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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 Western
Oregon.
Forest Industry representatives suggested using potent chemical
insecticides.
The ODA instead proposed a plan that involved spraying most of the
affected area with BT (Bacillus thuringiensis), a bacterial insecticide known
to be (1) target-specific (that is, it does little damage to organisms other than
moths), (2) ecologically safe, and (3) reasonable effective. As well as using BT,
the ODA proposed spraying three smaller areas near the city of Eugene with
the chemical spray Orthene.
Although Orthene was registered as an acceptable insecticide for garden
use, there was some doubt as to its ultimate ecological effects as well as its
dangers to humans.
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Gypsy Moth and the ODA
Forestry officials argued that the chemical insecticide was more potent
than BT and was necessary to ensure eradication in the most heavily affected
areas.
Environmentalists argued that the potential danger from the chemical
spray was too great to warrant its use.
Some individuals argued that spraying would not help because the
infestation already was so advanced that no program would be successful.
Others argued that an aggressive spray program could solve the problem
once and for all, but only if done immediately.
Clearly in making its final decision, the ODA would have to deal with
many 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 is
to help a decision maker think hard about the specific problem
at hand, including the overall structure of the problem as well as
her or his preferences and beliefs.
A good decision is one that is based on logic, considers all
available data and possible alternatives, and applies the
qualitative and quantitative approaches to solve them.
Decision analysis is also an information source. It does not only
provide a solution but it also provides insight into the situation
of 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, it
leads 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 decision
change?
Further Analysis: New objectives? New
Alternatives? 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 minimize
the cost when the outcome of each decision alternative is known
with 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 decision
alternative.
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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 values
2) 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 degree
To get a good job
To make money
To have a vacation
An individuals objectives taken together make up his or her values.
They define what is important to a person in making a decision.
A persons values are the reason for making decisions in the first
place. Without objectives, it would not be possible to tell which
alternative 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 its
computing capacity by purchasing a supercomputer, the
managers faced a huge task of assembling and evaluation
massive amounts of information.
There were system requirements and legal issues to consider, as
well as price and variety of management issues.
Source: D. Barnhart (1993), Decision Analysis Software Helps Boeing Select
Supercomputer, 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 think
about possible alternatives.
Some decisions should be made immediately based on the
possible 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 decision
alternatives 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 several
sequential 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 be
whether to produce it in house or subcontract the production.
Once the production decision is made, there may be marketing
decisions 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 exactly
what 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 outcomes
Camping decision: It can rain or not rain.
Continuous outcomes
A 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 stock
market 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 current
decision, 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 event
has been resolved, the decision makers fate is determined.
The consequence is what happens with respect to each of the
objectives.
Profit or loss? Success or failure?
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Consequences
Looking forward from the current time and current decision, the
end of the time line is called the planning 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 your
decision context and relevant objectives.
How to value consequences?
Monetary value
Not every consequence can be translated into monetary
value. 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 may
spend 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
periods
r = interest rate per period
Present value of x:
n
r
x
r n x PV
) 1 (
) , , (
+
=
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Net Present Value (NPV) of a Cash Flow
Suppose that a friend of yours makes the following proposal to
you: 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
x
NPV
0
) 1 (
NPV for a stream of cash flows x
0
, x
1
,.., x
n
over n periods at
interest rate r is:
A negative NPV for a project indicates that the money would be
better invested to earn interest rate r.