Decision Making

Environments
APK – SESSION I & II
HENRY YULIANDO
Learning Objectives

 Appreciate the need to structure decisions

 Able to draw maps of problems
 Able to make a list of the main elements of a decision and construct a
payoff matrix
 Able to tackle decisions under certainty
 Able to describe situations of uncertainty and use decision criteria to
suggest decisions
 Able to describe situations of risk and use expected values to suggest
decisions
 Able to use Bayes’ theorem to update conditional probabilities
 Understand the use of utilities
 Able to use decision trees to solve problems with sequential decisions.
Decision Process
Decision Environment

 Certainty
 Probabilistic
 Uncertainty
Decision Structures
 State of Nature
Favorable Market Unfavorable
Alternative
($) Market ($)
Construct a large
200,000 -180,000
plant
Construct a small
100,000 -20,000
plant
Do nothing 0 0
Note : It is important to include all alternative including “do
nothing”
DM under uncertainty
 Maximax (optimistic)

State of Nature
Favorable Market Unfaborable Maximum in
Alternative
($) Market ($) Row ($)
Construct a large
200,000 -180,000 200,000
plant Maximax

Construct a small
100,000 -20,000 100,000
plant
Do nothing 0 0 0
DM under uncertainty
 Maximin (pessimistic)

State of Nature
Favorable Market Unfavorable Minimum in Row
Alternative
($) Market ($) ($)
Construct a large
200,000 -180,000 -180,000
plant
Construct a small
100,000 -20,000 -20,000
plant

Do nothing 0 0 0
Maximin
DM under uncertainty
 Criterion of realism (Hurwicz Criterion)

State of Nature
Criteria of
Realism or
Favorable Market Unfavorable
Alternative Weighted
($) Market ($)
Average
( = 0.8) $
Construct a large
200,000 -180,000 124,000
plant Realism

Construct a small
100,000 -20,000 76,000
plant
Do nothing 0 0 0
DM under uncertainty
 Equally Likely (La Place)

State of Nature

Favorable Market Unfavorable Row Average

Alternative
($) Market ($) ($)

Construct a large
200,000 -180,000 10,000
plant
Construct a small
100,000 -20,000 40,000
plant Equally Likely

Do nothing 0 0 0
DM under uncertainty
 Minimax Regret

State of Nature
Maximum in a
Favorable Market Unfaborable
Alternative Row
($) Market ($)
($)
Construct a large
0 180,000 180,000
plant
Construct a small
100,000 20,000 100,000
plant MInimax

Do nothing 200,000 0 200,000

DM under risk
 Expected Monetary Value (EMV)
ＥＭＶ (alternative i)
= (payoff of the first state of nature) x
(probability of first state of nature) +
(payoff for second state of nature) x
(probability of second state of nature) +…+
(payoff of last state of nature) x
(probability of last state of nature)
EMV (large plant) = (0.50)($200,000)+(0.50)(-$180,000)=$10,000
EMV (small plant) = (0.50)($100,000)+(0.50)(-$20,000)=$40,000
EMV (do nothing) = (0.50)($0)+(0.50)($0)=$0
 State of Nature

Favorable Market Unfaborable Row Average

Alternative
($) Market ($) ($)

Construct a large
200,000 -180,000 10,000
plant
Construct a small
100,000 -20,000 40,000
plant
Do nothing 0 0 0
Probabilities 0.5 0.5
DM under risk
 Expected Value of Perfect Information (EVPI)
EVwPI = (best payoff or consequence for first state of nature) x
(probability of first state of nature) +
(best payoff for second state of nature) x
(probability of second state of nature) +…+
(best payoff for last state of nature)
= ($200,000))0.50)+($0)(0.50) = $100,000
EVPI = EVwPI – maximum EMV
= $100,000 - $40,000 = $60,000
DM under risk
 Expected Opportunity Loss (EOL)
EOL (construct large plant) = (0.5)($0) + (0.5)($180,000)
= $90,000
EOL (construct small plant) = (0.5)($100,000) + (0.5)($20,000)
= $60,000
EOL (do nothing) = (0.5)($200,000) + (0.5)($0)
= $100,000

Same result with maximum EMV

 State of Nature

Favorable Market Unfaborable EOL

Alternative
($) Market ($) ($)

Construct a large
0 180,000 90,000
plant
Construct a small
100,000 20,000 60,000
plant
Do nothing 200,000 0 100,000
DM under risk
 Sensitivity Analysis
P = probability of a favorable market
EMV (large plant) = $200,000P - $180,000(1-P)
= $380,000P - $180,000
EMV (small plant) = $100,000P - $20,000(1-P)
= $120,000P - $20,000
EMV (do nothing) = $0P - $0(1-P) = $0
Point 1 : EMV (do nothing) = EMV (small plant)
20,000
0  $120,000 P  $20,000 P  0.167
120,000
Point 2 : EMV (small plant) = EMV (large plant)
$120,000P - $20,000 = $380,000P - $180,000
160,000
$260,000 P  $160,000 P  0.615
260,000
Next Session