DECISION ANALYSIS

DECISION ANALYSIS

★ What are your considerations when making a

decision?
★ What is your major decision in life?
Ask yourself :)

If you will win a million pesos,

what will you do with the money?
 Decision-making situations occur under conditions of
uncertainty.
Decision situations can be categorized into two classes:
situations in which probabilities cannot be assigned to
future occurrences and situations in which probabilities
can be assigned.
Components of Decision Making
A decision-making situation includes several
components—the decisions themselves and the actual events
that may occur in the future, known as states of nature. At the
time a decision is made, the decision maker is uncertain which
states of nature will occur in the future and has no control over
them.
A distribution company is considering purchasing a
computer to increase the number of orders it can process
and thus increase its business.
★ What will happen if economic conditions remain good?
★ What will happen if economic takes a downturn?
 As another example, consider a concessions vendor who
must decide whether to stock coffee for the concession
stands at a football game in November. If the weather is cold,
most of the coffee will be sold, but if the weather is warm,
very little coffee will be sold.
Payoff Tables
To facilitate the analysis of these types of decision situations so that the
best decisions result, they are organized into payoff tables. In general, a
payoff table is a means of organizing and illustrating the payoffs from the
different decisions, given the various states of nature in a decision problem.

Payoffs are typically expressed in terms of profit, revenues, or cost

(although they can be expressed in terms of a variety of values).
Decision Making Without Probabilities

The investor must decide among an

apartment building, an office building,
and a warehouse. The future states of
nature that will determine how much
profit the investor will make are good
economic conditions and poor economic
conditions.
Decision-Making Criteria
Once the decision situation has been organized into a payoff table, several
criteria are available for making the actual decision. These decision criteria,
which will be presented in this section,include maximax, maximin, minimax
regret, Hurwicz, and equal likelihood. On occasion these criteria will result in
the same decision; however, often they will yield different decisions. The
decision maker must select the criterion or combination of criteria that best
suits his or her needs.
The Maximax Criterion
With the maximax criterion, the decision maker selects the decision that will result
in the maximum of the maximum payoffs. (In fact, this is how this criterion derives its
name—a maximum of a maximum.) The maximax criterion is very optimistic. The
decision maker assumes that the most favorable state of nature for each decision
alternative will occur. Thus, for example, using this criterion, the investor would
optimistically assume that good economic conditions will prevail in the future.
The Maximin Criterion
In contrast with the maximax criterion, which is very optimistic, the
maximin criterion is pessimistic. With the maximin criterion, the decision
maker selects the decision that will reflect the maximum of the minimum
payoffs. For each decision alternative, the decision maker assumes that the
minimum payoff will occur. Of these minimum payoffs, the maximum is
selected.
The Minimax Regret Criterion
Suppose the investor decided to purchase the warehouse, only to discover that
economic conditions in the future were better than expected. Naturally, the investor
would be disappointed that she had not purchased the office building because it
would have resulted in the largest payoff ($100,000) under good economic
conditions. In fact, the investor would regret the decision to purchase the
warehouse, and the degree of regret would be $70,000, the difference between the
payoff for the investor’s choice and the best choice.
With this decision criterion, the decision maker attempts to avoid regret by
selecting the decision alternative that minimizes the maximum regret.
Steps in Minimax Regret Criterion
1. Identify the maximum payoff in each condition
2. Subtract each payoff from the maximum payoff to determine the net
amount
3. Select the minimum value since it minimizes the maximum regret

https://jamboard.google.com/d/1N46zetKsTJ9SwMjq2-4-uUsrihHMNkichP-p26zgtpA/edit?usp=sharing
The Hurwicz Criterion
The Hurwicz criterion strikes a compromise between the maximax and maximin criteria. The
principle underlying this decision criterion is that the decision maker is neither totally optimistic (as
the maximax criterion assumes) nor totally pessimistic (as the maximin criterion assumes).

The coefficient of optimism, which we will define as 𝛂 is between zero and one.

0< 𝛂 ≤ 1.0
If 𝛂= 1.0, then the decision maker is said to be optimistic
If 𝛂= =0, then the decision maker is completely pessimistic.
The Hurwicz criterion requires that for each decision alternative, the maximum payoff be
multiplied by 𝛂 and the minimum payoff be multiplied by 1 - 𝛂. For our investment
example, if a equals.4 (i.e., the investor is slightly pessimistic), 1 - 𝛂 = .6, and the following
values will result:

The Hurwicz criterion specifies selection of the decision alternative corresponding to the
maximum weighted value, which is $38,000
 A limitation of the Hurwicz criterion is the fact that 𝛂 must be
determined by the decision maker. It can be quite difficult for a decision
maker to accurately determine his or her degree of optimism. Regardless of
how the decision maker determines 𝛂 , it is still a completely subjective
measure of the decision maker’s degree of optimism. Therefore, the Hurwicz
criterion is a completely subjective decision-making criterion.
The Equal Likelihood Criterion/ LaPlace, criterion
The equal likelihood, or LaPlace, criterion weights each state of nature
equally, thus assuming that the states of nature are equally likely to occur. In
applying the equal likelihood criterion, we are assuming a 50% chance, or .50
probability,that either state of nature will occur.Because there are two states of
nature in our example, we assign a weight of .50 to each one. Next, we multiply
these weights by each payoff for each decision:

We select the decision that has the maximum of these weighted values.
Because $40,000 is the highest weighted value, the investor’s decision would be
to purchase the apartment building.
Summary of Criteria Results
Decision Making With Probabilities
It is often possible for the decision maker to know enough about the
future states of nature to assign probabilities to their occurrence. Given that
probabilities can be assigned, several decision criteria are available to aid the
decision maker. We will consider two of these criteria: expected value and
expected opportunity loss (although several others, including the maximum
likelihood criterion, are available).
Expected Value
To apply the concept of expected value as a decision-making criterion, the
decision maker must first estimate the probability of occurrence of each state
of nature. Once these estimates have been made, the expected value for each
decision alternative can be computed. The expected value is computed by
multiplying each outcome (of a decision) by the probability of its occurrence
and then summing these products. The expected value of a random variable
x, written symbolically as EV1x2, is computed as follows:
Let us suppose that, based on several economic forecasts, the investor is able
to estimate a .60 probability that good economic conditions will prevail and a
.40 probability that poor economic conditions will prevail.
 The best decision is the one with the greatest expected value. Because the
greatest expected value is $44,000, the best decision is to purchase the office
building.
Expected Opportunity Loss
A decision criterion closely related to expected value is expected
opportunity loss. To use this criterion, we multiply the probabilities by the
regret (i.e., opportunity loss) for each decision outcome rather than
multiplying the decision outcomes by the probabilities of their occurrence, as
we did for expected monetary value.
The expected opportunity loss (EOL) for each decision is computed as follows:

Because $28,000 is the minimum expected regret, the decision is to purchase

the office building.
Notice that the decisions recommended by the expected value and expected
opportunity loss criteria were the same—to purchase the office building. This
is not a coincidence because these two methods always result in the same
decision.
Expected Value of Perfect Information
● It is often possible to purchase additional information regarding future events
and thus make a better decision. For example, a real estate investor could hire
an economic forecaster to perform an analysis of the economy to more
accurately determine which economic condition will occur in the future.
● The information has some maximum value that represents the limit of what the
decision maker would be willing to spend
● To compute the expected value of perfect information, we first look at the
decisions under each state of nature
Expected Value of Perfect Information
The expected value of the decision, given perfect information is:
$100,000(0.60)+ 30,000 (0.40) = $72,000
The expected value of perfect information is computed by subtracting
the expected value without perfect information ($44,000) from the expected
value, given perfect information ($72,000):
EVPI = $72,000 - 44,000 = $28,000
The expected value of perfect information, $28,000, is the maximum
amount that the investor would pay to purchase perfect information from
some other source, such as an economic forecaster.