INSTITUTE OF ACCOUNTANCY ARUSHA

MODULE: OPERATIONS RESEARCH - AFU07437 / BMU07424 / SSU07404

TOPIC: DECISION ANALYSIS

Lecture 1

Objectives:
After completing this topic, you should be able to:
􀂄Describe the decision environments of certainty, uncertainty and risk.
􀂄Construct a payoff table and an opportunity-loss table.
􀂄Use non-probabilistic and probabilistic criteria for decision making.
􀂄Define and apply the expected value criterion for decision making.
􀂄Compute the value of perfect information.
􀂄Develop and use decision trees for decision making.

Decision Making Overview

Decision Making

Decision Environment Decision Criteria

Certainty Non-probabilistic

Uncertainty
Probabilistic

Risk

The Decision Making Environment

Certainty: The results of decision alternatives are known. This means that the decision
maker knows with certainty the consequences of every alternative or decision choice.
Naturally, the choice would be the alternative that will result in the best outcome.

Example:
Must print 10,000 color brochures.
Offset press A: TZS 200,000 fixed cost + TZS 250 per page
Offset press B: TZS 500,000 fixed cost + TZS 200 per page

Uncertainty: The outcome that will occur after a choice is unknown. This means that
there are several outcomes for each alternative, and the decision maker does not know
the probabilities of the various outcomes. Non-probabilistic decision criteria are applied
under the environment of uncertainty.

Example:

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You must decide to buy an item now or wait. If you buy now the price is TZS 200,000. If
you wait the price may drop to TZS 150,000 or rise to TZS 220,000. There also may be
a new model available later with better features.

Risk: There are several possible outcomes for each alternative, and the decision maker
knows the probability of occurrence of each outcome. Probabilistic decision criteria are
applied under the environment of risk.

The Decision Making Criteria

Non-probabilistic Decision Criteria:Five decision rules that can be applied if the

probabilities of uncertain events are not known.

􀂄maximax criterion
􀂄maximin criterion
􀂄realism (Hurwicz) criterion
􀂄equally likely (laplace) criterion
􀂄minimax regret criterion

Probabilistic Decision Criteria: Consider the probabilities ofuncertain events and

select analternative to maximize theexpected payoff or minimize theexpected loss. Two
decision rules that can be applied if the probabilities of uncertain events are known.

􀂄maximize expected value

􀂄minimize expected opportunity loss

Steps in Decision Making

􀂄Clearly define the problem.

􀂄List all possible alternatives.
􀂄Identify all possible outcomes for each alternative.
􀂄Identify the payoff for each alternative and outcome combination.
􀂄Use a decision modeling technique or criteria to choose an alternative.

A Payoff Table:

A payoff table shows alternatives, states of nature, and payoffs.

Investment Choice Profit in TZS 1,000,000’s

(Alternatives) (States of Nature)
Strong Economy Stable Economy Weak Economy
Large Factory 200 50 -120
Medium Factory 90 120 -30
Small Factory 40 30 20

Non-probabilistic Decision Criteria:

Maximax Solution:
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The maximax criterion (an optimistic approach):
1. For each option, find the maximum payoff.
2. Choose the option with the greatest maximum payoff.

In the payoff table above, the maximum profit for each alternative is given below:
Large Factory = TZS 200,000,000
Medium Factory = TZS 120,000,000
Small Factory = TZS 40,000,000

The greatest maximum profit is therefore TZS 200,000,000.

The decision under the Maximax criterion is to choose Large Factory.

Maximin Solution:

The maximin criterion (a pessimistic approach):

1. For each option, find the minimum payoff
2. Choose the option with the greatest minimum payoff

In the payoff table above, the minimum profit for each alternative is given below:
Large Factory = (TZS 120,000,000)
Medium Factory = (TZS 30,000,000)
Small Factory = TZS 20,000,000

The greatest minimum profit is therefore TZS 20,000,000.

The decision under the Maximin criterion is to choose Small Factory.

Realism (Hurwicz) Solution:

The realism criterion:

1. Determine the coefficient of realism or index of optimism (). Note 0  1,
 = 0 Maximin and  = 1Maximax.
2. For each option, find the weighted average (= x maximum payoff + (1-) x
minimum payoff)
2. Choose the option with the greatest weighted average payoff.

In the payoff table above, the weighted average for each alternative is given below ( =
0.6):
Large Factory = 0.6 x 200,000,000 + 0.4 x (-120,000,000) = TZS 72,000,000
Medium Factory = 0.6 x 120,000,000 + 0.4 x (-30,000,000) = TZS 60,000,000
Small Factory = 0.6 x 40,000,000 + 0.4 x 20,000,000 = TZS 32,000,000

The greatest payoff is therefore TZS 72,000,000.

The decision under the Realism criterion is to choose Large Factory.

Equally Likely Solution:

The equally likely criterion (also known as laplace criterion) makes the assumption that
any of the states of nature could occur, but does not give preference to any one.

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 Calculate the weighted average for each alternative and then choose the best
payoff.

In the payoff table above, the weighted average for each alternative is given below:
Large Factory = 0.33 x 200,000,000 + 0.33 x 50,000,000 +0.33 x (-120,000,000) =
TZS 42,900,000
Medium Factory = 0.33 x 90,000,000 + 0.33 x 120,000,000 + 0.33 x (-30,000,000) =
TZS 60,000,000
Small Factory = 0.33 x 40,000,000 + 0.33 x 30,000,000 + 0.33 x 20,000,000 =
TZS 30,000,000

The greatest weighted average is therefore TZS 60,000,000.

The decision under the Equally Likely criterion is to choose Medium Factory.

Opportunity Loss:

Opportunity loss is the difference between an actual payoff for a decision and the
optimal payoff for that state of nature.

Investment Choice Profit in TZS 1,000,000’s

(Alternatives) (States of Nature)
Strong Economy Stable Economy Weak Economy
Large Factory 200 50 -120
Medium Factory 90 120 -30
Small Factory 40 30 20

The choice “Medium Factory” has payoff 90 for “Strong

Economy”. Given “Strong Economy”, the choice of “Large
Factory” would have given apayoff of 200, or 110 higher.
Therefore the opportunity loss = 110 for this cell.

Now, compute the opportunity loss for all cell to obtain the following “Opportunity Loss”
table:

OpportunityLoss Table:
Investment Choice Opportunity Loss in TZS 1,000,000’s
(Alternatives) (States of Nature)
Strong Economy Stable Economy Weak Economy
Large Factory 0 70 140
Medium Factory 110 0 50
Small Factory 160 90 0

Minimax Regret Solution:

1. For each alternative, find the maximum opportunity loss (or “regret”).
2. Choose the option with the smallest maximum loss.

In the Opportunity Loss table above, the maximum opportunity loss (or “regret”) for each
alternative is given below:
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 Large Factory = TZS 140,000,000
Medium Factory = TZS 110,000,000
Small Factory = TZS 160,000,000

The smallest maximum loss is therefore TZS 110,000,000.

The decision under the Minimax Regret criterion is to choose Medium Factory.