Decision Analysis

Monday, 5 September 2022 11:09 am

Decision analysis - used to develop and optimal strategy when a decision makers is faced with
several decision alternatives and uncertain or risk-filled pattern of future events

Problem Formulation

- Chance events - uncertain future events

- Consequences - combination of decision alternative and chance event outcomes
- Decision alternatives - different possible strategies the decision maker can employ
- States of nature - future events that are not under the control of the decision maker

Influence diagrams - graphical device that shows the relationships among the decisions, chance
events, and the consequences for a decision problem

Nodes- represent decisions, chance events, and consequences

- Decision nodes

- chance nodes

- consequence nodes

- referred to as arcs; shows the direction of influence

Payoff tables

Payoff - consequence resulting from a specific combination of a decision alternative and a state
of nature; a table that shows payoffs is called a payoff table

Decision trees

- Graphical representation for the decision-making process

DECISION MAKING WITHOUT PROBABILITIES

• Optimistic approach - decision with the largest payoff or lowest cost; also known as maximax

Pre-mid coverage Page 1

 • Conservative approach - evaluates in terms of the worst payoff that can occur. Alternative recommended is the one that
provides the best of the worst possible payoff

• Minimax regret approach - decision making one would choose the decision alternative that minimizes the maximum state of
regret that could occur over all possible states of nature
○ Regret - represents how much potential payoff one would forgo by selecting a particular decision alternative; referred to
as opportunity loss

DECISION MAKING WITH PROBABILITIES

- When probability assessments for the states of nature are available, use the expected
value approach
Expected value of a decision alternative is the sum of weighted payoffs for the decision
alternative

Decision Tree - chronological representation of the decision problem

Expected value with perfect information (EVwPI) -

Expected Value of Perfect Information (EVPI) - increase in the expected profit that would
result if one knew with certainty which state of nature would occur

FORMULAS TO REMEMBER:

Efficiency = (EVSI/EVPI)x100

EVPI = |EVwPI - EVwoPI

EVSI ={ [ Probability favorable( EV) + probability unfavorable(EV) ] - EVwoPI }

Joint probability P(Sₐ I F/U) : Prior probability P(Sₐ) X Conditional Probability P(F or
U I Sₐ)

Pre-mid coverage Page 2

Posterior Probability: ∑ Joint probability P (F or U I Sₐ) / Joint probability of Sₐ P(F I
Sₐ)

Pre-mid coverage Page 3