Decision Analysis

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3 – Decision Analysis

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Decision analysis is concerned with establishing systematic procedures for making decisions under uncertainty. Knowledge of decision analysis should help analyze a problem in a complicated and uncertain setting, to develop alternatives, and to identify possible outcomes. The decision maker then selects the alternative that best meets his or her objectives and psychological desires. Decision analysis is important because it provides decision makers with a rational way of making a selection. It does not guarantee an optimal decision since the problems are characterized by at least some uncertainty. However, it can indicate which alternative is most suited to the decision maker’s own philosophy, be it optimistic, pessimistic, or somewhere in between. 3 – Decision Analysis 2

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Applications of decision analysis are widespread such as selection of investment portfolios oil and gas exploration (to drill or not to drill) contracting (to bid or not to bid) agriculture (which crops to plant) manufacturing (which products to produce, how much to produce, which technology to invest) marketing (new products, promotion strategies), & so on.

3 – Decision Analysis

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A list of alternatives. A list of possible future states of nature. Payoffs associated with each alternative/state of nature combination. An assessment of the degree of certainty of possible future events. A decision criterion.

The list of alternatives must be the set of mutually exclusive and collectively exhaustive decisions that are available to the decision maker. Sometimes, but not always, one of these alternatives will be do nothing. 3 – Decision Analysis 4

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States of nature refer to a set of possible future conditions, or events, beyond the control of the decision maker that will be the primary determinants of the eventual consequence of the decision. The states of nature, like the list of alternatives, must be mutually exclusive and collectively exhaustive.

In order for a decision maker to be able to rationally approach a decision problem, it is necessary to have some idea of the payoffs that would be associated with each decision alternative and the various states of nature. The payoffs might be profits, revenues, costs, or other measure of value. Usually the measures are financial. They may be weekly, monthly, or annual amounts, or they might represent present values of future cash flows. Usually payoffs are estimated values. The more accurate these estimates, the more useful they will be for decisionmaking purposes and the more likely it is that the decision maker will choose an appropriate alternative. The number of payoffs depends on the number of alternative/state of nature combinations. 3 – Decision Analysis 5

The approach used by a decision maker often depends on the degree of certainty that exists. There can be different degree of certainty. One extreme is complete certainty and the other is complete uncertainty. The latter exists when the likelihood of the various states of nature are unknown. Between these two extremes is risk, a term that implies that probabilities are known for the states of nature. Knowledge of the likelihood of each of the states of nature can play an important role in selecting a course of action. Thus, if decision maker feels that a particular state of nature is highly likely, this will mean that the payoffs associated with that state of nature are also highly likely. Consequently, probability estimates for the various states of nature can serve an important function if they can be obtained. In some situations, accurate estimates of probabilities may not be available, in which case the decision maker may have to find a way to estimate the probabilities or select a course of action without the benefit of probabilities. 3 – Decision Analysis 6

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The process of selecting one alternative from a list of alternatives is governed by a decision criterion, which embodies the...
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