analysis

DPL Tree Plan Supertree Analysis with less effort. Full color presentations for managers

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Steps of Decision Tree Analysis

Define the problem Structure or draw the decision tree Assign probabilities to the states of nature Estimate payoffs for each possible combination of alternatives and states of nature Solve the problem by computing expected monetary values for each statestate-of of-nature node

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Decision Tree
State 1
Outcome 1 Outcome 2 Outcome 3 Outcome 4

State 2 State 1

2
Decision Node

State 2

State of Nature Node

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Ex1:Getz Ex1: Getz Products Decision Tree

EMV for node 1 = $10,000

Payoffs Favorable market (0.5) $200,000

1 Unfavorable market (0.5) -$180,000 Favorable market (0.5)

Construct small plant 2

$100,000 -20,000 0

Unfavorable market (0.5)

EMV for node 2 = $40,000

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A More Complex Decision Tree

Lets say Getz Products has two sequential decisions to make: Conduct a survey for $10000? Build a large or small plant or not build?

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Ex1:Getz Ex1: Getz Products Decision Tree

$106,400
1st decision point 2nd decision point
$106,400 Fav. Mkt (0.78) Unfav. Mkt (0.22) Fav. Mkt (0.78) Unfav. Mkt (0.22) Fav. Mkt (0.27) Unfav. Mkt (0.73) Fav. Mkt (0.27) Unfav. Mkt (0.73) Fav. Mkt (0.5) Unfav. Mkt (0.5) Fav. Mkt (0.5) Unfav. Mkt (0.5)

2
$63,600

$190,000 -$190,000 $90,000 -$30,000 -$10,000 $190,000 -$190,000 $90,000 -$30,000 -$10,000 $200,000 -$180,000 $100,000 -$20,000 $0
15

$49,200

3
-$87,400

1 $2,400 $49,200

4
$2,400

5
$10,000

$40,000

6
$40,000

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Resulting Decision
EMV of conducting the survey=$49,200 EMV of not conducting the survey=$40,000 So Getz should conduct the survey! If the survey results are favourable, build large plant. If the survey results are infavourable, build small plant.

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Ex2: Ponderosa Record Company

Decide whether or not to market the recordings of a rock group. Alternative1: test market 5000 units and if favorable, market 45000 units nationally Alternative2: Market 50000 units nationally Outcome is a complete success (all are sold) or failure
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Ex2: PonderosaPonderosa-costs, prices

Fixed payment to group: $5000 Production cost: $5000 and $0.75/cd Handling, distribution: $0.25/cd Price of a cd: $2/cd

Cost of producing 5,000 cds =5,000+5,000+(0.25+0.75)5,000=$15,000 Cost of producing 45,000 cds =0+5,000+(0.25+0.75)45,000=$50,000 Cost of producing 50,000 cds =5,000+5,000+(0.25+0.75)50,000=$60,000

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Ex2: PonderosaPonderosa-Event Probabilities

Without testing P(success)=P(failure)=0.5 With testing P(success|test result is favorable)=0.8 P(failure|test result is favorable)=0.2 P(success|test result is unfavorable)=0.2 P(failure|test result is unfavorable)=0.8

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Decision Tree for Ponderosa Record Company

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Backward Approach

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Optimal Decision Policy

Precision Tree provides excell addadd-ins. Optimal decision is: Test market
If the market is favorable, market nationally Else, abort

Risk Profile Possible outcomes for the opt. soln. $35,000 with probability 0.4 -$55,000 with probability 0.1 -$15,000 with probability 0.5
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Application Areas of Decision Theory

Investments in
research and development plant and equipment new buildings and structures

Production and Inventory control Aggregate Planning Maintenance Scheduling, etc.

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References
Lapin L.L., Whisler W.D., Quantitative Decision Making, 7e, 2002. Heizer J., Render, B., Operations Management, 7e, 2004. Render, B., Stair R. M., Quantitative Analysis for Management, 8e, 2003. Anderson, D.R., Sweeney D.J, Williams T.A., Statistics for Business and Economics, 8e, 2002 2002. . Taha, H., Operations Research, 1997 1997. .

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