Operational Research

Prabhat Mittal
profmittal@yahoo.co.in

Prabhat Mittal
profmittal@yahoo.co.in

Decision Theory

Prabhat Mittal
profmittal@yahoo.co.in

Introduction

At the Operational level hundreds of decisions are made in order to achieve local outcomes that contribute to the achievement of the companys overall strategic goal. Achieving good results for local outcomes is an important objective for individual operational units and individual operations managers. However, all these decisions are interrelated and must be coordinated for the purpose of attaining the overall company goals. Decision making is analogous to a great stage pay in which all the actors, the costumes, the music, the orchestra, and the script must be choreographed and staged by the Director, the stage managers, the author, and the conductor so that everything comes together for the performance.
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Prabhat Mittal
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Decision Theory
Decision Theory represents a general
approach to decision making which uses quantitative methods suitable for a wide range of operations management decisions, including:

Capacity planning location planning

product and product and service design service design equipment selection

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Decision Theory Elements

A set of possible future conditions exists that will have a bearing on the results of the decision A list of alternatives for the manager to choose from A known payoff for each alternative under each possible future condition

Prabhat Mittal
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Decision Theory Process

Identify possible future conditions called states of nature. Future states of nature may be high
demand or low demand for a product or good economic conditions or bad economic conditions etc.

Develop a list of possible alternatives, one of which may be to do nothing Determine the payoff associated with each alternative for every future condition
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Decision Theory Process

A payoff table is a means of organising and illustrating the payoffs from the different alternative decisions, given the various states of nature. Payoffs are typically expressed in terms of profit, revenues.
States of Nature Decision
1 2

a
Payoff 1a Payoff 2a

b
Payoff 1b Payoff2b

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Decision Theory Process (Contd)

If possible, determine the likelihood of each possible future condition Evaluate alternatives according to some decision criterion and select the best alternative

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Decision Environments

Uncertainty - Environment in which it is impossible to assess the likelihood or the probabilities of various future events (Or probability are not assigned to states of nature) Risk - Environment in which certain future events have probable outcomes i.e. probability are assigned to the states of nature
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Decision Making under Uncertainty

Maximin (Pessimistic nature) Choose the alternative with the best of the worst possible payoffs Maximax (Optimistic nature) Choose the alternative with the best possible payoff. The decision maker chooses the most favorable states of nature for each alternative decision. Laplace - Choose the alternative with the best average payoff of any of the alternatives Minimax Regret - Choose the alternative that has the least of the worst regrets
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Example
A management is contemplating the future of one of its plants. Three alternative decisions are being considered 1. Expand the plant and produce lightweight, durable materials for possible sales to the military, a market with little foreign competition; 2. maintain the status quo at the plant, continuing production of textile goods that are subject to heavy foreign competition; or 3. sell the plant now. The following payoff table describes this decision situation.
States of Nature
Decision Good Foreign Competitive Conditions Rs. 800,000 1,300,000 320,000 Poor Foreign Competitive Conditions Rs. 500,000 -150,000 320,000

Expand Maintain Status quo Sell down

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11

Solution
Probabilities are not assigned to the states of nature. We should use decision criteria under uncertainty
Maximax

Criteria: The company would optimistically

assume that good competitive conditions would prevail in the future resulting in the following maximum payoffs and decisions: States of Nature
Decision Competitive Conditions Expand: Rs.800, 000 Rs. 800,000 Expand Maintain S.Q: 1,300,000 Maintain Status quo 1,300,000 Sell: 320,000 Sell down 320,000 Decision: Maintain quo status Good Foreign Poor Foreign Competitive Conditions Rs. 500,000 -150,000 320,000

Prabhat Mittal
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Solution
Maximin Criteria: the decision maker selects the
decision that will reflect the maximum of the minimum payoffs. For each decision alternative, the decision maker assumes that the minimum payoff will occur; of these, the maximum is selected as follows:

Expand: Rs.500, 000 Maintain S.Q: -150,000 Sell: 320,000 Decision: Expand
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States of Nature
Decision G Foreign ood Competitive C onditions Poor Foreign Competitive Conditions Rs. 500,000 -150,000 320,000

Rs. 800,000 Expand M aintain Status quo 1,300,000 Sell dow n 320,000

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Solution
Minimax Regret Criteria: A decision maker first
selects the maximum payoff under each state of nature; then all other payoffs under the respective states of nature are subtracted from these amount as follows:
Good Foreign Competitive Conditions Poor Foreign Competitive Conditions

Rs.1,300,000 800,000 = 500,000 Rs.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

Prabhat Mittal
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Solution
Minimax Regret Criteria ctd.: The values represented in the
above table (Opportunity loss table) represents the regret for each decision that would be experienced by the decision maker if a decision were made that resulted in less than the maximum payoff. The maximum regret for each decision must be determined, and the decision corresponding to the minimum of these regret values is selected as follows

Rs.500, 000 Maintain S.Q: 650,000 Sell: 980,000 Decision: Expand Expand:

Good Foreign Competitive Conditions

Poor Foreign Competitive Conditions

Rs.1,300,000 800,000 = 500,000 Rs.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

Prabhat Mittal
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Solution
Laplace (or Equally Likelihood) Criteria: This
Criterion weights each state of nature equally, thus assuming that the states of nature are equally likely to occur. Since there are two states of nature in our example, we assign a weight of 0.50 to each one. Next, we multiply these weights by each payoff for each decision and select the alternative with the maximum of these weighted values. Expand: Rs.800,000(0.50)+500,000(0.50)=Rs.650,000 Status quo: 1,300, 000 (0.50) - 150,000 (0.50) = 575,000 Sell: 320, 000 (0.50) + 320,000 (0.50) = 320,000

Decision: Expand
Decision Sell down

States of Nature
Good Foreign Competitive Conditions Rs. 800,000 1,300,000 320,000 Poor Foreign Competitive Conditions Rs. 500,000 -150,000 320,000

Expand Maintain Status quo

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Decision Making under Risk

Expected Monetary Value (EMV).
Expected value is computed by multiplying each outcome by the probability of its occurrence and then summing these products according to the formulae:

EMV(x) = p(xi)*xi Where xi = ith outcome p(xi) = probability of ith outcome The decision maker selects the decision that has the highest EMV.
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17

Decision Making under Risk

Expected value of perfect information: Occasionally
additional information is available, or can be purchased, regarding future events, enabling the decision maker to make a better decision. For example, a company could hire an economic forecaster to determine more accurately the economic conditions that will occur in the future. However, it would be foolish to pay more for the information than it stands to gain in extra profit from having the information. The information has some maximum value that is the limit of what the decision maker would be willing to spend. This value of information can be computed as an expected value hence its name, the expected value of perfect information (EVPI) Expected payoff Expected value of = under certainty perfect information
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Expected payoff under risk

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Example
A glass factory specializing in crystal is experiencing a substantial backlog, and the firm's management is considering three courses of action: A) Arrange for subcontracting, B) Construct new facilities. C) Do nothing (no change) The correct choice depends largely upon demand, which may be low, medium, or high. By consensus, management estimates the respective demand probabilities as .10, .50, and .40.
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19

Example
The management also estimates the profits when choosing from the three alternatives (A, B, and C) under the differing probable levels of demand. These costs, in thousands of dollars are presented in the table below:

A B C
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0.1 Low 10 -120 20

0.5 Medium 50 25 40

0.4 High 90 200 60

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Solution
Probability are assigned to the states of Nature (Low, medium and high) hence we use decision criterion under Risk (EV & EVPI). Further it is find the best decision out of A, B or C 0.1 0.5 0.4 Expected Values Low Medium High A 10 50 90 10*0.1+ 50*.5 + 90*.4 = 62 B -120 25 200 -120*.1 + 25*.5 +200*.4 =80.5 C 20 40 60 20*.1 + 40*.5 + 60*.4 = 46
Decision:

EVPI = (Best outcome for 1st state of nature) * p(x1) + (Best outcome of 2nd state of nature) * p(x2) + (Best outcome for 3rd state of nature)* p(x3) EMV under risk = (20*0.1) + (50*0.5) + (200*0.4) -80.5 =26.5
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Format of a Decision Tree

of State
State o

Decision Point Chance Event A e os ho C

1

re 1 natu
e A 1 Choos
re 2
2

Payoff 1 Payoff 2

f natu

Choose

B
State 1 ture 2 of na

A2

Payoff 3 Payoff 4

e A 3 Choos
Choose

ho C e os
2 A

A4

Payoff 5 Payoff 6
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State o
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f natu

re 2

Example of a Decision Tree Problem: Step 1. We start by drawing the three decisions
A B C

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23

Example of Decision Tree Problem: Step 2. Add our possible states of nature, probabilities, and payoffs
High demand (.4) Medium demand (.5) Low demand (.1)

$90k $50k $10k $200k $25k -$120k $60k $40k $20k

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A B C

High demand (.4) Medium demand (.5) Low demand (.1) High demand (.4) Medium demand (.5) Low demand (.1)

Prabhat Mittal
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Example of Decision Tree Problem: Step 3. Determine the expected value of each decision
High demand (.4) Medium demand (.5)

$62k
A

Low demand (.1)

$90k $50k $10k

EVA=.4(90)+.5(50)+.1(10)=$62k

Prabhat Mittal
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Example of Decision Tree Problem: Step 4. Make decision

High demand (.4) Medium demand (.5)

$90k $50k $10k $200k $25k -$120k $60k $40k $20k

$62k
A

Low demand (.1) High demand (.4)

$80.5k B

Medium demand (.5) Low demand (.1)

C
High demand (.4)

$46k

Medium demand (.5) Low demand (.1)

Alternative B generates the greatest expected profit, so our choice is B or to construct a new facility.
Prabhat Mittal
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Causes of Poor Decisions

Bounded Rationality The limitations on decision making caused by costs, human abilities, time, technology, and availability of information Sub optimization The result of different departments each attempting to reach a solution that is optimum for that department
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27

Excel work Sheet

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Excel work Sheet

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Practice Question-1
The daily demand for loaves of bread in a grocery store can assume one of the following values: 100, 120 or 130 loaves with probabilities 0.2, 0.3, and 0.5. The owner of the store is thus limiting her alternatives to stocking one of the indicated four levels. If she stocks more than she can sell in the same day, she must dispose of the remaining loaves at a discount price of 55 cents/loaf. Assuming that she pays 60 cents per loaf and sells it for 105 cents. Find the optimum stock level by using a decision tree representation
Prabhat Mittal
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30

Practice Question-2
A company is evaluating four alternatives single-period investment opportunities whose returns are based on the state of the economy. The possible states of the economy and the associated probability distribution is as follows: State: Fair Good Great Probability: 0.2 0.5 0.3 Using, the decision tree approach, determine the expected return for each alternative. Which alternative investment proposal would you recommend if the expected monetary value criterion is to employed. The returns for each
investment opportunity and each state of the economy are as follows: Alternatives Fair (Rs.) A1 A2 A3
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States of Economy Good (Rs.) 3000 4500 5000 6000 Great (Rs.) 6000 6800 8000 8500 31 1000 500 0 -4000

A4

Practice Question-3
A person has two independent investments A and B available to him, but he can undertake only one at a time due to certain constraints. If he chooses investment A then success of A will encourage him to opt for investment B or vice-versa. The probability of success of A is 0.6, while for B it is 0.4. Both the investments require an initial capital outlay of Rs.10000 and both return nothing if the venture is unsuccessful. Successful completion of A will return Rs.20000 (over cost) and successful completion of B will return Rs.24000 (over cost). Draw decision tree and determine the best strategy.

Prabhat Mittal
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32

Practice Question-4
A company has the options now of building a full-size plant or a small plant that can be expanded later. The decision depends primarily on future demands for the product the plant will manufacture. The construction of a full-size plant can be justified economically if the level of demand is high otherwise, it may be advisable to construct a small plant now and then decide in two years whether it should be expanded. Logically, the company will consider possible future expansion of the small plant only if the demand over the first two years turns out to be high. A market survey indicates that the probabilities of having high and low demands over the next 10 years are 0.75 and 0.25 respectively. The immediate construction of a large plant will cost Rs.5 million and a small plant will cost Rs.1 million. The expansion of the small plant 2 years from now is estimated to cost Rs.4.2 million. Estimates of annual income for each of the alternatives are given as follows. Full-size plant and high (low) demand will yield Rs.1 million (Rs.0.3 millions) annually. Small plant and low demand will yield Rs.0.2 million annually. Small plant and high demand will yield Rs.0.25 million for each of the 10 years. Expanded small plant with high (low) demand will yield Rs.0.9 million (Rs.0.2 million) annually. Small plant with no expansion and high demand in the first two years followed by low demand will yield Rs.0.2 million in each of the remaining 8 years. Prabhat Mittal 33 profmittal@yahoo.co.in

Practice Question-5
Piyush lives off campus and has just missed the bus that could have taken him to campus for his 10 am. Test. It is now 9:45 a.m. and Piyush has several options available to get him to campus: Waiting for the next bus, walking, riding his bike, or driving his car. The bus is scheduled to arrive in 10 minutes, and it will take Piyush exactly 20 minutes to get to his test from the time he gets on the bus. However, there is 0.2 chance that the bus will be 5 minutes early, a 0.3 chance that the bus will be 5 minutes late. If Piyush walks, there is 0.8 chances he will get to test in 30 minutes m and 0.2 chance he will get there in 35 minutes. If Piyush rides his bike, he will get to the test in 25 minutes with probability 0.5, 30 minutes with probability 0.4, and there is 0.1 chance of a flat tyre, causing him to take 45 minutes. If Piyush drives his car to campus, he will take 15 minutes to get to campus, but the time needed to park his car and get to this test is given below: Time to park and arrive (in min): 10 15 20 25 Probability: 0.30 0.45 0.15 0.10 Prabhat Mittal 34 profmittal@yahoo.co.in