Quantitative Methods

MM ZG515 / QM ZG515

L10: Decision Analysis
BITS Pilani Srinivas Kota
Work Integrated Learning 
Programmes Division
Scope of this lecture

• Decision Analysis
• Decision Making without Probabilities
• Decision Making with Probabilities
• Expected Value of Perfect Information
• Sequential Decision Tree

2 MM ZG515/QMZG515 Quantitative Methods BITS Pilani, WILPD
 Decision Analysis

• Quantitative methods
• a set of tools for operations manager

• Decision analysis
• A set of quantitative decision‐making techniques for decision 
situations in which uncertainty exists

• Example of an uncertain situation
• demand for a product may vary between 0 and 200 units, depending 
on the state of market

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 Decision making without Probabilities

• States of nature
• Events that may occur in the future
• Examples of states of nature:
• high or low demand for a product
• good or bad economic conditions

• Decision making under risk
• probabilities can be assigned to the occurrence of states of nature in the 
future

• Decision making under uncertainty
• probabilities can NOT be assigned to the occurrence of states of nature 
in the future

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 Payoff Table

• Payoff table
• method for organizing and illustrating payoffs from different 
decisions given various states of nature
• Payoff
• outcome of a decision

States Of Nature
Decision a b
1 Payoff 1a Payoff 1b
2 Payoff 2a Payoff 2b

5 MM ZG515/QMZG515 Quantitative Methods BITS Pilani, WILPD
 Decision making Criteria under Uncertainty
• Maximax
• choose decision with the maximum of the maximum payoffs
• Maximin
• choose decision with the maximum of the minimum payoffs
• Minimax regret
• choose decision with the minimum of the maximum regrets for each 
alternative
• Hurwicz
• choose decision in which decision payoffs are weighted by a coefficient 
of optimism, alpha
• coefficient of optimism is a measure of a decision maker’s optimism, 
from 0 (completely pessimistic) to 1 (completely optimistic)
• Equal likelihood (La Place)
• choose decision in which each state of nature is weighted equally
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 Textile Company

STATES OF NATURE
Good Foreign Poor Foreign
DECISION Competitive Conditions Competitive Conditions
Expand 800,000 500,000
Maintain status quo 1,300,000 -150,000
Sell now 320,000 320,000

7 MM ZG515/QMZG515 Quantitative Methods BITS Pilani, WILPD
 Textile Company: Maximax Solution

STATES OF NATURE
Good Foreign Poor Foreign
DECISION Competitive Conditions Competitive Conditions
Expand 800,000 500,000
Maintain status quo 1,300,000 -150,000
Sell now 320,000 320,000

Expand: 800,000
Status quo: 1,300,000  Maximum
Sell: 320,000
Decision: Maintain status quo

8 MM ZG515/QMZG515 Quantitative Methods BITS Pilani, WILPD
 Textile Company: Maximin Solution

STATES OF NATURE
Good Foreign Poor Foreign
DECISION Competitive Conditions Competitive Conditions
Expand 800,000 500,000
Maintain status quo 1,300,000 -150,000
Sell now 320,000 320,000

Expand: 500,000  Maximum

Status quo: -150,000
Sell: 320,000
Decision: Expand

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 Textile Company: Minimax Regret Solution

STATES OF NATURE
Good Foreign Poor Foreign
DECISION Competitive Conditions Competitive Conditions
Expand 800,000 500,000
Maintain status quo 1,300,000 -150,000
Sell now 320,000 320,000

States of Nature
Good Foreign Poor Foreign
Competitive Conditions Competitive Conditions

1,300,000 - 800,000 = 500,000 500,000 - 500,000 = 0

1,300,000 - 1,300,000 = 0 500,000 - (-150,000)= 650,000
1,300,000 - 320,000 = 980,000 500,000 - 320,000= 180,000

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 Textile Company: Hurwicz Criteria

STATES OF NATURE
Good Foreign Poor Foreign
DECISION Competitive Conditions Competitive Conditions
Expand 800,000 500,000
Maintain status quo 1,300,000 -150,000
Sell now 320,000 320,000

 = 0.3 1 -  = 0.7

Expand: 800,000(0.3) + 500,000(0.7) = 590,000

Status quo: 1,300,000(0.3) -150,000(0.7) = 285,000
Sell: 320,000(0.3) + 320,000(0.7) = 320,000
Decision: Expand
11 MM ZG515/QMZG515 Quantitative Methods BITS Pilani, WILPD
 Textile Company: Equal Likelihood Criteria

STATES OF NATURE
Good Foreign Poor Foreign
DECISION Competitive Conditions Competitive Conditions
Expand 800,000 500,000
Maintain status quo 1,300,000 -150,000
Sell now 320,000 320,000

Two states of nature each weighted 0.50

Expand: 800,000(0.5) + 500,000(0.5) = 650,000  Maximum

Status quo: 1,300,000(0.5) -150,000(0.5) = 575,000
Sell: 320,000(0.5) + 320,000(0.5) = 320,000
Decision: Expand
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 Decision making with Probabilities

• Risk involves assigning probabilities to states of nature

• Expected value
• a weighted average of decision outcomes in which each 
future state of nature is assigned a probability of occurrence 
n
EV(x) = p(xi)xi
i =1
where
xi = outcome i
p(xi) = probability of outcome i

13 MM ZG515/QMZG515 Quantitative Methods BITS Pilani, WILPD
 Decision making with Probabilities

STATES OF NATURE
Good Foreign Poor Foreign
DECISION Competitive Conditions Competitive Conditions
Expand 800,000 500,000
Maintain status quo 1,300,000 -150,000
Sell now 320,000 320,000

p(good) = 0.70 p(poor) = 0.30

EV(expand): 800,000(0.7) + 500,000(0.3) = 710,000

EV(status quo): 1,300,000(0.7) -150,000(0.3) = 865,000
EV(sell): 320,000(0.7) + 320,000(0.3) = 320,000

Decision: Status quo

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 Sequential Decision Trees

• A graphical method for analyzing decision situations 
that require a sequence of decisions over time

• Decision tree consists of
• Square nodes ‐ indicating decision points
• Circles nodes ‐ indicating states of nature
• Arcs ‐ connecting nodes

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 Sequential Decision Trees
2,000,000
0.60 Market growth
2
0.40
225,000
3,000,000

0.80
6
700,000
0.20
1 4

450,000
0.60 2,300,000
3
0.40
0.30
7
0.70 1,000,000
5

210,000
16 MM ZG515/QMZG515 Quantitative Methods BITS Pilani, WILPD