Lecture 2 Decision Making
Importance of Decision Making
Decision Making: The Steps
1. Specify objectives and the criteria for making the decision (cost, profits, return on
investment, increased productivity, risk, company image, demand etc…)
2. Develop alternatives (brainstorm if possible, creativity, teamwork)
3. Analyse and compare alternatives (use statistical techniques if needed)
4. Select the best alternative
5. Implement the chosen alternative (invest, approve applications, authorise
overtime…)
6. Monitor the results to ensure that desired results are achieved
Decision Environments
1. Certainty (variables have known values e.g. cost, production capacity, demand of
product)
2. Risk (certain variables have probabilistic outcomes)
3. Uncertainty (impossible to assess the likelihood of future events)
Example
Profit per unit is $5, you have a demand of 200
Profit per unit is $5, there is 50% chance of an order of 100 and 50% chance
of an order of 200 units
Profit per unit is $5, probabilities for potential demand is unknown
Decision Theory
1. A set of future conditions exist that will have a bearing on the results of the
decision
2. A list of alternatives is available to choose from
3. There is a known payoff for each alternative under possible future condition
The Process
1. Identify the future conditions (demand low, medium, high) known as the states
of nature
Prepared by: Dr D.K.Hurreeram
August 04
Lecture 2 Decision Making
2. Develop the list of alternatives (a course of action or strategy that may be
chosen by a decision maker)
3. Determine or estimate the payoff associated with each alternative (The
Expected Monetary Value for an alternative is the sum of possible payoffs
from the alternative, each weighted by the probability of that payoff occurring).
4. Estimate the likelihood of each possible future condition
5. Evaluate alternatives according to some decision criterion (max. profit, reduce
cost etc…)
Example
Table shows expected payoff for each alternative under the various possible states
of nature.
Alternatives
Possible Future Demand ($ present value)
Low
Moderate
High
Small facility
10
10
10
Medium facility
7
12
12
(4)
2
16
Large facility
Select one alternative
Under Certainty
Choose the alternative that has the best payoff under that state of nature
Under Uncertainty
Maximin: Determine the worst possible payoff for each alternative, and
choose the alternative that has the 'best worst': pessimistic view
Maximax: Detemine the best possible payoff of each alternative, and
choose the alternative that has the best payoff: optimistic view
Laplace: Determine the average payoff for each alternative, and choose
the alternative with the best average.
Minimax Regret: Determine the worst regret for each alternative and
choose the alternative with the ‘best worst’.
Prepared by: Dr D.K.Hurreeram
August 04
Lecture 2 Decision Making
Under Risk
The probability of occurrence of each state of nature is known.
Use the Expected Monetary Value Criterion (EMV): sum of the payoffs of
an alternative where each payoff is weighted by the probability for the
relevant state of nature
E.g. probability of low, moderate and high demand is 0.3, 0.5 and 0.2
respectively, which alternative would be best?
Decision Trees*
A schematic representation of the alternatives available to a decision maker and
their possible consequences (useful for sequential decisions)
A decision node from which one or several alternatives may be selected
A state of nature out of which one state of nature will occur
Using Decision Trees
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 decision alternatives and
states of nature
5. Solve the problem by computing expected monetary value (EMV) for each
state of nature node. This is done by working backward – that is, by starting at
the right of the tree and working back to decision nodes on the left.
Example
ABC company is investigating the possibility of producing and marketing mouse
pads. Undertaking the project would require the construction of either a large or
small manufacturing plant. The market for the product would be favourable or
unfavourable. The company can of course decide not to produce the product at all.
Construct the decision tree for this project
Prepared by: Dr D.K.Hurreeram
August 04
Lecture 2 Decision Making
With a favourable market, a large facility will give ABC a net profit of Rs200000. If
the market is unfavourable a net loss of Rs180000 will occur. A small plant will result
in a net profit of Rs100000 in a favourable market and a net loss of Rs20000 in a
unfavorable market.
Construct the payoff table and decide on the best alternative under minimax,
maximax and Laplace criterion (UNCERTAINTY)
Given that the probability of a fovourable market is the same as that of an
unfavourable market, what do you think should be the best decision? (RISK)
A marketing research team proposes to tell ABC with certainty whether or not the
market is favourable for the proposed product. The cost for the research is Rs65000.
What do you recommend to ABC? How much should ABC pay for the research?
ABC decides to conduct a survey for the sum of Rs10000 instead of subcontracting
the research. The probability that the survey results are favourable is 0.45 and 0.55
for unfavourable…Discuss
Expected Value for Perfect Information (EVPI): upper limit on the amount the
decision maker will be willing to spend to obtain perfect information on the
issue.
EVPI = EMVcertainty - Maximum EMVrisk
Example
An oil company has recently acquired right in a certain area to conduct surveys and
test drillings to lead to lifting oil if it is found in commercially exploitable quantities.
The area is considered to have good potential for finding oil in commercial quantities.
At the outset the company has the choice to conduct further geological tests or to
carryout a drilling programme immediately. On the known conditions, the company
estimates that there is a 70:30 chance of further tests showing a success.
Whether the tests show the possibility of ultimate success or not or even if no tests
are undertaken at all, the company could still pursue its drilling programme or
alternatively consider selling its rights to drill in the area. Thereafter, however, if it
Prepared by: Dr D.K.Hurreeram
August 04
Lecture 2 Decision Making
carries out the drilling programme, the likelihood of final success or failure is
considered dependent on the foregoing stages. Thus:
If successful tests have been carried out, the expectation of success in drilling is
given as 80:20
If the tests indicate failure, then the expectation of success in drilling is 20:80.
If no tests have been carried out the expectation of success in drilling is 55:45.
Costs and revenues have been estimated for all possible outcomes and the net
present value of each is as follows:Outcome
Success
With prior test
Without prior test
Failure
With prior test
Without prior test
Sale of exploitation rights
Prior test show success
Prior test show failure
Without prior test
Prepared by: Dr D.K.Hurreeram
August 04
NPV (Rs Million)
100
120
-50
-40
65
15
45