CHAPTER four

DECISION ANALYSIS/
DECISION THEORY
 2.1. Introduction
• Decision analysis (DA) is a form of decision-making that involves
identifying and assessing all aspects of a decision, and taking actions based
on the decision that produces the most favorable outcome.
• The goal of decision analysis is to ensure that decisions are made with all the
relevant information and options available.
• Decision analysis uses a variety of tools and also incorporates aspects of
psychology, management techniques, and economics.
• Several scenarios could be developed to describe how the various factors
combine to form the possible uncertain future events.
• Even when a careful decision analysis has been conducted, the uncertain
future events make the final consequence uncertain.
• In some cases, the selected decision alternative may provide good or
excellent results.
• In other cases, a relatively unlikely future event may occur causing the
selected decision alternative to provide only fair or even poor result.
 2.2. Problem Formulation
• The first step in the decision analysis process is problem
formulation.
• We begin with a verbal statement of the problem.
• We then identify the decision alternatives, the uncertain future
events, referred to as chance events, and the consequences
associated with each decision alternative and each chance event
outcome.
• Example
• Walif Construction Corporation (WCC) has purchased land, which
will be the site of a new luxury Real state complex.
• The location provides a magnificent view of Finfine which is
located at Entoto peak.
• WCC plans to price the individual home units between 1,000,000
and 8,000,000 Birr.
 Cont’d
• WCC has conducted a preliminary architectural drawings for three
different-sized projects: one with 30 Real state , one with 60 Real state ,
and one with 90 Real state .
• The financial success of the project depends upon the size of the Real state
complex and the chance event concerning the demand for the Real state.
• The statement of the WCC decision problem is to select the size of the new
luxury Real state project that will lead to the largest profit given the
uncertainty concerning the demand for the Real state.
• Given the statement of the problem, it is clear that the decision is to select
the best size for the Real state complex.
• Based on the above premises WCC has the following three decision
alternatives:
 D1: a small complex with 30 condominiums
 D2: a medium complex with 60 condominiums
 D3: a large complex with 90 condominiums
 Cont’d
• A factor in selecting the best decision alternative is the uncertainty associated with
the chance event concerning the demand for the Real state.
• When asked about the possible demand for the Real state, WCC’s president
acknowledged a wide range of possibilities, but decided that it would be adequate
to consider two possible chance event outcomes: a strong demand and a weak
demand.
• In decision analysis, the possible outcomes for a chance event are referred to as
the states of nature.
• The states of nature are defined so that one and only one of the possible states of
nature will occur.
• For the WCC problem, the chance event concerning the demand for the Real state
has two states of nature:
 S1: strong demand for the Real state
 S2: weak demand for the Real state
• Thus, management must first select a decision alternative (complex size), then a
state of nature follows (demand for the Real state), and finally a consequence will
occur.
• In this case, the consequence is the WCC’s profit.
 2.3 Influence Diagrams
• An influence diagram is a graphical
device that shows the relationships among States of
Nature Strong
the decisions, the chance events, and the Demand (s1) Weak (s2)

consequences for a decision problem.

• The nodes in an influence diagram are
used to represent the decisions, chance
events, and consequences.
• The lines connecting the nodes, referred
to as arcs, show the direction of influence Profit
Complex
that the nodes have on one another. Size
• The complex size is the decision node,
demand is the chance node, and profit is
the consequence node.
Decision Alternatives Consequence
• The arcs connecting the nodes show that Small complex (d1) Profit
Medium complex (d2)
both the complex size and the demand Large complex (d3)

influence WCC’s profit

 2.4. Payoff Table
• Given the three decision alternatives and
the two states of nature, which complex
size should WCC choose?
• To answer this question, WCC will need State of
Nature
to know the consequence associated with
each decision alternative and each state
Decision Alternative Strong
of nature. Small complex, d1
Demand s1 Weak Demand s2
Medium complex, d 8 7
• In decision analysis, we refer to the Large complex, d
2
14 5
3
20
-9
consequence resulting from a specific
combination of a decision alternative and
a state of nature as a payoff.
• Payoffs can be expressed in terms of
profit, cost, time, distance, or any other
measure appropriate for the decision
problem being analyzed.
• Because WCC wants to select the
complex size that provides the largest
profit, profit is used as the consequence.
 2.5 Decision Trees
• A decision tree provides a Strong (s1)

graphical representation of the Small (d1)

8

decision-making process. 2

Weak (s2)
• Experts in problem solving 7

agree that the first step in

solving a complex problem is to
Strong (s1)
decompose it into a series of 14

Medium (d2)
smaller sub problems. 1
3

• So, the decision tree shows the

Weak (s2)
5

natural or logical progression

that will occur over time.
Strong (s1)
• Thus, the decision tree shows 20

graphically the sequences of

Large (d3)
4

decision alternatives and states Weak (s2)

–
9

of nature that provide the six

possible payoffs for WCC.
 2.6 Decision Making Without Probabilities

• Decision making without probabilities represents approaches to

decision making that do not require knowledge of the probabilities of
the states of nature.
• These approaches are appropriate in situations in which the decision
maker has little confidence in his or her ability to assess the
probabilities, or in which a simple best case and worst case analysis is
desirable.
• Many people think of a good decision as one in which the consequence
is good. However, in some instances, a good, well- thought-out
decision may still lead to a bad or undesirable consequence.
• Because different approaches sometimes lead to different decision
recommendations, the decision maker needs to understand the
approaches available and then select the specific approach that,
according to the decision maker’s judgment, is the most appropriate.
 Optimistic Approach (maxi-max)

• This approach evaluates each decision alternative in terms of

the best outcome that can occur.
• The decision alternative that is recommended is the one that
provides the best possible payoff.
• For a maximization problem, the optimistic approach often is
referred to as the maxi-max approach; for a minimization
problem, the corresponding terminology is mini-min.
 First, we determine the maximum payoff for each decision alternative
 Then we select the decision alternative that provides the overall
maximum payoff.
 These steps systematically identify the decision alternative that provides
the largest possible profit.
 Conservative Approach (maxi-min)
• The conservative approach also called pessimistic evaluates each
decision alternative in terms of the worst payoff that can occur.
• The decision alternative recommended is the one that provides the
best of the worst possible payoffs.
• For a maximization problem, the conservative approach is often
referred to as the maxi-min approach; for a minimization problem,
the corresponding terminology is mini-max.
• This decision approach is considered conservative because it
identifies the worst possible payoffs and then recommends the
decision alternative that avoids the possibility of extremely “bad”
payoffs.
• In the conservative approach, WCC is guaranteed a profit of at least
$7 million. Although WCC may make more, it cannot make less than
$7 million.
 DECISION MAKING WITH PROBABILITIES
• In many decision-making situations, we can obtain
probability assessments for the states of nature.
• When such probabilities are available, we can use the
expected value approach to identify the best decision
alternative.
 N = the number of states of nature
 P(sj) = the probability of state of nature sj
• The probabilities must satisfy two conditions:
 P(sj) > 0 for all states of nature
 P(sj) = P(s1) + P(s2) + . . . + P(sN) = 1
• The expected value (EV) of decision alternative di is defined
as follows
 EV (di) = p(s1) (v1)+ p(s2) (v2)…+p (SN) (vN)
 If V represents probability of occurrences of state of nature
 cont’d
• Suppose that WCC attaches an initial subjective
probability assessment of 0.8 strong (s1) demand and a
corresponding probability of 0.2 weak (s2) demand. Thus,
P(s1) = 0.8 and P(s2) = 0.2.
• Using the previous payoff values of 8 and 7 for small
complex, 14 and 5 for medium complex and 20 and -9 for
large complex:
• EV(d1) = 0.8(8) + 0.2(7) = 7.8
• EV(d2) = 0.8(14) + 0.2(5) = 12.2
• EV(d3) = 0.8(20) + 0.2(-9) = 14.2
• Thus, using the expected value approach, we find that the large
condominium complex, with an expected value of $14.2
million, is the recommended decision.
THANKS
!