Decision Analysis

Decisions for Decision Theory Approach
1.

Set of possible future conditions exist that will have a bearing on the results of the decision

2.

A list of alternatives for manager to choose from

3.

A known payoff for each alternative under each possible future condition

2

Concepts
• Problem Formulation
• Decision Making without Probabilities
• Decision Making with Probabilities
• Risk Analysis and Sensitivity Analysis
• Decision Analysis with Sample Information
• Computing Branch Probabilities

Decision Theory Elements
• A set of possible future conditions (states of nature) exists

that will have a bearing on the results of the decision
• Mutually exclusive and collectively exhaustive

• A list of decision alternatives for the manager to choose from
• A known payoff for each alternative under each possible

future condition
Question 1:

Payoff
Table

Possible future demand*

Alternatives

Low Moderate High

Small facility

$10

$10

$10

Medium facility

7

12

12

Large facility

(4)

2

16

*Present value in $ millions
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Question 1
Nomis Malls are looking to purchase a new retail outlet that will be developed for Outlet Stores. Nomis has three plans to consider for this project – they can purchase the location and produce a small facility with capacity for 40 outlet stores, a medium size facility with capacity for 80 outlet stores or a large facility with capacity for 120 outlet stores.
The success of the Nomis Outlet Mall project will depend on the size of the facility and the demand for retail space for the outlets. Nomis needs to decide what size facility to produce that will lead to the largest profit given the uncertainty concerning the demand for the retail spaces.
The following information is available about your expected future income for each possibility:
Question 1:

Payoff
Table

Alternatives

Possible Future Demand*
LOW
MODERATE
HIGH

Small Facility
Medium Facility
Large Facility

$10
$7
($4)

* Present values in $ millions.
5

$10
$12
$2

$10
$12
$20

Decision Theory Process
1. Identify possible future conditions called states of nature
2. Develop a list of possible alternatives, one of which may be to do nothing
3. Determine the payoff associated with each alternative for every future condition
4. If possible, determine the likelihood of each possible future condition (prior probabilities-best available estimates of the probabilities prior to obtaining more information)
5. Evaluate alternatives according to some decision criterion and select the best alternative

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Decision Making without Probabilities


Three commonly used criteria for decision making when probability information regarding the likelihood of the states of nature is unavailable are:

•the optimistic approach (Maximax)
•the conservative approach (Maximin)
•the minimax regret approach

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Question 1. Decision Making without Probabilities
(i) Optimistic Approach MAXIMAX
Determine the best alternative in the payoff table using the maximax strategy: Alternatives

Possible Future Demand*
LOW
MODERATE
HIGH

Small Facility
Medium Facility
Large Facility

$10
$7
($4)

$10
$12
$2

* Present values in $ millions.

Decision:
8

$10
$12
$20

BEST

Question 1. Decision Making without Probabilities
(ii) Conservative Approach (MAXIMIN)
Determine the best alternative in the payoff table using the maximin strategy: Alternatives

Possible Future Demand*
LOW
MODERATE
HIGH

Small Facility
Medium Facility
Large Facility

$10
$7
($4)

$10
$12
$2

* Present values in $ millions.

Decision:
9

$10
$12
$20

WORST

Decision Making without Probabilities
(iii) Minimax Regret Approach
1.

2.

3.

Construction of a regret table or an opportunity loss table. •
Calculating for each state of nature the difference between each payoff and the largest payoff for that state of nature.
Select the maximum regret for each possible decision is listed.
The decision chosen is the one corresponding to the minimum of the maximum regrets.
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Decision