Lecture Notes on Operations Research

LECTURE 8
DECISION ANALYSIS
Nature of Decision Analysis

In real life, future events cannot be predicted with absolute certainty. The best that can be
done is to make decisions that are based upon the likelihood of possible future events. In the
mining industry, increasing rates of change of parameters such as grade, prices, costs and
demand for minerals, are forcing engineers and managers to focus more and more on
strategic, long-term decisions to solving problems using decision analysis methods. At the
heart of the decision analysis lie two essential features that serve as the focus for this lecture:

(i) Decision theory; and

(ii) Decision trees.

Terminologies

Strategies: These are controllable variables or appropriate actions to be taken, including the
decision to do nothing. Generally, in any decision making process, it is best to generate as
many potentially feasible strategies as possible.

States of Nature: These refer to future events that can occur for which strategies must to be
identified. These events, which are termed as states of nature, represent those variables (non-
controllable) that are beyond control of the decision maker. Like states of nature, strategies
also form an integral part of a payoff matrix.

Payoff Matrix or List: A typical grouping of possible outcomes in a problem is called payoff
matrix. Outcomes can be expressed in dollars (profits, costs, etc.), units, or some other
appropriate measure. In a payoff matrix, the intersection of each row and column gives a
specific outcome; ie, the consequence of choosing a particular strategy (row), given that a
certain state of nature (column) occurs.

Example of payoff matrix

States of Nature
1 2 3… n
1 011 012 013… 01n
Strategies 2 021 022 023… 02n
    

m 0m1 0m2 0m3 0mn

In this example, 0mn represents the outcome for the combination of strategy m and nature n.
although a payoff matrix is needed in many cases to formulate a problem, a list that shows
the potential outcome is sufficient in other cases. This list may focus on only one of the states
of nature – good, average, or bad – rather than all of the possible states. The attendant
circumstances will dictate which approach is the best – a payoff matrix or a list.

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Conditional Profit (gains) and Losses: The outcomes presented in a payoff matrix are
typically called conditional profits and losses, because for a specific strategy they are
dependent upon a specific state of nature.

Associated Probabilities: For a typical payoff matrix, there are probabilities associated with
the chance of each outcome occurring. Hence, the manager must assign appropriate
associated probabilities with each outcome. If the probabilities are based on past experience,
they are considered to be objective. On the other hand, if the probabilities are estimates of the
future, they are considered to be subjective. In either case, the probabilities are used to
determine the expected profits and losses for each outcome. The calculation of expected
payoffs (ie, profits or losses) for specific outcomes allows the selection of the best criterion.

Decision Tree: The graphic representation of probability logic as applied to decision

alternatives is called decision tree. It is so called because it looks like a tree, although for the
sake of convenience it is tipped over on its side. The base of the tree marks the initial
decision point. Each subsequent chance event produces two or more possible effects (more
branches), some of which lead to other chance events and subsequent decision points.
Decision trees represent decision making under risk where known probabilities are used in
conjunction with profits and losses to calculate expected profits and losses.

Objective Function: The purpose of the objective function is to provide some starting point,
i.e., an objective to be achieved by problem solving.

Selection of Best Decision Criterion

Selecting the best decision criterion hinges on one’s utilisation of probability factors.
Depending on how much we know about the states of nature (or the business environment),
we can refer to decision making under the following conditions:

• Certainty
• Risk
• Uncertainty

Decision Criterion Under Certainty: When the state of nature that will occur is known with
complete certainty, ie, when a probability of 1.0 can be assigned to a specific state of nature,
one can make a decision with certainty.

In a payoff matrix, there is only one column that applies. The strategy (row) that features the
largest payoff should be selected.

Example:

Consider the following payoff matrix, which shows the profits from undertaking a certain
mining venture:

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States of nature

N1 N2 N3
Strategies S1 22 000 15 000 8 000
S2 25 000 17 000 10 000
S3 28 000 19 000 11 000

N1 = period of 2% to 5% increase in product price

N2 = period of no change in product price
N3 = period of 2% to 5% decrease in product price

Suppose it is known with certainty that there will be no change in product prize, ie. the state
of nature N2 will occur, then strategy S3 would be selected since it offers the highest return.
The decision criterion under certainty is to select that strategy with the largest payoff based
upon a given state of nature.

Decision Criterion under Risk

Decision making under risk refers to situations where there are a number of states of nature,
and the manager knows the probability of occurrence for each of these states of nature. In
certain situations, the probabilities of the respective states of nature are known because they
are based on past experience or objective probability. An inventory decision problem for
optimum stocking of equipment replacement parts is an example of decision making under
risk, because historical data on parts replaced can be compiled for a certain period of time.
Another example is the life insurance policy, where insurance rates are based on life
expectancy factors.

Illustrative Example

(a) The Bush Mining Company (BMC) undertakes an alluvial mining project. Experience
over the past 5 years has shown that mineralisation is so erratic that in a given month, the
grade can be high, average or low. The probabilities of the grade being high, average or low
are shown in Table 1.

(b) BMC has three alternative strategies to adopt in the coming month’s production
planning:

S1: produce less ore and concentrate on overburden stripping.

S2: produce ore and strip overburden by equal amounts.
S3: stop ore production and strip as much overburden as possible.

(c) The conditional payoffs for each strategy depending on the grade of ore that will be
mined are shown in Table 1. Which planning strategy should BMC take?

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Table 1 Payoff Matrix of BMC

High Grade Average Grade Low Grade
States of Nature
N1 N2 N3
Probability .25 .5 .25

Strategies S1 40 000 60 000 10 000

S2 50 000 40 000 15 000
S3 60 000 20 000 12 000

Solution:

The equations for computing expected payoffs for the strategies (ES) are as follows:
ES1 = O11 P1 + O12 P2 +.........+ O1 j Pj
ES2 = O21 P1 + O22 P2 +.........+ O2 j Pj
ES3 = O31 P1 + O32 P2 +.........+ O3 j Pj
…………………………
ESi = Oi1P1 + Oi 2 P2 +............ Oi 3 P3

where: P1 + P2 +......+ Pj = 1

We can use these equations to calculate expected payoffs for each of the strategies (i = 1, 2,
3):

ES1 = 40000( 0.25) + 60000( 0.50) + 10000( 0.25) = $42 500

ES2 = 50000( 0.25) + 40000( 0.50) + 15000( 0.25) = $36 250
ES3 = 60000( 0.25) + 20000( 0.50) + 12 000( 0.25) = $28 000

Because the expected payoff is greatest for the first strategy, the first strategy S1 is
selected.

Sensitivity Analysis: Suppose we change the probabilities in this problem from 0.25, 0.50
and 0.25 to 0.50, 0.25 and 0.25 respectively, then

ES1 = 40 000(0.50) + 60 000(0.25) + 10 000(0.25) = $37 500

ES2 = 50 000(0.50) + 40 000(0.25) + 15 000(0.25) = $38 750
ES3 = 60 000(0.50) + 20 000(0.25) + 12 000(0.25) = $38 000

Therefore, in this case, strategy 2 (S2) must be selected.

It should be noted that if we introduce a very high probability for N1, the third strategy
will have the highest expected payoff.

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Decision Criterion under Uncertainty

The third type of decision criteria, decision making under uncertainty, refers to situations
where the probabilities of occurrence for the various states of nature are unknown. Examples
are problems that deal with:

• opening a new mine

• increasing plant capacity
• floating new stock issues

There are five basic approaches to decision making under uncertainty:

(1) Maximax Decision Criterion
(2) The Hurwicz Decision Criterion
(3) The Wald Decision Criterion (Maximin)
(4) The Savage Decision Criterion (Minimax Regret)
(5) The Laplace Decision Criterion

The choice depends on the size of the company, the company’s objectives, manager’s
feelings or some logical basis. We illustrate them with an example problem.

Question

The Bush Mining Company (BMC) is thinking about embarking on one of the following:

S1 : develop a new rich orebody which can significantly increase the company’s profit.
S2 : increase production from existing average grade orebody so as to slightly increase
the company’s profit.
S3 : continue mining the existing average grade orebody at the same production rate
with no change in the company’s profit.

The three possible states of nature are:

N1 – good economic conditions in the host country
N2 – average economic conditions in the host country
N3 – poor economic conditions in the host country
The research department of BMC has estimated the outcomes, in terms of yearly net profits
before tax to be as follows:

N1 N2 N3
S1 $500 000 $100 000 $50 000
S2 $300 000 $250 000 0
S3 $100 000 $100 000 $100 000

Which strategy is best?

Solution 1: MAXIMAX Decision Criterion

The Maximax Decision is one of optimism: it is based on the idea that we do get favourable
or lucky breaks. In his view, since nature can be good to us, the state of nature with highest

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payoff for each strategy should be selected. Then the strategy with the highest payoff should
be selected as the best strategy. So, in the example, we examine the various payoffs for each
strategy and then select the highest amount for each as follows:

Strategy Largest Payoff

1 $500 000
2 $300 000
3 $100 000

Next, we select Strategy 1 which has the highest payoff value. This payoff is often referred to
as MAXIMAX (maximum maximum).

Note: Maximax decision criterion is only good for big companies and should be applied with
great caution. If a small company utilised this approach and nature became unfavourable, the
financial shock may not be absorbed and the company would collapse.

Solution 2: Hurwicz Decision Criterion

Hurwicz is not so optimistic as to suggest that life is an utopian state, not a real world.
Hurwicz introduced the coefficient of optimism concept. This means considering both the
minimum and maximum payoff and then weighing their importance according to some
probability factor, ie, the coefficient of optimism concept (0 to 1).

Example:
If the decision maker in our example has a coefficient of optimism equals to 0.667, then he
should be satisfied to receive a maximum payoff with a probability of 0.667 and a minimum
payoff with a probability of 0.333. Then to make the selection, the following calculation is
necessary.

Strategy Maximum payoff Minimum payoff

1 $500 000 $50 000 $500 000(0.667) + $50 000(0.333) = $350150
2 $300 000 0 $300 000(0.667) + 0(0.333) = $200 100
3 $100 000 $100 000 $100 000(0.667) +$100 000(0.333) = $100 000

Using the Hurwicz decision criterion, BMC should select Strategy 1.

Solution32: Wald Decision criterion (MAXIMIN)

Wald suggests that pessimism and conservatism are the best policy. Under normal conditions
and assuming any of the states of nature can occur with equal chances, Wald states that the
maximum of the minimum payoffs should indicate the best strategy. So, in our problem, we
should select the minimum payoffs for each strategy as follows:

Strategy Minimum Payoff

1 $50 000
2 0
3 $100 000

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Next, we select Strategy 3 because it has the highest of the minimum payoffs. This means the
worst of nature that would occur would give a payoff of $100 000.

Note: Wald’s decision criterion is good for small companies which stand the risk of going
bankrupt in case nature became unfavourable.

Solution 4: Savage Decision Criterion (MINIMAX REGRET)

Savage’s decision criterion suggests that the manager might experience regret after the
decision has been made and the state of nature has occurred. The manager may have
preferred choosing a completely different strategy than the one selected.

The Savage criterion attempts to minimise the potential regret before the selection of a
particular strategy is made. Savage does this by initially constructing a regret matrix. In our
example, we look at the original payoff matrix.

N1 N2 N3
S1 $500 000 $100 000 $50 000
S2 $300 000 $250 000 0
S3 $100 000 $100 000 $100 000

We construct a regret matrix as follows:

• If we refer to N1 state of nature, Savage suggests that the amount of regret can be
measured by the difference between the payoff one may actually receive and the
payoff one could have possibly received.

• The highest payoff for N1 column is $500 000. If N1 occurred, and Strategy 1 was
selected, the decision maker would have experienced no regret. Hence, a value of zero
is assigned in the regret matrix. Suppose the manager had selected Strategy 2 and N1
had occurred, there would be a regret of $(500 000 – 300 000) = $200 000, etc. Thus,
a regret matrix is calculated:

N1 N2 N3
S1 0 $150 000 $50 000
S2 $200 000 0 $100 000
S3 $400 000 $150 000 0

The strategy that yields the minimum of maximum regrets is selected. This means we select
the highest regret value from each possible strategy, based upon the matrix and then construct
a new table as follows

Strategy Maximum Payoff

1 $150 000
2 $200 000
3 $400 000

Strategy 1 is selected because it has the minimum of the maximum regrets (MINMAX).

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We note that Savage’s decision criterion has less popularity because the decision finally
becomes that of optimistic or pessimistic – already discussed, but nonetheless, it is useful to
minimise regrets in the long run.

Solution 5: The Laplace Decision Criterion

This is the oldest decision criterion: (dates as far back as 500 BC). This principle assumes
that various states of nature have equal chances of occurring, or that one state of nature is as
likely to occur as another. Therefore each state of nature has the same probability of
occurring.

For each payoff, the expected amount is calculated and the strategy with the highest expected
payoff is selected.

Thus, this criterion is one of rationality and is based on the “principle of insufficient reason.”
The hypothesis is that if we know of no reason for probabilities to be different, we should
consider them to be equal.

So we calculate the expected payoff:

Strategy Expected Payoff

1 1/3 (500 000) + 1/3 (100 000) + 1/3 (50 000) = $216 667
2 1/3 (300 000) + 1/3 (250 000) + 1/3 (0) = $183 333
3 1/3 (100 000) + 1/3 (100 000) + 1/3 (100 000) = $100 000

Thus, Strategy 1 can be selected. In real life, the states of nature may be fairly well known in
advance. For example, falling gold price is normally followed by stabilised gold price and
then followed by rising gold price. In reality therefore, each state of nature does not have
equal chances of occurring.

• Laplace criterion is also good for bigger companies.

Summary of the decision criteria under uncertainty:

Criterion Strategy Expected Payoff
Maximax 1 $500,000
Hurwicz 1 $350,000
Maximin (Wald) 3 $100 000
Minimax Regret (Savage) 1 $150 000
Insufficient Reason (Laplace) 1 $216 667

This summary shows that two strategies have been selected. No criterion is best. The
selection of criterion depends on the size of the company, the company policy and intuitive
feelings of the managers.

Illustrative Example of Decision Theory Problems

Question:
The Tarkus Mining Company (TMC) is planning to develop a new orebody with an
investment of $80 000 in fixed costs and projected variable costs of $0.90 per tonne of ore
mined. The proposed selling price per tonne of ore to a nearby processing plant is $1.25 per

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tonne. The deposit is expected to have a life of five years. It is estimated that the yearly
demand and the probabilities under average economic conditions will be as follows:

Selling Price of $1.25 per tonne

Year
Demand Probability
1 25 000 0.05
2 50 000 0.10
3 75 000 0.20
4 100 000 0.30
5 110 000 0.35

In addition, yearly demand and the probabilities for selling prices at $1.15 and $1.35 under
average economic conditions are determined to be as follows:

Selling Price of $1.15 per tonne

Year
Demand Probability
1 30 000 0.05
2 65 000 0.10
3 90 000 0.15
4 125 000 0.30
5 140 000 0.40

Selling Price of $1.35 per tonne

Year
Demand Probability
1 20 000 0.10
2 40 000 0.15
3 60 000 0.20
4 85 000 0.25
5 95 000 0.30

The company’s cut-off point for net profit on sales is 3% before tax. Determine the expected
profits and so advise TMC on whether or not it is feasible to develop the deposit.

Solution:

Objective: To make 3% profit.

Model formulation:

There are 3 strategies:

(i) to sell at $1.15
(ii) to sell at $1.25
(iii) to sell at $1.35

There is one state of nature:

(i) average economic conditions.

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Payoff Matrix: because there is only one state of nature (average economic conditions) the
payoff matrix is one column matrix. (Note that it could have included poor economic
conditions).

Calculation of Payoff (Expected profit)

Annual Annual Variable Condi-

Contri- Fixed Expected
Sales Revenue Costs tional Proba
At a butions ($) Costs Profit
(tonnes) ($) ($) Profit bility
($) 30 000 34 500 - 27 000 = 7 500 - 16000 = -8 500  0.05 = -425
Selling
65 000 74 750 - 58 000 = 16 250 - 16000 = 250  0.10 = 25
Price
90 000 103 500 - 81 000 = 22 500 - 16000 = 6 500  0.15 = 975
$1.15
125 000 143 750 - 112 000 = 31 250 - 16000 = 15 250  0.30 = 4 575
140 000 161 000 - 126 000 = 35 000 - 16000 = 19 000  0.40 = 7 600

Total 517 500 1.00 = $12 750

At a 25 000 31 250 - 22 500 = 8 750 - 16000 = -7 250  0.05 = -362.50

($) 50 000 62 500 - 45 000 = 17 500 - 16000 = 1 500  0.10 = 150.00
Selling 75 000 93 750 - 67 500 = 26 250 - 16000 = 10 250  0.20 = 2 050.00
Price 100 000 125 500 - 90 000 = 35 500 - 16000 = 19 500  0.30 = 5 850.00
$1.25 110 000 137 500 - 99 000 = 38 500 - 16000 = 22 500  0.35 = 7 875.00

Total 450 000 1.00 $15 562.50

At a 20 000 27 000 - 18 000 = 9 000 - 16000 = -7 000  0.10 = -700

($) 40 000 54 000 - 36 000 = 18 000 - 16000 = 2 000  0.15 = 300
Selling 60 000 81 000 - 54 000 = 27 000 - 16000 = 11 000  0.20 = 2 200
Price 85 000 114 750 - 76 000 = 38 750 - 16000 = 22 750  0.25 = 5 687.50
$1.35 95 000 128 250 - 85 500 = 42 750 - 16000 = 26 750  0.30 = 8 025

Total 404 000 1.00 $15 512.50

Therefore, the payoff matrix is:

N1
S1 12 750.00
S2 15 562.50
S3 15 512.50

Strategy 2 should be selected because it has the highest payoff.

• This presupposes that profits can be made in all strategies. BUT what percentage of
profit on sales can be expected? That is, do the percentages meet the company’s
established profit on sales of 3 % (before taxes)? For 3% sale in profit, it will be a
better objective to select S2, S3 and then to select S2 finally!
S1 = 12750/517500 =2.46 %
S2 = 15562.50/45000 =3.46 %
S3 = 15512.50/40400 =3.84 %

• Note that if the company wanted at least 3.5% profit, s3 would have been the best
strategy.

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Illustrative Example on Decision Trees

Question:

The Tarkus Mining Company (TMC) must decide whether to continue with regional
distribution of its aggregates for road construction or to expand to national distribution. (This
constitutes a decision point). The chance events that will affect the national distribution are
differing degrees of national demand for the products, namely: large, average or limited. If
there is a large demand, a conditional profit of $4M is expected, whereas conditional profits
of only $2M and $0.5M are expected if the demand is average or limited, respectively. The
probability factors are 0.5, 0.25 and 0.25 respectively. Three more payoffs can be predicted,
if the company continues with regional distribution:

(1) If the regional demand is large, a conditional profit of $2M is expected.

(2) If the regional demand is average, a conditional profit of $1.8M is expected.
(3) If the regional demand is limited, a conditional profit of only 1.5M is expected.

Should the company maintain its present status or expand? Assume that the respective
probabilities are 0.5, 0.25 and 0.25 respectively.

Step1: We construct a decision tree as a model of the problem. The decision tree
representing our problem is presented in Fig. 8.1.

Step 2: We calculate the expected profits for the strategies under the given states. This
means simply multiply the conditional profit by the corresponding marginal
probabilities.

Step 3: Sum up the expected profits for the strategies.

Step 4: Select the strategy with the highest total expected profit. In our example, we select
the strategy of distributing nationally.

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Fig. 8.1 Decision Tree of the TMC Problem

Lecture Assignment

(a) Briefly outline a situation in life in which you may have applied any one of Maximax,
Hurwicz, Wald, Savage and Laplace decision criteria before you came to know about
them.

(b) An investor is considering three alternative investments, a hotel, a theatre and a

restaurant. The hotel and restaurant will be affected by the availability of water while the
theatre will be relatively stable for any condition. The payoff matrix under uncertainty for
this decision framework is:

Water Supply Shortage Stable Surplus

Investment Alternatives
Hotel -$8,000 $10,000 $25,000
Restaurant -12,000 8,000 4,000
Theatre 6,000 6,000 5,000

Determine the best investment alternative under conditions of uncertainty using the Maximin,
Hurwicz (α = 0.4) Minimax and Laplace decision criteria.

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