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 Small facility Medium facility 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. Possible Future Demand ($ present value) Low 10 7 (4) Moderate 10 12 2 High 10 12 16

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 unfavourableDiscuss 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 -50 -40 65 15 45 NPV (Rs Million) 100 120

Prepared by: Dr D.K.Hurreeram August 04