Chapter 16

Markov Analysis

To accompany
Quantitative Analysis for Management, Tenth Edition,
by Render, Stair, and Hanna 2008 Prentice-Hall, Inc.
Power Point slides created by Jeff Heyl 2009 Prentice-Hall, Inc.
 Learning Objectives
After completing this chapter, students will be able to:

1. Determine future states or conditions by

using Markov analysis
2. Compute long-term or steady-state
conditions by using only the matrix of
transition probabilities
3. Understand the use of absorbing state
analysis in predicting future conditions

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 Chapter Outline
16.1 Introduction
16.2 States and State Probabilities
16.3 Matrix of Transition Probabilities
16.4 Predicting Future Market Share
16.5 Markov Analysis of Machine Operations
16.6 Equilibrium Conditions
16.7 Absorbing States and the Fundamental
Matrix: Accounts Receivable Application

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 Introduction
Markov analysis is a technique that deals
with the probabilities of future occurrences
by analyzing presently known probabilities
It has numerous applications in business
Markov analysis makes the assumption that
the system starts in an initial state or
condition
The probabilities of changing from one state
to another are called a matrix of transition
probabilities
Solving Markov problems requires basic
matrix manipulation

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 Introduction
This discussion will be limited to Markov
problems that follow four assumptions
1. There are a limited or finite number of
possible states
2. The probability of changing states
remains the same over time
3. We can predict any future state from the
previous state and the matrix of transition
probabilities
4. The size and makeup of the system do
not change during the analysis

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 States and State Probabilities
States are used to identify all possible conditions
of a process or system
It is possible to identify specific states for many
processes or systems
In Markov analysis we assume that the states are
both collectively exhaustive and mutually
exclusive
After the states have been identified, the next
step is to determine the probability that the
system is in this state

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 States and State Probabilities
The information is placed into a vector of state
probabilities
(i) = vector of state probabilities
for period i
= ( 1 , 2 , 3 , , n )

where

n = number of states
1, 2, , n = probability
of being in state 1, state 2, ,
state n
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 States and State Probabilities
In some cases it is possible to know with
complete certainty what state an item is in
Vector states can then be represented as

(1) = (1, 0)
where
(1) = vector of states for
the machine in period 1
1 = 1 = probability of
being in the first state
2 = 0 = probability of
being in the second state
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 The Vector of State Probabilities for
Three Grocery Stores Example
States for people in a small town with three
grocery stores
A total of 100,000 people shop at the three
groceries during any given month
Forty thousand may be shopping at American
Food Store state 1
Thirty thousand may be shopping at Food Mart
state 2
Thirty thousand may be shopping at Atlas Foods
state 3

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 The Vector of State Probabilities for
Three Grocery Stores Example
Probabilities are as follows
State 1 American Food Store: 40,000/100,000 = 0.40 = 40%
State 2 Food Mart: 30,000/100,000 = 0.30 = 30%
State 3 Atlas Foods: 30,000/100,000 = 0.30 = 30%
These probabilities can be placed in the following
vector of state probabilities
(1) = (0.4, 0.3, 0.3)
where (1) = vector of state probabilities for
the three grocery stores for period 1
1 = 0.4 = probability that person will
shop at American Food, state 1
2 = 0.3 = probability that person will
shop at Food Mart, state 2
3 = 0.3 = probability that person will
shop at Atlas Foods, state 3 2009 Prentice-Hall, Inc. 16 10
 The Vector of State Probabilities for
Three Grocery Stores Example
The probabilities of the vector states represent
the market shares for the three groceries
Management will be interested in how their
market share changes over time
Figure 16.1 shows a tree diagram of how the
market shares in the next month

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 The Vector of State Probabilities for
Three Grocery Stores Example
Tree diagram for three grocery stores example

0.8 #1 0.32 = 0.4(0.8)

American Food #1 0.1
#2 0.04 = 0.4(0.1)
0.4 0.1
#3 0.04 = 0.4(0.1)

0.1 #1 0.03
Food Mart #2 0.7
#2 0.21
0.3 0.2
#3 0.06

0.2 #1 0.06
Atlas Foods #3 0.2
#2 0.06
0.3 0.6
#3 0.18

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 Matrix of Transition Probabilities

The matrix of transition probabilities allows us to

get from a current state to a future state

Let Pij = conditional probability of being in state j

in the future given the current state of i

For example, P12 is the probability of being in

state 2 in the future given the event was in state 1
in the period before

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 Matrix of Transition Probabilities

Let P = the matrix of transition probabilities

P11 P12 P13 P1n

P= P21
P22 P23 P2n

Pm1 Pmn

Individual Pij values are determined empirically

The probabilities in each row will sum to 1

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 Transition Probabilities for the
Three Grocery Stores
We used historical data to develop the following
matrix
0.8 0.1 0.1
P = 0.1 0.7 0.2
0.2 0.2 0.6

Row 1
0.8 = P11 = probability of being in state 1 after being in state 1 in the
preceding period
0.1 = P12 = probability of being in state 2 after being in state 1 in the
preceding period
0.1 = P13 = probability of being in state 3 after being in state 1 in the
preceding period

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 Transition Probabilities for the
Three Grocery Stores

Row 2
0.1 = P21 = probability of being in state 1 after being in state 2 in the
preceding period
0.7 = P22 = probability of being in state 2 after being in state 2 in the
preceding period
0.2 = P23 = probability of being in state 3 after being in state 2 in the
preceding period

Row 3
0.2 = P31 = probability of being in state 1 after being in state 3 in the
preceding period
0.2 = P32 = probability of being in state 2 after being in state 3 in the
preceding period
0.6 = P33 = probability of being in state 3 after being in state 3 in the
preceding period

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 Predicting Future Market Shares

One of the purposes of Markov analysis is to

predict the future
Given the vector of state probabilities and the
matrix of transitional probabilities, it is not very
difficult to determine the state probabilities at a
future date
This type of analysis allows the computation of
the probability that a person will be at one of the
grocery stores in the future.
Since this probability is equal to market share, it
is possible to determine the future market shares
of the grocery stores

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 Predicting Future Market Shares
When the current period is 0, the state
probabilities for the next period 1 are determined
as follows

(1) = (0)P

For any period n we can compute the state

probabilities for period n + 1

(n + 1) = (n)P

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 Predicting Future Market Shares

The computations for the next periods market

share are

(1) = (0)P

0.8 0.1 0.1

= (0.4, 0.3, 0.3) 0.1 0.7 0.2
0.2 0.2 0.6
= [(0.4)(0.8) + (0.3)(0.1) + (0.3)(0.2),
(0.4)(0.1) + (0.3)(0.7) + (0.3)(0.2),
(0.4)(0.1) + (0.3)(0.2) + (0.3)(0.6)]
= (0.41, 0.31, 0.28)

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 Predicting Future Market Shares

The market share for American Food and Food

Mart have increased and the market share for
Atlas Foods has decreased
We can determine if this will continue by looking
at the state probabilities will be in the future
For two time periods from now

(2) = (1)P

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 Predicting Future Market Shares
Since we know that

(1) = (0)P
We have

(2) = (1)P = [ (0)P]P = (0)PP = (0)P2

In general

(n) = (0)Pn

The question of whether American and Food Mart

will continue to gain market share and Atlas will
continue to loose is best addressed in terms of
equilibrium or steady state conditions
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 Markov Analysis of
Machine Operations
The owner of Tolsky Works has recorded the
operation of his milling machine for several years
Over the past two years, 80% of the time the
milling machine functioned correctly for the
current month if it had functioned correctly
during the preceding month
90% of the time the machine remained incorrectly
adjusted if it had been incorrectly adjusted in the
preceding month
10% of the time the machine corrected to
problems and operated correctly when it had
been operating incorrectly

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 Markov Analysis of
Machine Operations
The matrix of transition probabilities for this
machine is
0.8 0.2
P=
0.1 0.9
where
P11 = 0.8 = probability that the machine will be correctly functioning
this month given it was correctly functioning last month
P12 = 0.2 = probability that the machine will not be correctly
functioning this month given it was correctly functioning
last month
P21 = 0.1 = probability that the machine will be correctly functioning
this month given it was not correctly functioning last
month
P22 = 0.9 = probability that the machine will not be correctly
functioning this month given it was not correctly
functioning last month
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 Markov Analysis of
Machine Operations
What is the probability that the machine will be
functioning correctly one and two months from
now?
(1) = (0)P
0.8 0.2
= (1, 0)
0.1 0.9
= [(1)(0.8) + (0)(0.1), (1)(0.2) + (0)(0.9)]
= (0.8, 0.2)

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 Markov Analysis of
Machine Operations
What is the probability that the machine will be
functioning correctly one and two months from
now?
(2) = (1)P
0.8 0.2
= (0.8, 0.2)
0.1 0.9
= [(0.8)(0.8) + (0.2)(0.1), (0.8)(0.2) + (0.2)(0.9)]
= (0.66, 0.34)

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 Equilibrium Conditions
It is easy to imagine that all market shares will
eventually be 0 or 1
But equilibrium share of the market values or
probabilities generally exist
An equilibrium condition exists if state
probabilities do not change after a large number
of periods
At equilibrium, state probabilities for the next
period equal the state probabilities for current
period
Equilibrium state probabilities can be computed
by repeating Markov analysis for a large number
of periods
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 Equilibrium Conditions
It is always true that
(next period) = (this period)P
Or
(n + 1) = (n)P
At equilibrium
(n + 1) = (n)
So at equilibrium
(n + 1) = (n)P = (n)
Or
= P
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 Equilibrium Conditions
For Tolskys machine

=P
0.8 0.2
( 1, 2) = ( 1, 2)
0.1 0.9

Using matrix multiplication

( 1, 2) = [( 1)(0.8) + ( 2)(0.1), ( 1)(0.2) + ( 2)(0.9)]

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 Equilibrium Conditions
The first and second terms on the left side, 1 and
2, are equal to the first terms on the right side
1 = 0.8 1 + 0.1 2
2 = 0.2 1 + 0.9 2

The state probabilities sum to 1

1 + 2 + + n = 1

For Tolskys machine

1 + 2 = 1

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 Equilibrium Conditions
We arbitrarily decide to solve the following two
equations
2 = 0.2 1 + 0.9 2
1 + 2 = 1
Through rearrangement and substitution we get
0.1 2 = 0.2 1
2 = 2 1
1 + 2 = 1
1 + 2 1 = 1
3 1 = 1
1 = 1/3 = 0.33333333
2 = 2/3 = 0.66666667 2009 Prentice-Hall, Inc. 16 30
 Absorbing States and the
Fundamental Matrix
Accounts Receivable example
The examples so far assume it is possible to go
from one state to another
This is not always possible
If you must remain in a state it is called an
absorbing state
An accounts receivable system normally places
accounts in three possible states
State 1 ( 1): paid, all bills
State 2 ( 2): bad debt, overdue more than three months
State 3 ( 3): overdue less than one month
State 4 ( 4): overdue between one and three months

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 Absorbing States and the
Fundamental Matrix
The matrix of transition probabilities of this
problem is
NEXT MONTH
BAD <1 1 TO 3
THIS MONTH PAID DEBT MONTH MONTHS
Paid 1 0 0 0
Bad debt 0 1 0 0
Less than 1 month 0.6 0 0.2 0.2
1 to 3 months 0.4 0.1 0.3 0.2

Thus
1 0 0 0
0 1 0 0
P=
0.6 0 0.2 0.2
0.4 0.1 0.3 0.2
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 Absorbing States and the
Fundamental Matrix
To obtain the fundamental matrix, it is necessary
to partition the matrix of transition probabilities
as follows
I 0

1 0 0 0 1 0 0 0
I= 0=
0 1 0 0 0 1 0 0
P=
0.6 0 0.2 0.2 0.6 0 0.2 0.2
0.4 0.1 0.3 0.2 A= B=
0.4 0.1 0.3 0.2

A B

where
I = an identity matrix
0 = a matrix with all 0s
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 Absorbing States and the
Fundamental Matrix
The fundamental matrix can be computed as

F = (I B)1
1
1 0 0.2 0.2
F=
0 1 0.3 0.2
1
0.8 0.2
F=
0.3 0.8

1
d b
The inverse a b
is
a b
=
r r
of the matrix c d c d c a
r r
where
r = ad bc
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 Absorbing States and the
Fundamental Matrix
To find the matrix F we compute

r = ad bc = (0.8)(0.8) (0.3)(0.2) = 0.64 0.06 = 0.58

With this we have

1
0.8 (0.2)
0.8 0.2 0.58 0.58 1.38 0.34
F= = =
0.3 0.8 (0.3) 0.8 0.52 1.38
0.58 0.58

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 Absorbing States and the
Fundamental Matrix
We can use the FA matrix to answer questions
such as how much of the debt in the less than one
month category will be paid back and how much
will become bad debt

M = (M1, M2, M3, , Mn)

where
n = number of nonabsorbing states
M1 = amount in the first state or category
M2 = amount in the second state or category
Mn = amount in the nth state or category

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 Absorbing States and the
Fundamental Matrix
If we assume there is $2,000 in the less than one
month category and $5,000 in the one to three
month category, M would be

M = (2,000, 5,000)

Amount paid and = MFA

amount in bad debts 0.97 0.03
= (2,000, 5,000)
0.86 0.14
= (6,240, 760)

Out of the total of $7,000, $6,240 will eventually be

paid and $760 will end up as bad debt
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