Quantitative Methods for

Decision Making

Dr. Tanvir Abir

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►
Outline
The Decision Process in Operations
► Fundamentals of Decision Making
► Decision Tables
► Types of Decision-Making Environments
► Decision Trees
Learning Objectives
When you complete this chapter you should be
able to:

1. Create a simple decision tree

2. Build a decision table
3. Explain when to use each of the three
types of decision-making environments
4. Calculate an expected monetary value
(EMV)
Learning Objectives
When you complete this chapter you
should be able to:

5. Compute the expected value of

perfect information (EVPI)
6. Evaluate the nodes in a decision tree
7. Create a decision tree with sequential
decisions
 What is Decision theory ?
Decision theory is an analytic and systematic approach to the study of
decision making.

A good decision is based on logic

The Six Steps in Decision Making

1. Clearly define the problem at hand.

2. List the possible alternatives.
3. Identify the possible outcomes or states of nature.
4. List the payoff (typically profit) of each combination of alternatives and
outcomes.
5. Select one of the mathematical decision theory models.
6. Apply the model and make your decision.

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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
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The Decision Process in
Operations
1. Clearly define the problem and the
factors that influence it
2. Develop specific and measurable
objectives
3. Develop a model
4. Evaluate each alternative solution
5. Select the best alternative
6. Implement the decision and set a
timetable for completion
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 Tree Example
A decision node A state of nature node
Favorable market

1
t ruct t Unfavorable market
o ns plan
C ge
lar Favorable market
Construct
small plant
2
Do Unfavorable market
no
thi
ng

Figure A.1
Decision Table Example
TABLE A.1 Decision Table with Conditional Values for Getz Products
STATES OF NATURE
ALTERNATIVES FAVORABLE MARKET UNFAVORABLE MARKET
Construct large plant $200,000 –$180,000
Construct small plant $100,000 –$ 20,000
Do nothing $ 0 $ 0
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
Decision making under uncertainty
1. Optimistic (maximax)
2. Pessimistic (maximin)
3. Criterion of realism (Hurwicz)
4. Equally likely (Laplace)
5. Minimax regret

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Uncertainty Example
TABLE A.2 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
plant $200,000 –$180,000 $200,000 –$180,000 $10,000
Construct small
plant $100,000 –$ 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 plant

2. Maximin choice is to do nothing
3. Equally likely choice is to construct a small plant
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)

© 2014 Pearson Education, Inc. MA - 19

EMV Example
TABLE A.3 Decision Table for Getz Products
STATES OF NATURE
FAVORABLE UNFAVORABLE
ALTERNATIVES MARKET MARKET
Construct large plant (A1) $200,000 –$180,000
Construct small plant (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
 Types of Decision-Making Environments

In the environment of decision making under certainty,

decision makers know with certainty the consequence of
every alternative or decision choice. Naturally, they will
choose the alternative that will maximize their well-being
or will result in the best outcome.

For example, let’s say that you have $1,000 to invest for a 1-
year period. One alternative is to open a savings account
paying 4% interest and another is to invest in a
government Treasury bond paying 6% interest. If both
investments are secure and guaranteed, there is a certainty
that the Treasury bond will pay a higher return. The return
after 1 year will be $60 in interest.
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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 Trees
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 working backward
through the tree computing the EMV for
each state-of-nature node
Decision Tree Example
Figure A.2 EMV for node 1
= $48,000 = (.6)($200,000) + (.4)(–$180,000)

Payoffs
Favorable market (.6)
$200,000

nt 1
e pla Unfavorable market (.4)
l arg
t
–$180,000
s t ruc Favorable market (.6)
n
Co $100,000
Construct
small plant 2
Unfavorable market (.4)
Do –$20,000
no
th
in EMV for node 2
g = (.6)($100,000) + (.4)(–$20,000)
= $52,000

$0
Complex
Decision
Tree
Example

Figure A.3
Complex Example
1. Given favorable survey results

EMV(2) = (.78)($190,000) + (.22)(–$190,000) = $106,400

EMV(3) = (.78)($90,000) + (.22)(–$30,000) = $63,600

The EMV for no plant = –$10,000 so, if

the survey results are favorable, build
the large plant
Complex Example
2. Given negative survey results

EMV(4) = (.27)($190,000) + (.73)(–$190,000) = –$87,400

EMV(5) = (.27)($90,000) + (.73)(–$30,000) = $2,400

The EMV for no plant = –$10,000 so, if

the survey results are negative, build
the small plant
Complex Example
3. Compute the expected value of the
market survey
EMV(1) = (.45)($106,400) + (.55)($2,400) = $49,200

4. If the market survey is not conducted

EMV(6) = (.6)($200,000) + (.4)(–$180,000) = $10,000
EMV(7) = (.6)($100,000) + (.4)(–$20,000) = $40,000

The EMV for no plant = $0 so, given

no survey, build the small plant
Complex Example
5. The expected monetary value of not
conducting the survey is $52,000 and the
EMV for conducting the study is $49,200

The best choice is to not seek marketing

information and build the small plant
 Decision Analysis
Solved Problems
3-1,
3-2
3-3

Recommended Book:
Quantitative Analysis for Management twelfth
edition Barry Render • Ralph M. Stair, Jr. • Michael
E. Hanna • Trevor S. Hale

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