Elements of Decision Problems

1. Elements of Decision Problems Dr. Yan Liu Department of Biomedical, Industrial & Human Factors Engineering Wright State University

2. Elements of Decision Problem • Values and Objectives • Decisions to Make (and Alternatives) • Uncertain Events (and Outcomes) • Consequences

3. Values and Objectives • Values • What the decision maker cares about in the current decision context • Values should drive decisions (value-focused thinking) • Objectives • The specific things to be achieved • Features of objectives • Object • A direction of preference One objective of a forest company is “ to minimize environmental impacts” Object: Environmental impact Direction of preference: Less impact rather than more

4. Values and Objectives (Cont.) • Multiple Objectives • Some objectives can be related • e.g. Improving the image of a company may in turn bring it more profits • There can be tradeoffs among multiple objectives • e.g. Economic benefits gained by using chemical insecticide lead to health risk • A requisite model includes all objectives that matter and only those that matter in the decision context at hand

5. Boeing Example Boeing needs computing power for a number of tasks, including accounting and word processing, CAD, inventory control and tracking, and manufacturing support. When the company’s engineering department needed to expand its high-power computing capacity by purchasing a supercomputer, the manager faced a huge task of assembling and evaluating massive amounts of information. There were system requirements and legal issues to be considered, as well as price and a variety of management issues. What are the values and objectives of Boeing?

6. Decision Context • To acquire computing capacity for its engineering needs Values • Costs, performance, user needs, operational needs, and management • Objectives • Minimizing costs • Maximizing performance • Satisfying user needs • Satisfying operational needs • Satisfying management issues

7. Decisions to Make • Think about All Possible Alternatives (Be Creative !) • Specific alternatives • e.g. Purchasing or leasing a car • Choose a specific value out of a range of possible values • e.g. Deciding the amount of money to invest in a project • Consider the possibility of no action and of waiting to obtain more information

8. Decisions to Make (Cont.) • Sequential Decisions • Multiple decisions are ordered sequentially • Dynamic decisions: a future decision may depend on exactly what happened before • e.g. First decide purchase or lease a car, next decide what kind of car to purchase or lease, then decide where to get the car, … • It is important to identify the order in which the decisions occur Last Decision Third Decision Second Decision First Decision Time Line Now Planning Horizon

9. Uncertain Events • Uncertainty about the future makes decision problems hard • It is important to focus on only the relevantuncertain events • The possible outcomes can be finite or within some range of values • e.g. whether it will rain or not, the profits of a company in the next year • Complicated decision problems can involve interdependent uncertain events • e.g. The interest rate of car mortgage depends on the market economy status

10. Resolved after the last decision Resolved before the last decision Resolved before the second decision Resolved before the third decision Uncertain Events Last Decision Third Decision Second Decision First Decision Planning Horizon Time Line Now Uncertain Events (Cont.) • The time sequence of uncertain events in sequential decisions is critical • What events are unknown and what information is available before a decision is made

11. Consequences • The final results after the last decision has been made and the last uncertain event has been resolved • Planning Horizon • The end of the time line when the final consequences are revealed • How far to look into the future? • Choosing a planning horizon that is consistent with the decision context and relevant objectives • Valuing Consequences • Often in terms of monetary values • e.g. cost, profit • Nonmonetary values • e.g. public image, goodwill • Tradeoffs among multiple objectives

12. Payoff Table • A useful means of organizing a decision situation, presenting the payoffs from different decisions given various outcomes

13. Time Value of Money • The value of a dollar depends on when it is available to the decision maker • Investing dollars at different points in time is a special tradeoff (Why?) • Present Value (PV) of Cash Flow • PV of amount x at the end of n time periods r: interest rate per time period

14. $1,500/(1+0.05/12)36 = $1,291.46 monthly interest rate Suppose a savings account pays 5% simple annual interest and you will receive $1,500 at the end of three years from now, then the PV of the $1,500 is $1,500/(1+0.05)3= $1,295.76 Suppose a savings account pays 5% annual interest compounded monthly and you will receive $1,500 at the end of three years from now, then the PV of the $1,500 is

15. Time Value of Money (Cont.) • Net Present Value (NPV) • The PV of the cash flows minus the cost of the deal NPV for a stream of cash flows x0, x1,… xn over n periods at interest rate r is: Initial Cost Suppose a business deal costs $2,500 today and will return $1,500 at the end of this year and $1,700 at the end of the following year. If the annual interest rate is 13%, then the NPV of the deal is = -2500/(1.13)0 + 1500/(1.13)1 +1700/(1.13)2 = $158.78 > 0 Negative indicates cost