Chapter 1_Introduction to Decision Analysis

8/12/2019 Chapter 1_Introduction to Decision Analysis

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Introduction to Decision Analysis

An Example: Gypsy Moths and the ODA

In the winter of 1985, the Oregon Department of Agriculture (ODA)faced with the problem of gypsy moth infestation in Lane County in WesternOregon.

Forest Industry representatives suggested using potent chemicalinsecticides.

The ODA instead proposed a plan that involved spraying most of the

affected area with BT (Bacillus thuringiensis), a bacterial insecticide knownto be (1) target-specific (that is, it does little damage to organisms other thanmoths), (2) ecologically safe, and (3) reasonable effective. As well as using BT,the ODA proposed spraying three smaller areas near the city of Eugene withthe chemical spray Orthene.

Although Orthene was registered as an acceptable insecticide for gardenuse, there was some doubt as to its ultimate ecological effects as well as itsdangers to humans.


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Gypsy Moth and the ODA

Forestry officials argued that the chemical insecticide was more potentthan BT and was necessary to ensure eradication in the most heavily affectedareas.

Environmentalists argued that the potential danger from the chemicalspray was too great to warrant its use.

Some individuals argued that spraying would not help because theinfestation already was so advanced that no program would be successful.

Others argued that an aggressive spray program could solve the problemonce and for all, but only if done immediately.

Clearly in making its final decision, the ODA would have to deal withmany issues.


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Why are decisions hard?

Complexity

Inherent uncertainty in the situation

Multiple Objectives

Different Perspectives


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Definition of Decision Analysis

Decision analysis is an analytic and systematic approach to

studying decision making. The objective of decision analysis isto help a decision maker think hard about the specific problem

at hand, including the overall structure of the problem as well asher or his preferences and beliefs.

A good decision is one that is based on logic, considers allavailable data and possible alternatives, and applies thequalitative and quantitative approaches to solve them.

Decision analysis is also an information source. It does not onlyprovide a solution but it also provides insight into the situationof interest, sources of uncertainty , objectives, trade-offs, etc.


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Why study decision analysis?

If we carefully apply decision analysis techniques to a problem, itleads to better decisions.

Decision analysis

provides methods for organizing decisions;

allows identification of important sources of uncertainty;

provides framework for dealing with multiple objectives.

Does a good decision always lead to a successful outcome?


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Decision Analysis Process

Identify the problem: Define the situation clearly.

Objectives: Min. cost? Max. profit? Min. risk?

Max. market share? Alternatives: Invest, not invest? Partially invest?

Use chemical sprays, use BT? Use both?

Decompose and model the problem

Sensitivity: What if? Does optimal decisionchange?

Further Analysis: New objectives? NewAlternatives? Changed insight in uncertainties?

Changed insight in preference?


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Cases of Decision Making

Decision Making under Certainty

The decision maker tends to maximize the return or minimizethe cost when the outcome of each decision alternative is knownwith certainty.

Decision Making under Uncertainty

The decision-maker cannot estimate or anticipate the probability

of possible outcomes for each decision alternative.

Decision Making under Risk

The problem is probabilistic, the decision-maker can estimate or

anticipate the probability of possible outcomes for each decisionalternative.


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Types of Decisions

Simple Decisions (Certain Environment)

Hard Decisions (Uncertain and Risky Environment)

Sequential Decisions

Objectives of Decision Analysis Single objective

Multiple objectives

Conflicting objectives Hierarchy of objectives


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Elements of Decision Problems

Given a complicated problem, how should one begin?

A critical first step is to identify the elements of the situation.

These elements can be classified as:

1) Objectives and values2) Decisions to make

3) Uncertain events

4) Consequences


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Objectives and values

An objective is a specific thing that you want to achieve.

Examples:

To get a graduate degreeTo get a good job

To make money

To have a vacationAn individuals objectives taken together make up his or hervalues.

They define what is important to a person in making a decision.

A persons values are the reason for making decisions in the firstplace. Without objectives, it would not be possible to tell whichalternative would be the best choice!


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Example: Boeings supercomputer

As a largescale manufacturer of sophisticated aircraft,Boeing needs computing power for various tasks.

When the companys engineering department needed to expand itscomputing capacity by purchasing a supercomputer, themanagers faced a huge task of assembling and evaluation

massive amounts ofinformation.

There were system requirements and legal issues to consider, aswell as price and variety of management issues.

Source: D. Barnhart (1993), Decision Analysis Software Helps Boeing SelectSupercomputer, OR/MS Today, April, 62-63.


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Objectives for Boeings supercomputer

Each specific decision situation calls for specific objectives. We call

the setting in which the decision occurs the decision context.


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Decisions to Make

In identifying the central decision, it is important also to thinkabout possible alternatives.

Some decisions should be made immediately based on thepossible alternatives.

Other alternative courses of action:

Do nothing

Wait and obtain more information

Hedge or make insurance against possible losses

Example: Consider a farmer who has a fruit orchard that is nearly

ripe. What can be the objective(s) of the farmer? What decisionalternatives does the farmer have based on the current forecast?


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Sequential Decisions

In many cases, there is no simple decision to make, but severalsequential decisions.

Example:

A manufacturer considering a new product might first decide

whether or not to introduce it.

If the decision is to go ahead, the next decision might bewhether to produce it in house or subcontract the production.

Once the production decision is made, there may be marketingdecisions about distribution, promotion, and pricing.

A future decision depends on the past decisions and what

happened before. (Dynamic decision situations)


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Uncertain Events

Many important decisions have to be made without knowing exactlywhat will happen.

Investment decision: Will stock of company go up or not? Camping decision: Will it rain or not?

The possible things that can happen in the resolution of an uncertain

event are called outcomes.

Discrete outcomesCamping decision: It can rain or not rain.

Continuous outcomesA stock bought today is $50 per share. Next year, it can be

anywhere between $0 and $100.


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Uncertain Events

A decision problem becomes more complicated when the

number of relevant uncertain events increases.

Some uncertain events may relate to each other.

The price of a specific stock may go up if the overall stockmarket increases value.


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Uncertain Events

The time sequence of uncertain events is important. Why?

It tells you what information becomes known before a decision

has to be made.

Uncertain events may be unknown at the time of the currentdecision, but may be known at the time of subsequent decisions.


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Consequences

After the last decision has been made and the last uncertain eventhas been resolved, the decision makers fate is determined.

The consequence is what happens with respect to each of theobjectives.

Profit or loss? Success or failure?


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Consequences

Looking forward from the current time and current decision, theend of the time line is called theplanning horizon.

For the farmer with the orchard example

planning horizon = time until harvest For an investor in the stock market

planning horizon = a week? a month? a year?

What is an appropriate planning horizon?Choose a planning horizon that is consistent with yourdecision context and relevant objectives.

How to value consequences?

Monetary value Not every consequence can be translated into monetaryvalue. Most of the time, there are trade-offs involved.


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Time Value of Money: A Special Kind of Trade-off

One of the most common consequences in personal, public and

business decisions is a stream of cash flows. An investor mayspend money on a project in order to obtain revenue in the future.

A special kind of trade-off: Spending today to obtain more in the

future.

Present value of money:x = amount of money that will be received at the end of n

periodsr = interest rate per period

Present value of x:

nr

xrnxPV

)1(),,(

+

=


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Net Present Value (NPV) of a Cash Flow

Suppose that a friend of yours makes the following proposal toyou: If you pay him $425 now, he will give you $110 next year,$121 the following, $133.1 the third year, and $146.41 at the end

of year 4. Would you take this offer?

=

+

=

n

i

i

i

r

xNPV

0 )1(

NPV for a stream of cash flows x0, x1,.., xn over n periods at

interest rate r is:

A negative NPV for a project indicates that the money would bebetter invested to earn interest rate r.

Chapter 1_Introduction to Decision Analysis

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