Chapter 8 Decision Analysis

Slides 8a: Introduction

Decision Analysis

A set of alternative actions

We

may chose whichever we please

A set of possible states of nature

Only

one will be correct, but we dont know in advance

A set of outcomes and a value for each

Each

is a combination of an alternative action and a state of nature Value can be monetary or otherwise

Decision Analysis

Certainty
Decision

Maker knows with certainty what the state of nature will be - only one possible state of nature Maker knows all possible states of nature, but does not know probability of occurrence

Ignorance
Decision

Risk
Decision

Maker knows all possible states of nature, and can assign probability of occurrence for each state

Decision Making Under Certainty

Decision Variable Units to build Parameter Estimates Cost to build (/unit) Revenue (/unit) Demand (units) Consequence Variables Total Revenue Total Cost Performance Measure Net Revenue 150

$ $

6,000 14,000 250

$ 2,100,000 $ 900,000

$ 1,200,000

Decision Making Under Ignorance Payoff Table

Kelly Construction Payoff Table (Prob. 8-17)
State of Nature Demand Alternative Actions Low (50 units) Medium (100 units) High (150 units) Build 50 Build 100 Build 150 400,000 100,000 (200,000) 400,000 800,000 500,000 400,000 800,000 1,200,000

Decision Making Under Ignorance

Maximax Select the strategy with the highest possible return Maximin Select the strategy with the smallest possible loss LaPlace-Bayes All states of nature are equally likely to occur. Select alternative with best average payoff

Maximax:
The Optimistic Point of View

Select the best of the best strategy

Evaluates

each decision by the maximum possible return associated with that decision (Note: if cost data is used, the minimum return is best) The decision that yields the maximum of these maximum returns (maximax) is then selected

For risk takers

Doesnt

consider the down side risk Ignores the possible losses from the selected alternative

Maximax Example
Kelly Construction
State of Nature Alternative Actions Build 50 Build 100 Build 150 Demand Low (50 units) Medium (100 units) High (150 units) 400,000 100,000 (200,000) 400,000 800,000 500,000 400,000 800,000 1,200,000 Maximax Criterion Max 400,000 800,000 1,200,000

Maximin:
The Pessimistic Point of View

Select the best of the worst strategy

Evaluates

each decision by the minimum possible return associated with the decision The decision that yields the maximum value of the minimum returns (maximin) is selected

For risk averse decision makers

A

protect strategy Worst case scenario the focus

Maximin
Kelly Construction
State of Nature Alternative Actions Build 50 Build 100 Build 150 Demand Low (50 units) Medium (100 units) High (150 units) 400,000 100,000 (200,000) 400,000 800,000 500,000 400,000 800,000 1,200,000 Maximin Criterion Min 400,000 100,000 (200,000)

Decision Making Under Risk

Expected Return (ER)*

Select A

the alternative with the highest (long term) expected return weighted average of the possible returns for each alternative, with the probabilities used as weights

* Also referred to as Expected Value (EV) or Expected

Monetary Value (EMV) **Note that this amount will not be obtained in the short term, or if the decision is a one-time event!

Expected Return
State of Nature Alternative Actions Build 50 Build 100 Build 150 Probability Demand Low (50 units) Medium (100 units) High (150 units) 400,000 100,000 (200,000) 0.2 400,000 800,000 500,000 0.5 400,000 800,000 1,200,000 0.3 Expected Return ER 400,000 660,000 570,000 1.0

Expected Value of Perfect Information

EVPI measures how much better you could do on this decision if you could always know when each state of nature would occur, where:
EVUPI

= Expected Value Under Perfect Information (also called EVwPI, the EV with perfect information, or EVC, the EV under certainty) = Expected Value of the best action with imperfect information (also called EVBest ) = EVUPI EVUII

EVUII EVPI

EVPI tells you how much you are willing to pay for perfect information (or is the upper limit for what you would pay for additional imperfect information!)

Expected Value of Perfect Information

State of Nature Alternative Actions Build 50 Build 100 Build 150 Probability Best Decision Demand Low (50 units) Medium (100 units) High (150 units) 400,000 100,000 (200,000) 0.2 400,000 400,000 800,000 500,000 0.5 800,000 400,000 800,000 1,200,000 0.3 1,200,000 EVPI Expected Return ER 400,000 660,000 570,000 1.0 840,000 180,000

Using Excel to Calculate EVPI:

Formulas View
Kelly Construction
A 1 2 3 4 5 6 7 8 9 10 11 12 13 14 B C D E

Payoffs Alternatives Build 50 Build 100 Build 150 Probability Best Decision

States of Nature Low (50 units) Medium (100 units) 400000 400000 100000 800000 -200000 500000 0.2 0.5 =MAX(B5:B7) =MAX(C5:C7)

Expected Return High (150 units) ER 400000 =SUMPRODUCT(B5:D5,B$8:D$8) 800000 =SUMPRODUCT(B6:D6,B$8:D$8) 1200000 =SUMPRODUCT(B7:D7,B$8:D$8) 0.3 =MAX(D5:D7) EVwPI = =SUMPRODUCT(B9:D9,B8:D8) EVBest = =MAX(E5:E7) EVPI = =E11-E12

The Newsvendor Model

A newsvendor can buy the Wall Street Journal newspapers for 40 cents each and sell them for 75 cents. However, he must buy the papers before he knows how many he can actually sell. If he buys more papers than he can sell, he disposes of the excess at no additional cost. If he does not buy enough papers, he loses potential sales now and possibly in the future. Suppose that the loss of future sales is captured by a loss of goodwill cost of 50 cents per unsatisfied customer.

The demand distribution is as follows:

P0 = Prob{demand = 0} = 0.1
P1 = Prob{demand = 1} = 0.3

P2 = Prob{demand = 2} = 0.4
P3 = Prob{demand = 3} = 0.2

Each of these four values represent the states of nature. The number of papers ordered is the decision. The returns or payoffs are as follows:

Decision 0

State of Nature (Demand) 0 1 2 3

0 -50 -100 -150

1
2 3

-40
-80 -120

35
-5 -45

-15
70 30

-65
20 105

Payoff = 75(# papers sold) 40(# papers ordered) 50(unmet demand) Where 75 = selling price 40 = cost of buying a paper 50 = cost of loss of goodwill

Now, the ER is calculated for each decision:

ER0 = 0(0.1) 50(0.3) 100(0.4) 150(0.2) = -85 ER1 = -40(0.1) + 35(0.3) 15(0.4) 65(0.2) = -12.5

ER2 = -80(0.1) 5(0.3) + 70(0.4) + 20(0.2) = 22.5 ER3 = -120(0.1) 45(0.3) + 30(0.4) 105(0.2) = 7.5
State of Nature (Demand) Decision 0 1 2 3 0 1 2 3 -150 -65 20 105 ER -85 -12.5 22.5 7.5 0 -50 -100 Of these four ERs, -40 35 -15 choose the maximum, -80 -120

and order 2 papers

-45 30

-5

70

Prob.

0.1

0.3

0.4

0.2

State of Nature

Decision
0 1 2 3

0
0 -40 -80 -120

1
-50 35 -5 -45

2
-100 -15 70 30

3
-150 -65 20 105

Prob.

0.1

0.3

0.4

0.2

ER(new) = 0(0.1) + 35(0.3) + 70(0.4) + 105(0.2) = 59.5 ER(current) = 22.5

EVPI = 59.5 22.5 = 37.0 cents

Maximax Criterion: The Maximax criterion is an

optimistic decision making criterion. This method evaluates each decision by the maximum possible return associated with that decision. The decision that yields the maximum of these maximum returns (maximax) is then selected.

Maximin Criterion: The Maximin criterion is an

extremely conservative, or pessimistic, approach to making decisions. Maximin evaluates each decision by the minimum possible return associated with the decision. Then, the decision that yields the maximum value of the minimum returns (maximin) is selected.

So, using the 3 criteria, we made the following decisions regarding the newsvendor data:

Criteria
Maximin Cash Flow Expected Return Maximax Cash Flow

Decision
Order 1 paper Order 2 papers Order 3 papers

THE RATIONALE FOR UTILITY

Most people are risk-averse, which means they would feel that the loss of a certain amount of money would be more painful than the gain of the same amount of money.

Utility functions in decision analysis measure the

attractiveness of money.

Utility can be thought of as a measure of satisfaction.

Typical risk-averse utility function:

A gain in utility of 0.06
Utility 1.0 0.910 0.850 0.775 0.680

0.524

100

200

300

400

500

600 Dollars

Go from $400 to $500 results in

To illustrate, first suppose you have $100 and someone gives you an additional $100. Note that your utility increases by

U(200) U(100) = 0.680 0.524 = 0.156

Now suppose you start with $400 and someone gives you an additional $100. Now your utility increases by

U(500) U(400) = 0.910 0.850 = 0.060

This illustrates that an additional $100 is less attractive if you have $400 on hand than it is if you start with $100.

Utilities and Decisions under Risk

Summary:
Utility is a way to incorporate risk aversion into the
expected return calculation.
Calculating a utility function is out of the scope of this course, but it can be calculated by a series of lottery questions (e.g., Would you prefer one million dollars or a 50% chance of earning five million?).