Contemporary Management Science With Spreadsheets: Anderson Sweeney Williams
Contemporary Management Science With Spreadsheets: Anderson Sweeney Williams
Structuring the Decision Problem Decision Making Without Probabilities Decision Making with Probabilities Expected Value of Perfect Information Decision Analysis with Sample Information Developing a Decision Strategy Expected Value of Sample Information
Slide 2
A decision problem is characterized by decision alternatives, states of nature, and resulting payoffs. The decision alternatives are the different possible strategies the decision maker can employ. The states of nature refer to future events, not under the control of the decision maker, which may occur. States of nature should be defined so that they are mutually exclusive and collectively exhaustive. For each decision alternative and state of nature, there is an outcome. These outcomes are often represented in a matrix called a payoff table.
Slide 3
Decision Trees
A decision tree is a chronological representation of the decision problem. Each decision tree has two types of nodes; round nodes correspond to the states of nature while square nodes correspond to the decision alternatives. The branches leaving each round node represent the different states of nature while the branches leaving each square node represent the different decision alternatives. At the end of each limb of a tree are the payoffs attained from the series of branches making up that limb.
Slide 4
If the decision maker does not know with certainty which state of nature will occur, then he is said to be doing decision making under uncertainty. Three commonly used criteria for decision making under uncertainty when probability information regarding the likelihood of the states of nature is unavailable are: the optimistic approach the conservative approach the minimax regret approach.
Slide 5
Optimistic Approach
The optimistic approach would be used by an optimistic decision maker. The decision with the largest possible payoff is chosen. If the payoff table was in terms of costs, the decision with the lowest cost would be chosen.
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Conservative Approach
The conservative approach would be used by a conservative decision maker. For each decision the minimum payoff is listed and then the decision corresponding to the maximum of these minimum payoffs is selected. (Hence, the minimum possible payoff is maximized.) If the payoff was in terms of costs, the maximum costs would be determined for each decision and then the decision corresponding to the minimum of these maximum costs is selected. (Hence, the maximum possible cost is minimized.)
Slide 7
The minimax regret approach requires the construction of a regret table or an opportunity loss table. This is done by calculating for each state of nature the difference between each payoff and the largest payoff for that state of nature. Then, using this regret table, the maximum regret for each possible decision is listed. The decision chosen is the one corresponding to the minimum of the maximum regrets.
Slide 8
Example
Consider the following problem with three decision alternatives and three states of nature with the following payoff table representing profits: States of Nature s1 s2 s3 d1 Decisions d2 d3 4 0 1 4 3 5 -2 -1 -3
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Example
Optimistic Approach An optimistic decision maker would use the optimistic approach. All we really need to do is to choose the decision that has the largest single value in the payoff table. This largest value is 5, and hence the optimal decision is d3. Maximum Decision Payoff d1 4 d2 3 choose d3 d3 5 maximum
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Example
1 2 3 4 5 6 7 8 9
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Example
1 2 3 4 5 6 7 8 9
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Example
Conservative Approach A conservative decision maker would use the conservative approach. List the minimum payoff for each decision. Choose the decision with the maximum of these minimum payoffs. Minimum Decision Payoff d1 -2 choose d2 d2 -1 maximum d3 -3
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Example
1 2 3 4 5 6 7 8 9
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Example
1 2 3 4 5 6 7 8 9
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Example
Minimax Regret Approach For the minimax regret approach, first compute a regret table by subtracting each payoff in a column from the largest payoff in that column. In this example, in the first column subtract 4, 0, and 1 from 4; in the second column, subtract 4, 3, and 5 from 5; etc. The resulting regret table is: s1 s2 s3
d1 d2 d3 0 4 3 1 2 0 1 0 2
Slide 16
Example
Minimax Regret Approach (continued) For each decision list the maximum regret. Choose the decision with the minimum of these values. Decision d1 d2 d3 Maximum Regret 1 minimum 4 3
choose d1
Slide 17
Example
PAYOFF TABLE
Altern. d1 d2 d3
State of Nature s2
=MA X($C$4:$C$6)-C4 =MA X($C$4:$C$6)-C5 =MA X($C$4:$C$6)-C6
Maximum s3
=MA X($D$4:$D$6)-D4 =MA X($D$4:$D$6)-D5 =MA X($D$4:$D$6)-D6
Recommended Decision
Regret
Slide 18
Example
1 2 3 4 5 6 7 8 9 10 11 12 13 14 O P P O R TU N ITY L O S S TA B L E D e c i si o n A l te r n a ti v e d1 d2 d3 s1 0 4 3 S ta te o f N a tu r e s2 1 2 0 s3 1 0 2 M a x im u m R e g re t 1 4 3 1 Re co m m e n d e d D e c i si o n d1
M in im a x R e g re t V a lu e
Slide 19
Expected Value Approach If probabilistic information regarding he states of nature is available, one may use the expected value (EV) approach. Here the expected return for each decision is calculated by summing the products of the payoff under each state of nature and the probability of the respective state of nature occurring. The decision yielding the best expected return is chosen.
Slide 20
The expected value of a decision alternative is the sum of weighted payoffs for the decision alternative. The expected value (EV) of decision alternative di is defined as:
EV( d i ) P( s j )Vij
j 1
where:
N = the number of states of nature P(sj) = the probability of state of nature sj Vij = the payoff corresponding to decision alternative di and state of nature sj
Slide 21
Slide 22
Expected Value Approach Calculate the expected value for each decision. The decision tree on the next slide can assist in this calculation. Here d1, d2, d3 represent the decision alternatives of models A, B, C, and s1, s2, s3 represent the states of nature of 80, 100, and 120.
Slide 23
Decision Tree
s1 .4
2
d1
1
s2 .2 s3 .4 s1 .4 s2 .2 s3 .4 s1
.4 .2
d2
3
8,000 18,000
d3
12,000
6,000 16,000 .4
s2 s3
21,000
Slide 24
Model B
d2
Model C
d3
EV = .4(6,000) + .2(16,000) + .4(21,000) = $14,000 4
4 Alternative s1 = 80 s2 = 100 s3 = 120 5 6 7 9 Model A Model B Model C 10,000 8,000 6,000 0.4 15,000 18,000 16,000 0.2
14,000 =$B$8*B5+$C$8*C5+$D$8*D5 =IF(E5=$E$9,A5,"") 12,000 =$B$8*B6+$C$8*C6+$D$8*D6 =IF(E6=$E$9,A6,"") 21,000 =$B$8*B7+$C$8*C7+$D$8*D7 =IF(E7=$E$9,A7,"") 0.4 =MAX (E5:E7)
8 Probability
Slide 26
1 2 3 4 5 6 7 8 9
M a x im um Ex pe cte d Va lue
Slide 27
Frequently information is available which can improve the probability estimates for the states of nature. The expected value of perfect information (EVPI) is the increase in the expected profit that would result if one knew with certainty which state of nature would occur. The EVPI provides an upper bound on the expected value of any sample or survey information.
Slide 28
EVPI Calculation Step 1: Determine the optimal return corresponding to each state of nature. Step 2: Compute the expected value of these optimal returns. Step 3: Subtract the EV of the optimal decision from the amount determined in step (2).
Slide 29
Expected Value of Perfect Information Calculate the expected value for the optimum payoff for each state of nature and subtract the EV of the optimal decision.
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1 2 3 4 5 6 7 8 9 10 11 12
Slide 31
Knowledge of sample or survey information can be used to revise the probability estimates for the states of nature. Prior to obtaining this information, the probability estimates for the states of nature are called prior probabilities. With knowledge of conditional probabilities for the outcomes or indicators of the sample or survey information, these prior probabilities can be revised by employing Bayes' Theorem. The outcomes of this analysis are called posterior probabilities.
Slide 32
Posterior Probabilities
Posterior Probabilities Calculation Step 1: For each state of nature, multiply the prior probability by its conditional probability for the indicator -- this gives the joint probabilities for the states and indicator. Step 2: Sum these joint probabilities over all states -- this gives the marginal probability for the indicator. Step 3: For each state, divide its joint probability by the marginal probability for the indicator -- this gives the posterior probability distribution.
Slide 33
The expected value of sample information (EVSI) is the additional expected profit possible through knowledge of the sample or survey information.
Slide 34
EVSI Calculation Step 1: Determine the optimal decision and its expected return for the possible outcomes of the sample using the posterior probabilities for the states of nature. Step 2: Compute the expected value of these optimal returns. Step 3: Subtract the EV of the optimal decision obtained without using the sample information from the amount determined in step (2).
Slide 35
Efficiency of sample information is the ratio of EVSI to EVPI. As the EVPI provides an upper bound for the EVSI, efficiency is always a number between 0 and 1.
Slide 36
Sample Information Burger Prince must decide whether or not to purchase a marketing survey from Stanton Marketing for $1,000. The results of the survey are "favorable" or "unfavorable". The conditional probabilities are: P(favorable | 80 customers per hour) = .2 P(favorable | 100 customers per hour) = .5 P(favorable | 120 customers per hour) = .9 Should Burger Prince have the survey performed by Stanton Marketing?
Slide 37
Posterior Probabilities Favorable Survey Results State 80 100 120 Prior .4 .2 .4 Conditional Joint .2 .08 .5 .10 .9 .36 Total .54 P(favorable) = .54 Posterior .148 .185 .667 1.000
Slide 38
Posterior Probabilities Unfavorable Survey Results State 80 100 120 Prior .4 .2 .4 Conditional .8 .5 .1 Total Joint .32 .10 .04 .46 Posterior .696 .217 .087 1.000
P(unfavorable) = .46
Slide 39
1 2 3 4 5 6 7 8 9 10 1 1 S t a t e o f N a t u re 12 13 14 15 s 1 = 80 s 2 = 100 s 3 = 120 M a rk e t R e s e a rc h U n fa vo ra b le P rio r P ro b a b ilit ie s 0.4 0.2 0.4 C o n d it io n a l P ro b a b ilit ie s 0.8 0.5 0.1 Jo in t P ro b a b ilit ie s = B 1 2 *C 1 2 = B 1 3 *C 1 3 = B 1 4 *C 1 4 P o s t erio r P ro b a b ilit ie s = D 1 2 / $ D$ 1 5 = D 1 3 / $ D$ 1 5 = D 1 4 / $ D$ 1 5 S t a t e o f N a t u re s 1 = 80 s 2 = 100 s 3 = 120
P (U n fa vo ra b le ) = = S U M (D 1 2 : D 1 4 )
Slide 40
1 2 3 4 5 6 7 8 9 10 1 1 S t a t e o f N a t u re 12 13 14 15 s 1 = 80 s 2 = 100 s 3 = 120 M a rk e t R e s e a rc h U n fa vo ra b le P rio r P ro b a b ilit ie s 0.4 0.2 0.4 C o n d it io n a l P ro b a b ilit ie s 0.8 0.5 0.1 P (F a vo ra b le ) = Jo in t P ro b a b ilit ie s 0.32 0.10 0.04 0.46 P o s t e rior P ro b a b ilit ie s 0.696 0.217 0.087 S t a t e o f N a t u re s 1 = 80 s 2 = 100 s 3 = 120
Slide 41
d1 d2 d3
6 1
s2 (.185) s3 (.667)
I1
(.54)
s1 (.148) s2 (.185)
s3 (.667)
Slide 42
I2
(.46)
d1
d2
3
d3
9
$8,000 s2 (.217) $18,000 s3 (.087) $12,000 s1 (.696) $6,000 s2 (.217) s3 (.087) $16,000 $21,000 Slide 43
d2
d3
I1
(.54)
6 1
I2
(.46) 3 $11,433
d1 d2 d3
EMV = .696(10,000) + .217(15,000) +.087(14,000)= $11,433 EMV = .696(8,000) + .217(18,000) + .087(12,000) = $10,554
Decision Strategy Assuming the Survey is Undertaken: If the outcome of the survey is favorable, choose Model C. If it is unfavorable, choose Model A.
Slide 45
Question: Should the survey be undertaken? Answer: If the Expected Value with Sample Information (EVwSI) is greater, after deducting expenses, than the Expected Value without Sample Information (EVwoSI), the survey is recommended.
Slide 46
Expected Value with Sample Information (EVwSI) EVwSI = .54($17,855) + .46($11,433) = $14,900.88
Expected Value of Sample Information (EVSI) EVSI = EVwSI - EVwoSI assuming maximization EVSI= $14,900.88 - $14,000 = $900.88
Slide 47
Conclusion EVSI = $900.88 Since the EVSI is less than the cost of the survey ($1000), the survey should not be purchased.
Slide 48
Efficiency of Sample Information The efficiency of the survey: EVSI/EVPI = ($900.88)/($2000) = .4504
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