DECISION MAKING

UNDER RISK
EXPECTED MONETARY VALUE
The EMV for an alternative is just the sum of possible payoffs of the
alternative, each weighted by the probability of that payoff occurring.
EMV (alternative i) = (payoff of first state of nature)
x (probability of first state of nature)
+ (payoff of second state of nature)
x (probability of second state of nature)
++ (payoff of last state of nature)
x (probability of last state of nature)
TABLE 2.2
DECISION TABLE W/ PROBABILITIES AND EMVS FOR THOMPSON LUMBER

STATE OF NATURE
ALTERNATIVE FAVORABLE UNFAVORABLE EMV
MARKET MARKET COMPUTED
($) ($) ($)
Construct a large 200,000 -180,000 10,000
plant
Construct a small 100,000 -20,000 40,000
plant
Do nothing 0 0 0

Probabilities 0.50 0.50

EXPECTED VALUE OF PERFECT INFORMATION

The expected value of information is the expected average return, in the long run, if we
have a perfect information before a decision has to be made. To calculate this, we choose
the best alternative for each state of nature and multiply its payoff times the probability
of occurrence of that state of nature.
EVPI= expected value with perfect information --- maximum EMV
= $100,000-$40,000 = $60,000
 OPPORTUNITY LOSS

Expected opportunity loss (EOL) is the cost of not picking the best solution.
Opportunity loss, sometimes called regret, refers to the difference between the optimal
profit or payoff and the actual payoff received.
TABLE 2.4
TABLE 2.3 Opportunity Loss Table for Thompson Lumber
Determining Opportunity Losses STATE OF NATURE
for Thompson Lumber
ALTERNATIVE FAVORABLE UNFAVORABLE
STATE OF NATURE
MARKET ($) MARKET ($)
FAVORABLE UNFAVORABLE
MARKET ($) MARKET ($) Construct a large 0 180,000
plant
200,000-200,000 0-(-180,000)
Construct a small 100,000 20,000
200,000-100,000 0-(-20,000) plant
Do nothing 200,000 0
200,000-0 0-0
Probabilities 0.50 0.50
 SENSITIVITY ANALYSIS

It investigates how our decision might change given a change in a problem data.
P= probability of a favorable market
EMV Values

$300,000
EMV( large plant)
$200,000 Point 2
Point 1 EMV (small plant)
$100,000

0 1 EMV (do nothing)

0
-$100,000 Values of P

-$200,000
 The results of this sensitivity analysis are displayed in the following table

Alternative Range of P Values

Do nothing Less than 0.167

Constuct a small plant 0.167-0.62

Construct a large plant Greater than 0.62

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