Chapter 12 - Decision Analysis Chapter Topics

Components of Decision Making Decision Making without Probabilities Decision Making with Probabilities

Decision Analysis with Additional Information

Utility

Chapter 12 - Decision Analysis

Decision Analysis Components of Decision Making A state of nature is an actual event that may occur in the future. A payoff table is a means of organizing a decision situation, presenting the payoffs from different decisions given the various states of nature.

Table 12.1 Payoff Table Chapter 12 - Decision Analysis 2

Decision Analysis Decision Making without Probabilities

Decision situation:

Table 12.2 Payoff Table for the Real Estate Investments

Decision-Making Criteria: maximax, maximin, minimax, minimax regret, Hurwicz, equal likelihood
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Decision Making without Probabilities The Maximax Criterion

- In the maximax criterion the decision maker selects the decision that will result in the
maximum of maximum payoffs; an optimistic criterion.

Table 12.3 Payoff Table Illustrating a Maximax Decision Chapter 12 - Decision Analysis 4

Decision Making without Probabilities The Maximin Criterion

- In the maximin criterion the decision maker selects the decision that will reflect the maximum of the minimum payoffs; a pessimistic criterion.

Table 12.4 Payoff Table Illustrating a Maximin Decision

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Decision Making without Probabilities The Minimax Regret Criterion

- Regret is the difference between the payoff from the best decision and all other decision payoffs. - The decision maker attempts to avoid regret by selecting the decision alternative that minimizes the maximum regret.

Table 12.6 Regret Table Illustrating the Minimax Regret Decision

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Decision Making without Probabilities

The Hurwicz Criterion
- The Hurwicz criterion is a compromise between the maximax and maximin criterion. - A coefficient of optimism, , is a measure of the decision makers optimism.

- The Hurwicz criterion multiplies the best payoff by and the worst payoff by 1- ., for each decision, and the best result is selected.

Decision
Apartment building Office building

Values
$50,000(.4) + 30,000(.6) = 38,000 $100,000(.4) - 40,000(.6) = 16,000

Warehouse

$30,000(.4) + 10,000(.6) = 18,000

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Decision Making without Probabilities

The Equal Likelihood Criterion
- The equal likelihood ( or Laplace) criterion multiplies the decision payoff for each state of nature by an equal weight, thus assuming that the states of nature are equally likely to occur.

Decision Apartment building Office building Warehouse

Values $50,000(.5) + 30,000(.5) = 40,000 $100,000(.5) - 40,000(.5) = 30,000 $30,000(.5) + 10,000(.5) = 20,000

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Decision Making without Probabilities Summary of Criteria Results

- A dominant decision is one that has a better payoff than another decision under each state of nature.
- The appropriate criterion is dependent on the risk personality and philosophy of the decision maker. Criterion Maximax Decision (Purchase) Office building

Maximin
Minimax regret Hurwicz

Apartment building
Apartment building Apartment building

Equal liklihood

Apartment building
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Decision Making without Probabilities Solutions with QM for Windows (1 of 2)

Exhibit 12.1

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Decision Making without Probabilities Solutions with QM for Windows (2 of 2)

Exhibit 12.2

Exhibit 12.3

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Decision Making with Probabilities Expected Value

-Expected value is computed by multiplying each decision outcome under each state of nature by the probability of its occurance.

Table 12.7 Payoff table with Probabilities for States of Nature

EV(Apartment) = $50,000(.6) + 30,000(.4) = 42,000

EV(Office) = $100,000(.6) - 40,000(.4) = 44,000

EV(Warehouse) = $30,000(.6) + 10,000(.4) = 22,000
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Decision Making with Probabilities Expected Opportunity Loss

- The expected opportunity loss is the expected value of the regret for each decision. - The expected value and expected opportunity loss criterion result in the same decision.

Table 12.8 Regret (Opportunity Loss) Table with Probabilities for States of Nature

EOL(Apartment) = $50,000(.6) + 0(.4) = 30,000 EOL(Office) = $0(.6) + 70,000(.4) = 28,000 EOL(Warehouse) = $70,000(.6) + 20,000(.4) = 50,000
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Decision Making with Probabilities Solution of Expected Value Problems with QM for Windows

Exhibit 12.4

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Decision Making with Probabilities Solution of Expected Value Problems with Excel and Excel QM (1 of 2)

Exhibit 12.5

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Decision Making with Probabilities Solution of Expected Value Problems with Excel and Excel QM (2 of 2)

Exhibit 12.6

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Decision Making with Probabilities

Expected Value of Perfect Information The expected value of perfect information (EVPI) is the maximum amount a decision maker would pay for additional information.

EVPI equals the expected value given perfect information minus the expected value without perfect information.
EVPI equals the expected opportunity loss (EOL) for the best decision.

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Decision Making with Probabilities EVPI Example

Table 12.9 Payoff Table with Decisions, Given Perfect Information

Decision with perfect information: $100,000(.60) + 30,000(.40) = $72,000 Decision without perfect information: EV(office) = $100,000(.60) - 40,000(.40) = $44,000 EVPI = $72,000 - 44,000 = $28,000 EOL(office) = $0(.60) + 70,000(.4) = $28,000
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Decision Making with Probabilities EVPI with QM for Windows

Exhibit 12.7

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Decision Making with Probabilities Decision Trees (1 of 2)

- A decision tree is a diagram consisting of decision nodes (represented as squares), probability nodes (circles), and decision alternatives (branches).
Table 12.10 Payoff Table for Real Estate Investment Example

Figure 12.1 Decision tree for real estate investment example

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Decision Making with Probabilities Decision Trees (2 of 2)

- The expected value is computed at each probability node: EV(node 2) = .60($50,000) + .40(30,000) = $42,000 EV(node 3) = .60($100,000) + .40(-40,000) = $44,000

EV(node 4) = .60($30,000) + .40(10,000) = $22,000

- Branches with the greartest expected value are selected :
Figure 12.2 Decision tree with expected value at probability nodes

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Decision Making with Probabilities Decision Trees with QM for Windows

Exhibit 12.8 Chapter 12 - Decision Analysis 22

Decision Making with Probabilities Decision Trees with Excel and TreePlan (1 of 4)

Exhibit 12.9

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Decision Making with Probabilities Decision Trees with Excel and TreePlan (2 of 4)

Exhibit 12.10

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Decision Making with Probabilities Decision Trees with Excel and TreePlan (3 of 4)

Exhibit 12.11 Chapter 12 - Decision Analysis 25

Decision Making with Probabilities Decision Trees with Excel and TreePlan (4 of 4)

Exhibit 12.12 Chapter 12 - Decision Analysis 26

Decision Making with Probabilities Sequential Decision Trees (1 of 2)

- A sequential decision tree is used to illustrate a situation requiring a series of decisions. - Used where a payoff table, limited to a single decision, cannot be used. - Real estate investment example modified to encompass a ten-year period in which several decisions must be made:

Figure 12.3 Sequential decision tree

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Decision Making with Probabilities Sequential Decision Trees (2 of 2)

- Decision is to purchase land; highest net expected value ($1,160,000).
- Payoff of the decision is $1,160,000.

Figure 12.4 Sequential decision tree with nodal expected values Chapter 12 - Decision Analysis 28

Sequential Decision Tree Analysis with QM for Windows

Exhibit 12.13

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Sequential Decision Tree Analysis with Excel and TreePlan

Exhibit 12.14 Chapter 12 - Decision Analysis 30

Decision Analysis with Additional Information Bayesian Analysis (1 of 3)

- Bayesian analysis uses additional information to alter the marginal probability of the occurence of an event. - In real estate investment example, using expected value criterion, best decision was to purchase office building with expected value of $444,000, and EVPI of $28,000.

Table 12.11 Payoff Table for the Real Estate Investment Example Chapter 12 - Decision Analysis 31

Decision Analysis with Additional Information Bayesian Analysis (2 of 3)

- A conditional probability is the probability that an event will occur given that another event has already occurred. - Economic analyst provides additional information for real estate investment decision, forming conditional probabilities: g = good economic conditions p = poor economic conditions P = positive economic report N = negative economic report P(Pg) = .80 P(Ng) = .20 P(Pp) = .10 P(Np) = .90
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Decision Analysis with Additional Information Bayesian Analysis (3 of 3)

- A posteria probability is the altered marginal probability of an event based on additional information.
-Prior probabilities for good or poor economic conditions in real estate decision: P(g) = .60; P(p) = .40 - Posteria probabilities by Bayess rule: P(gP) = P(PG)P(g)/[P(Pg)P(g) + P(Pp)P(p)] = (.80)(.60)/[(.80)(.60) + (.10)(.40)] = .923 - Posteria (revised) probabilities for decision: P(gN) = .250 P(pP) = .077 P(pN) = .750

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Decision Analysis with Additional Information Decision Trees with Posterior Probabilities (1 of 2)
- Decision tree below differs from earlier versions in that : 1. Two new branches at beginning of tree represent report outcomes;

2. Probabilities of each state of nature are posterior probabilities from Bayess rule.

Figure 12.5 Decision tree with posterior probabilities

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Decision Analysis with Additional Information Decision Trees with Posterior Probabilities (2 of 2)
- EV (apartment building) = $50,000(.923) + 30,000(.077) = $48,460 - EV (strategy) = $89,220(.52) + 35,000(.48) = $63,194

Figure 12.6 Decision tree analysis

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Decision Analysis with Additional Information Computing Posterior Probabilities with Tables

Table 12.12 Computation of Posterior Probabilities

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Decision Analysis with Additional Information

The Expected Value of Sample Information
The expected value of sample information (EVSI) is the difference between the expected value with and without information.: For example problem, EVSI = $63,194 - 44,000 = $19,194 The efficiency of sample information is the ratio of the expected value of sample information to the expected value of perfect information: efficiency = EVSI /EVPI = $19,194/ 28,000 = .68

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Decision Analysis with Additional Information Utility

Table 12.13 Payoff Table for Auto Insurance Example

Expected Cost (insurance) = .992($500) + .008(500) = $500 Expected Cost (no insurance) = .992($0) + .008(10,000) = $80 - Decision should be do not purchase insurance, but people almost always do purchase insurance. - Utility is a measure of personal satisfaction derived from money. - Utiles are units of subjective measures of utility.

- Risk averters forgo a high expected value to avoid a low-probability disaster.

- Risk takers take a chance for a bonanza on a very low-probability event in lieu of a sure thing.
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Example Problem Solution (1 of 7)

States of Nature Decision Expand Maintain Status Quo Sell now Good Foreign Competitive Conditions $800,000 1,300,000 320,000 Poor Foreign Competitive Conditions $500,000 -150,000 320,000

a. Determine the best decision without probabilities using the 5 criteria of the chapter. b. Determine best decision with probabilites assuming .70 probability of good conditions, .30 of poor conditions. Use expected value and expected opportunity loss criteria. c. Compute expected value of perfect information. d. Develp a decision tree with expected value at the nodes. e. Given following, P(Pg) = .70, P(Ng) = .30, P(Pp) = 20, P(Np) = .80, determine posteria probabilities using Bayess rule. f. Perform a decision tree analysis using the posterior probability obtained in part e.
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Example Problem Solution (2 of 7)

Step 1 (part a): Determine Decisions Without Probabilities Maximax Decision: Maintain status quo Decisions Expand Status quo Sell Maximum Payoffs $800,000 1,300,000 (maximum) 320,000

Maximin Decision: Expand Decisions Expand Status quo Sell Minimum Payoffs $500,000 (maximum) -150,000 320,000
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Example Problem Solution (3 of 7)

Minimax Regret Decision: Expand Decisions Expand Status quo Sell Hurwicz ( = .3) Decision: Expand Expand Status quo Sell $800,000(.3) + 500,000(.7) = $590,000 $1,300,000(.3) - 150,000(.7) = $285,000 $320,000(.3) + 320,000(.7) = $320,000 Maximum Regrets $500,000 (minimum) 650,000 980,000

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Example Problem Solution (4 of 7)

Equal Liklihood Decision: Expand Expand Status quo $800,000(.5) + 500,000(.5) = $650,000 $1,300,000(.5) - 150,000(.5) = $575,000

Sell

$320,000(.5) + 320,000(.5) = $320,000

Step 2 (part b): Determine Decisions with EV and EOL

Expected value decision: Maintain status quo

Expand Status quo $800,000(.7) + 500,000(.3) = $710,000 $1,300,000(.7) - 150,000(.3) = $865,000

Sell

$320,000(.7) + 320,000(.3) = $320,000

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Example Problem Solution (5 of 7)

Expected opportunity loss decision: Maintain status quo Expand Status quo $500,000(.7) + 0(.3) = $350,000 0(.7) + 650,000(.3) = $195,000

Sell

$980,000(.7) + 180,000(.3) = $740,000

Step 3 (part c): Compute EVPI

EV given perfect information = 1,300,000(.7) + 500,000(.3) = $1,060,000

EV without perfect information = $1,300,000(.7) - 150,000(.3) = $865,000 EVPI = $1.060,000 - 865,000 = $195,000

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Example Problem Solution (6 of 7)

Step 4 (part d): Develop a Decision Tree

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Example Problem Solution (7 of 7)

Step 5 (part e): Determine Posterior Probabilities
P(gP) = P(Pg)P(g)/[P(Pg)P(g) + P(Pp)P(p)]

= (.70)(.70)/[(.70)(.70) + (.20)(.30)] = .891

P(p P) = .109 P(gN) = P(Ng)P(g)/[P(Ng)P(g) + P(Np)P(p)] = (.30)(.70)/[(.30)(.70) + (.80)(.30)] = .467

P(pN) = .533

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Step 6 (part f): Perform Decision tree Analysis with Posterior Probabilities

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