Transportation & Distribution Planning

Lecture 23
Decision Analysis

Course Instructor: Sayda Uzma Tahira

UCP Business School, University of Central Punjab Lahore
 Chapter Outline
▶ Decision Making under Uncertainty
▶ Decision Making under Risk
▶ Decision Making under Certainty
▶ Decision Trees
▶ Single Stage Decisions
▶ Multi-Stage Decisions
▶ Using Tree Plan for Making Decision Trees in
Excel
 Fundamentals of
Decision Making
1. Terms:
a. Alternative – a course of action or
strategy that may be chosen by the
decision maker
b. State of nature – an occurrence or a
situation over which the decision
maker has little or no control
 Fundamentals of
Decision Making
2. Symbols used in a decision tree:
a. – Decision node from which one of
several alternatives may be selected
b. – A state-of-nature node out of
which one state of nature will occur
Decision-Making Environments
▶ Decision making under uncertainty
▶ Complete uncertainty as to which state of
nature may occur
▶ Decision making under risk
▶ Several states of nature may occur
▶ Each has a probability of occurring
▶ Decision making under certainty
▶ State of nature is known
 Uncertainty
1. Maximax
▶ Find the alternative that maximizes the
maximum outcome for every alternative
▶ Pick the outcome with the maximum
number
▶ Highest possible gain
▶ This is viewed as an optimistic decision
criteria
 Uncertainty
2. Maximin
▶ Find the alternative that maximizes the
minimum outcome for every alternative
▶ Pick the outcome with the minimum
number
▶ Least possible loss
▶ This is viewed as a pessimistic decision
criteria
 Uncertainty
3. Equally likely
▶ Find the alternative with the highest
average outcome
▶ Pick the outcome with the maximum
number
▶ Assumes each state of nature is equally
likely to occur
 Uncertainty Example
Decision Table for Decision Making Under Uncertainty
STATES OF NATURE
FAVORABLE UNFAVORABLE MAXIMUM MINIMUM ROW
ALTERNATIVES MARKET MARKET IN ROW IN ROW AVERAGE
Construct large
DC $200,000 –$180,000 $200,000 –$180,000 $10,000
Construct small
DC $100,000 –$ 20,000 $100,000 –$ 20,000 $40,000
Do nothing $ 0 $ 0 $ 0 $ 0 $ 0
Maximax Maximin Equally
likely

1. Maximax choice is to construct a large DC

2. Maximin choice is to do nothing
3. Equally likely choice is to construct a small DC
Decision Making Under Risk
▶ Each possible state of nature has an
assumed probability
▶ States of nature are mutually exclusive
▶ Probabilities must sum to 1
▶ Determine the expected monetary
value (EMV) for each alternative
Expected Monetary Value

EMV (Alternative i) = (Payoff of 1st state of nature)

x (Probability of 1st state of
nature)
+ (Payoff of 2nd state of nature)
x (Probability of 2nd state of
nature)
+ … + (Payoff of last state of
nature) x (Probability of
last state of nature)
 EMV Example
Decision Table/ Payoff Table
STATES OF NATURE
FAVORABLE UNFAVORABLE
ALTERNATIVES MARKET MARKET
Construct large DC (A1) $200,000 –$180,000
Construct small DC (A2) $100,000 –$ 20,000
Do nothing (A3) $ 0 $ 0
Probabilities 0.6 0.4

1. EMV(A1) = (.6)($200,000) + (.4)(–$180,000) = $48,000

2. EMV(A2) = (.6)($100,000) + (.4)(–$20,000) = $52,000
3. EMV(A3) = (.6)($0) + (.4)($0) = $0
Best Option
Decision Making Under Certainty

▶ Is the cost of perfect information

worth it?
▶ Determine the expected value of
perfect information (EVPI)
 Expected Value of
Perfect Information
EVPI is the difference between the payoff
under certainty and the payoff under risk
Expected value Maximum
EVPI = with perfect – EMV
information
Expected value with = (Best outcome or consequence for 1st state
perfect information of nature) x (Probability of 1st state of
(EVwPI) nature)
+ Best outcome for 2nd state of nature)
x (Probability of 2nd state of nature)
+ … + Best outcome for last state of nature)
x (Probability of last state of nature)
 EVPI Example
1. The best outcome for the state of nature
“favorable market” is “build a large facility”
with a payoff of $200,000. The best outcome
for “unfavorable” is “do nothing” with a payoff
of $0.
Expected value
with perfect = ($200,000)(.6) + ($0)(.4) = $120,000
information
 EVPI Example
2. The maximum EMV is $52,000, which is the
expected outcome without perfect
information. Thus:

EVPI = EVwPI – Maximum

EMV

= $120,000 – $52,000 = $68,000

The most the company should pay for perfect

information is $68,000
 Decision Trees
▶ Information in decision tables can be
displayed as decision trees
▶ A decision tree is a graphic display of the
decision process that indicates decision
alternatives, states of nature and their
respective probabilities, and payoffs for each
combination of decision alternative and state
of nature
▶ Appropriate for showing sequential decisions
 Decision Tree Example
A decision node A state of nature node
Favorable market

1
t r uct t Unfavorable market
o ns Plan
C e
g
lar Favorable market
Construct
small Plant
2
Do Unfavorable market
no
thi
ng

Figure A.1
Decision Trees and
Capacity Decision
Market favorable (.4)
$100,000

Market unfavorable (.6)

nt -$90,000
P l a
arge
L
Market favorable (.4)
$60,000
Medium Plant
Sm Market unfavorable (.6)
all -$10,000
pl a
nt
Do Market favorable (.4)
no $40,000
th
ing
Market unfavorable (.6)
-$5,000

$0
 Decision Trees and
Capacity Decision
Market favorable (.4)
$100,000

Market unfavorable (.6)

nt -$90,000
pl a
arge
L
Market favorable (.4)
$60,000
Medium plant
SLarge
ma Plant Market unfavorable (.6)
-$10,000
ll p
l an
t
EMV = (.4)($100,000)
Do Market favorable (.4)
no
+ (.6)(-$90,000) $40,000
th
ing
Market unfavorable (.6)
EMV = -$14,000 -$5,000

$0
Decision Trees and
Capacity Decision
-$14,000
Market favorable (.4)
$100,000

Market unfavorable (.6)

nt -$90,000
pl a
arge $18,000
L
Market favorable (.4)
$60,000
Medium plant
Sm Market unfavorable (.6)
all -$10,000
pl a
nt $13,000
Do Market favorable (.4)
no $40,000
th
ing
Market unfavorable (.6)
-$5,000

$0
Applying Expected Monetary
Value (EMV) and Capacity
Decisions
► Determine states of nature
► Future demand
► Market favorability
► Assign probability values to states
of nature to determine expected
value
 EMV Applied to Capacity
Decision
▶ Southern Hospital Supplies capacity
expansion
EMV (large plant) = (.4)($100,000) + (.6)(–$90,000)
= –$14,000
EMV (medium plant) = (.4)($60,000) + (.6)(–$10,000)
= +$18,000
EMV (small plant) = (.4)($40,000) + (.6)(–$5,000)
= +$13,000
EMV (do nothing) = $0